Return on investment (ROI);how to apply the concept in practice

Return on investment (ROI) is a metric used to identify how much the company has financial income from any investment made.It is through it that the company finds out what was the gain (or loss) obtained to cover the costs involved in the application of the resources and still have a financial return (if any).

How to calculate ROI?

Calculating ROI is simple. Initially, the gain from the investment is subtracted from the amount invested, and then the result is divided by the same amount of investment. Thus, the formula is as follows:

  • ROI = (Profit obtained – Investment) / Investment

So, if an application yields a gain of $ 200,000 and the initial investment was $ 40,000, we have to:

(200,000 – 40,000) / 40,000 = 4

This means that the return on investment was four times the amount initially applied. Since ROI is usually expressed as a percentage, this result is multiplied by 100. Thus, in the example above, ROI was 400%.

It is important to note that the amount invested initially must include absolutely all the money used during the process, as well as all the amount received. If the objective is to have an accurate result, all expenses, however small, must be included in the calculation, as well as all revenu.

Advantages and disadvantages of ROI

Benefits

  • It is the best profitability indicator

ROI relates to the net profit of investments in a relative way, giving a better measure of profitability by situation. With this, investors are able to know and compare exactly how is their performance in each of their applications, encouraging them over time to be better. ROI is an important tool for measuring efficiency in decisions and resource allocation.

Thus, it can be said that the main focus of ROI is to show that in a given period of time, there will be an optimal level of investment in each asset that helps to maximize profit for any type of application. Such a cost-benefit analysis helps investors discover the rate of return that can be expected from different investment options. This allows you to choose an investment that will improve the performance of your portfolios, as well as allow for the effective use of existing investments.

  • Makes comparative analysis easier

ROI helps to compare different types of investments in terms of profitability and asset utilization. It can be used as a basis for classifying different applications, as long as they are of the same type and have a similar size. Therefore, ROI allows the relative cost of capital for each to be easily compared, allowing the identification of the best investment opportunities.

  • Ease of calculation

ROI is based entirely on financial data that is widely used in accounting. That is, it is not necessary to collect new numbers or metrics to generate information for its calculation. All the numbers needed to conduct an ROI study are already easily available in conventional financial statements. Adjustments to some existing information may be necessary, but this does not pose any problem in calculating ROI.

Disadvantages

  • Difficulty in defining key concepts

ROI works, respectively, with the concepts of “profit” and “investment”. However, it is often difficult to define correctly what these terms are, as well as to find them satisfactorily. Profit, for example, can be several things: gross profit, operating profit, profit before interest and taxes, financial profit, profit after deducting all costs. Likewise, long-term investment can have different connotations, such as gross value, net value, historical cost of assets, the current cost of material goods, including or excluding intangible assets.

  • Incompatibility in analyzing different investments

When analyzing the ROI of different assets together, the investor must strive to use compatible and similar data. Usually different types of investments have their own metrics and profitability calculations, which makes it difficult for them to be placed side by side to be compared.

  • Long-term investment disadvantage

ROI provides an analysis more focused on short-term profitability, ignoring long-term investments and more passive profitability. This is because ROI considers only revenues and costs for the current period and does not include in its calculation how these expenses and investments may affect the long-term profitability of the asset.

ROI can influence the investor to select only investments with high rates of return (that is, rates that are at or above the ROI used as the basis). This may mean that other investments that possibly reduce the portfolio’s ROI, but that on the other hand could increase the value in the long run, are at risk of being rejected. This type of decision turns out to be inefficient over time, and can distort the optimal allocation of resources, motivating the investor to make an investment just to preserve his existing ROI.

When and where ROI should be used

ROI is indicated for:

Evaluate simple investment situations, which have only one inflow (investment) and one outlet (return), such as investment in a fixed income security.

Analyze more complex business scenarios, where there are several cash inflows / outflows throughout the life of the investment, such as investing to set up a company, for example.

  • Simple investments of two events:

For direct investment scenarios, where there is only one outflow (income) and one inflow (investment), the data for calculating ROI is simple: (1) The cash inflow value and (2) the cash outflow.

As an example, consider the question:

What is the ROI on a player’s winning bet in a horse race?

In this case, immediately before the race, the bettor places a $ 10 bet on horse 4 and then horse 4 finishes the race first. The reward for a winning bet depends, of course, on the odds in effect when the betting period closes, but suppose that in this case the winning bet pays $ 24. So, for this simple investment:

ROI = (24-10) / 10 = 140%

There is a cash outflow (the $ 10 bet) and a cash inflow ($ 24 reward). Both events are caused directly by the investment action (the bet), thus making the ROI application valid. The calculation of ROI here is not concerned with the length of time between departure and arrival, nor with the investment risks or the desirability of making such an investment.

The two-event ROI model can also be applied to other types of simple-flow investments, such as the purchase of securities in the financial market, assets, real estate, works of art, among others.

  • Complex multi-event investments

The ROI metric is also often used in business to assess questions about the viability of stocks viewed as investments. The fact that this type of investment involves having multiple cash inflows and outflows over a long period of time that can extend over many years makes your calculation more comprehensive. In this case, the data needed to find the ROI are the sum of investment costs over the entire investment period, and the sum of investment returns for that same period.

For the case of a bakery, for example, where the initial investment plus capital contributions for 5 years add up to $ 100,000, and the sum of its turnover during that same period is $ 215,000, the ROI is calculated by:

ROI = (215-100) / 100 = 21.5%

Therefore, the figure of 21.5% must be described as the “5-year ROI” for investment in a bakery. It is necessary to designate the investment period in this case, because it was also possible to calculate the ROI for other investment periods, such as the 3-year ROI.

It can be seen that the ROI result for the entire 5-year period is not concerned with the timing of inflows and outflows within the designated investment period. This contrasts with other investment valuation metrics, such as NPV, IRR and payback, which take into account the cash flow time within the investment period over several years.

The return on investment calculation of this type can cover a very wide range of investments, such as: investments in business, in technology development, in marketing programs, in professional training, among others.

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