In our last article, we have discussed how to calculate the total assets turnover ratio to know how effectively a company is using its assets to generate sales. To compare a company’s net profit with the total investments or assets, analysts calculate return on investment ratio. Its popularly known as ROI.
Return on investment (ROI) is a performance measure that evaluates management’s efficiency by comparing net profit with the total assets.
Net profit measures the performance of the business/company. So, ROI represents what percentage you get back compared to what you put in. This indicates the capability of the company to generate a return on new investments.
Don’t get confused ROI with return on the owner’s equity. It’s a different comparison.
Formula to calculate return on investment or ROI
Return on investment is calculated by dividing net profit by total assets or investments.
Here is the formula:
Return on investment or ROI = (net profit / total assets)*100
If I multiply sales/sales to the above equation, then we will arrive at the following arithmetic equation:
Return on Investment or ROI = (net profit/total assets)* (sales/sales)
= (net profit / sales ) * (sales / total assets)
= Net profit margin * total assets turnover
The significance of the relationship between the net profit margin and total assets turnover can be seen in the above equation. This means, if my net profit margin is high, then with a good total asset turnover ratio, I can have a better return on investments.
Similarly, if the net profit margin is low and the company has a low total assets turnover, then the business will have low ROI.
Any impact on the net profit margin or sales of the company will have a similar reflection on return on investments.
If company XYZ has a net profit of Rs 1,00,000 and total assets invested is Rs 3,00,000 then ROI for the year would be 0.33 or 33%. Which is calculated dividing Rs 1,00,000 by Rs 3,00,000.
Return on investment or ROI = ( 1,00,000/3,00,000 ) * 100
This also indicates that if you invest another Rs 2,00,000 into the business then your chances of getting a return are Rs 66,000.
If your assets are not generating profit in comparison to other players in the industry, then you will lose money if invested more money into it.
Analysis of Return on Investment ratio
The goal of the investment is to make a profit. Due to this reason, it’s always better to measure your return in comparison to investments. ROI is a profitability ratio calculated to measure return in comparison to investments.
As discussed above, we calculate return on investment to know how well a company uses its total assets to generate profit. To analyze the effectiveness of the management or company, we need to compare it with the industry standards and with its competitors.
If the ROI is high in comparison to its competitors or industry standards, then it indicates that the company is very effective in managing assets and the cost of the company. A higher sales in comparison to total assets and higher net profit in comparison to sales will give your higher ROI.
Similarly, a low net profit margin and low sales in comparison to total assets will give you a low return on investments. To have a higher ROI, you need to improve the net profit margin and sales of the company by managing the costs and assets of the company effectively.
ROI is always expressed as a percentage of the investments. You can also use it to make personal financial decisions.
As an investor, you can use it to calculate the return on stocks. For instance, if you have invested Rs 1,00,000 in stock of a company and sell it for Rs 1,20,000, then net profit for the invested amount is Rs 20,000.
For this example, Return on investment would be calculated as follows:
Return on Investment (ROI) = (20,000/1,00,000)*100 = 20%
You can recalculate it if any expenses are incurred by you and taxes are paid. In this case, formula to calculate ROI would be:
Return on Investment (ROI) = ( Proceeds obtained by selling Investments – Cost of investments ) / Cost of investments = profit / original costs of investment
Instead of investing in stock, if you bought a house property valued Rs 50,00,000. Five years later you sold it for Rs 100,00,000. By using above formula your ROI = [(100,00,000-50,00,000) / 50,00,000]*100 = 100%. This means it has given you 100% return in five years.
Calculating the expected return on investment (ROI) before investing will help you to know whether to take or skip the investment opportunity. If it’s positive, then it’s an indication that the result will be favorable to you. Please note, ROI does not take risk into consideration as it’s calculated on actual return, not on future expected return.
If the company was financed only by equity shareholders, then the rate of return on investments (ROI) and the return on equity (ROE) would be the same because total assets would be equal to equity share capital.
Use of ROI on personal investments
Return on investments (ROI) is also used as a financial ratio between net earnings and the cost of investment. ROI measures the amount of return on an investment, relative to your investment’s cost.
ROI is the best way of relating gains/profits on investment to capital invested. You can easily assess the benefit an investor will receive in relation to their investment cost.
To calculate return on investment, you need to divide the return of investment by its cost. The resultant figure is expressed as a percentage of ratio.
Return on investment = Net Income / Cost of investment = (gain from investment – cost of investment) / cost of investment
A high return on investment (ROI) means your investments have gains compare to its cost.
Why use ROI for investments
Here are the most important reasons why ROI is used in investments;
- It simple and easy to calculate;
- Return on Investment (ROI) helps you to evaluate the performance of your investment and compare it to others;
- to measure the rate of return on money invested. and to compare it with the expected rate of return on money invested;
- it helps to decide whether or not to make further investments;
- used as an indicator to compare different investments within your portfolio.
One of the biggest problems of the return on investment (ROI) ratio is it disregards the factor of time.
A higher return on investment (ROI) ratio does not always mean a better investment option.
While comparing, you need to consider the period of return. For instance, if you are comparing 3 years’ return on investment with 2 years ROI, it does not make sense. Therefore, while comparing two investments under the same period and the same circumstance must be considered.