Term

What is Return on Investment (ROI)?

3 MIN READ

Return on Investment (ROI)

ROI, which is an abbreviation for return on investment, is a metric that measures how much money a business has earned or lost in relation to the initial investment. Using ROI, business owners can decide whether the investment is worth making and see the profitability of each business unit that can help to optimize their operations and increase earnings.

Many enterprises use ROI because it is simple and versatile. Once calculated, ROI is a useful metric for both business owners and investors because they can see whether the business is profitable and worth investing money. For example, if there is a clothing store that has a 20% ROI and another similar store with ROI of 5%, investors will tend to put their money in the store that brings more profit.

Calculation of ROI 

The formula to calculate ROI is quite simple. To calculate ROI you need to divide net profit by the cost of investment and multiply by 100%. Net profit is calculated by subtracting the cost of investment from the investment’s current value.

For example, let’s say that you have purchased an old car worth 500$. After certain renovations that cost you an additional 400$ and made this car worth 900$, you sell this car for 2.500$. A formula for this case will look as follows:

(($2.500 – $900) / $900) x100

ROI = 177.7%

The same way ROI can be calculated for anything, from stock investments to marketing campaigns. and because it is flexible and clear many enterprises use ROI to calculate their profits.

Advantages and disadvantages of ROI

As well as with any other formula, there are advantages and disadvantages of ROI.

Advantages:

  • Simple. The formula of ROI is not complicated and can be defined without even using any specific devices.
  • Flexible. ROI is designed not only for the business but also for individuals that invested in something (house renovation, purchase of vintage furniture)
  • Clear. If the ROI is positive then you gain profit, if not, then you gain loss.

Disadvantages:

  • Time neglect.  ROI doesn’t consider the holding period and therefore investors will always be uncertain about long-term investments.
  • Human error. If the wrong input values are used, the ROI can be inaccurate and misleading.
  • Variance.  While calculating ROI, business owners should take into account factors like interest, tax, and gross profit. Keeping these factors in mind makes it more difficult to compare the company’s ROI with the competitor’s.

 

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