Return on Investment (ROI)

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Definition

Return on investment (ROI) is performance measure used to evaluate the efficiency of investment. It compares the magnitude and timing of gains from investment directly to the magnitude and timing of investment costs. It is one of most commonly used approaches for evaluating the financial consequences of business investments, decisions, or actions.

If an investment has a positive ROI and there are no other opportunities with a higher ROI, then the investment should be undertaken. A higher ROI means that investment gains compare favorably to investment costs.

ROI is an important financial metric for:

  • asset purchase decisions (such as computer systems, machinery, or service vehicles)
  • approval and funding decisions for projects and programs of different types (for example marketing programs, recruiting programs, and training programs)
  • traditional investment decisions (for example management of stock portfolios or the use of venture capital).

Calculation (Formula)

To calculate return on investment, the benefits (or returns) of an investment are divided by the costs of the investment. The result can be expressed as a percentage or a ratio.

Return on Investment (ROI) = (Gains from Investment – Cost of Investment) / Cost of Investment

It should be noted that the definition and formula of return on investment can be modified to suit the circumstances -it all depends on what is included as returns and costs. For example to measure the profitability of a company the following formula can be used to calculate return on investment.

Return on Investment = Net profit after interest and tax / Total Assets

Norms and Limits

One drawback of ROI is that it by itself says nothing about the likelihood that expected returns and costs will appear as predicted. Neither does it say anything about the risk of an investment. ROI simply shows how returns compare to costs if the action or investment brings the expected results. Therefore, a good investment analysis should also measure the probabilities of different ROI outcomes. It is important to consider both the ROI magnitude and the risks that go with it.

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