Return on investment or ROI, as we commonly call it, is a financial ratio and is also known as Return on assets ratio. It is usually calculated in a percentage (%) form and is used for calculating the percentage of net income in comparison to the net cost incurred.
It is a positively-sloped ratio i.e. the more the net income, the higher the ratio. In business terms, it lets the owner to assess how well the company has used its total assets to generate the given sales figure. Total assets include both current assets like cash and fixed assets like plant and machinery, etc.
How to calculate Return on Investment?
As we already know, it is the percentage of net income when compared to net cost incurred. We can define the formula in the following two ways –
ROI = Net Income / Cost of Investment
ROI = Investment Gain / Investment Base
Benefits of Return on Investment
Following are the many benefits of using ROI-
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It involves only two figures and is customizable because cost of investment is different for different people. So it lets us take any Cost of investment as per convenience.
- Universally acknowledged
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Everyone understands net income and cost incurred. There is no need to change the formula for anyone. This makes it easier for people from any part of the world to understand it.
Limitations of Return on Investment
Though being very easy to calculate, it has a few shortcomings which make it difficult to rely upon it –
- Difference in perception of two different people
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Since it allows customizability in terms of cost incurred calculation, it can be misinterpreted by people. Like the sales manager may ignore some costs so as to show a higher ROI. This cannot be concluded to be incorrect but still doesn’t show the entire picture.
- Ignoring the Time factor
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ROI, in its original form, ignores the time factor. You may see a 200% ROI but if you dive deeper you will realize that the return is for 10 years. The formula will never disclose this to you.
People who don’t understand financial ratio may be misguided by this information. To overcome this shortage, Annualized ROI can be used.
Annualized ROI, a much more reliable sibling
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Annualized ROI calculates the average return for an year of investment. It takes the time factor into consideration and is hence, much more reliable. Like in the above paragraph, 200% return is spread over 10 years and you cannot tell that while seeing the traditional ROI.
Annualized ROI, on the other hand will show you the true picture by dividing the return with the number of years, 200% / 10 years = 20%. This answer is much more relevant.
ROI is mostly being used because of being versatile and simple at the same time. It is calculated to get a quick overview of the situation. But looking at its drawbacks, it’s very difficult to use it on a long term basis. You can instead opt for Internal Rate of Return (IRR) which is a much more dependable method of calculating your returns.