How to calculate return on investment (ROI)

In our last article we have discussed how to calculate total assets turnover ratio to know how effectively 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 which 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 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:

ROI = (net profit / total assets)*100

If i multiply sales/sales to the above equation, then we will arrive at following arithmetic equation:

ROI = (net profit/total assets)* (sales/sales)

      = (net profit / sales ) * (sales / total assets)

      = Net profit margin * total assets turnover

The significance of relationship between 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 net profit margin is low and the company has a low total assets turnover, then business will have low ROI.

Any impact on net profit margin or sales of the company will have similar reflection on return on investments.

Example

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.

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 return is 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 ROI

Goal of the investment is to make profit. Due to this reason, its 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 analyse 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 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 low return on investments. To have a higher ROI, you need to improve net profit margin and sales of the company by managing costs and assets of the company effectively.

ROI is always expressed as a percentage to the investments. You can also use it to take personal financial decision.

As a investors 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:

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:

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 expected ROI before investing will help you to know whether to take or skip the investment opportunity. If its positive, then it’s a indication that result will be favorable to you. Please note, ROI does not take risk into consideration as its calculated on actual return not on future expected return.

If the company were financed only by equity shareholders, then the rate of return on investments (ROI) and the return on equity (ROE) would be same because total assets would be equal to equity share capital.