Return on Investment (ROI) is one of the most common ratios to help determine the efficiency of an investment. ROI ratio is calculated by dividing net profit with the cost of investment. ROI isn’t the same as profit or owner’s equity. It tells you about the money that you invested in the company and the return you can hope to get depending on the net profit.
ROI represents the amount of benefit you can hope to gain from an investment. It measures what you might get back compared to what you put in in the first place. The idea of ROI is to ensure that you can get the maximum amount of return for investing little. It may sound like a profit when you indicate that you need to earn more than what you spent, but it’s different. You’ll find out how if you read the entire thing.
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Return on Investment
The ROI calculation is pretty flexible and can be altered depending on the person who’s using it to calculate his or her estimated return on a stock or potential investment. Higher ROI indicated to higher gain from an investment. ROI is usually represented as a ratio and it can be calculated by dividing the amount one can gain from an investment by the said amount of investment.
For example, if you spend $100 per week on your advertisement campaign and manage to earn $300 per week because of that advertisement, then your ROI would be ($300÷$100) = $3. So your ROI, in this case, is $3 or if shown in ratio, it would be 3:1. In simpler words, it means that for every $1 you spend on your advertisement, you’ll earn $3.
You can use ROI in your business to determine how much money you should spend on the entire business plan that will provide you with the best results. ROI can also point out your expenses to help with your decisions. How much money should you spend on a new line? Will it generate enough for the next shipment? Is it ideal to spend more on IT? Will it lead to you earning more or cause loss?
These are the questions you can get answered through ROI calculation. It helps you with forecasting the monetary aspects of your business.
ROI is used mostly because of its simplicity and flexibility. This also means that it can be easily manipulated and cause the results to vary among different people who use it. Still, ROI has proved to be quite helpful in the business area as it can help you understand what the most beneficial step is.
For example, if you calculate that your investment in the new warehouse will not help you to generate enough profit rather it can lead you to lose your funds, then you’d reconsider your business decisions. Here, ROI is the tool for your forecast. Here are some of the factors where you can use ROI:
- Compare multiple opportunities for investment and select the one with the best results
- Helps you to understand the rate of profitability in an investment
- With the help of ROI, you can evaluate your previous or current investments to find out how they’ve performed
- You can separate low-performing investments from your high-performers and make necessary adjustments
- You can optimize your investments in the best way with the help of ROI
- ROI can help with detecting weaknesses in individual assets that are connected with inventories
ROI has proven to be rather useful in forecasting the financial state of a business but there are limitations to using this simple yet effective formula. Higher ROI cannot always indicate a better investment decision as ROI doesn’t take the factor of time into account.
For example, you decide to invest in two options where they indicate the same rate of ROI but the time is different for both. One is a six-month investment whereas the other is for one year. Here, the ROI might be the same but when you compare the time, you can dissect the better option. In this case, ROI will not generate the correct result.
We already mentioned that ROI is flexible in the calculation, which also means that it can be manipulated. Best results for ROI depend on the person using it.
If a manager decides to calculate the ROI with the basic expense and expected revenue without taking any additional costs into account. The result will not be an optimum one. An investor needs an accurate ROI result for taking the correct investment decision.
Profit and Return on Investment
There are similarities between profit and ROI formula and you can easily confuse one with the other. However, profit helps to determine the performance of a business and ROI is used to find out the amount you can generate depending on your net profit on the business.
Profit solely focuses on the income you can generate based on your expenses. ROI takes profit and investment cost into account for generating a result. We already mentioned how you can calculate ROI, by dividing the amount you will gain from an investment with the amount you spent on said investment.
To calculate profit, you subtract your total expense from your total income. This tells you how much you earned from your activity but doesn’t make the initial investment into account. ROI uses the profit to determine the best investment decision. Hopefully, this cleared out any confusion you had regarding ROI and profit calculation.
In conclusion, ROI is mostly used in the business field for its simple calculation and effectiveness even with the presence of certain limitations. ROI can help an investor by acting as a guide as to where to put the money.
When you’re operating a business, you need to determine the best approach that can benefit both you and everyone associated with your business. If you can figure out a way to work around the limitations provided by ROI. It is undoubtedly the best tool to use to help with your decision-making.