This article explains Return On Investment or ROI in a practical way. After reading you will understand the basics of this powerful financial management tool.
What is Return on investment (ROI)?
Running a business and making investments are inextricably linked with one another. Running a business includes making continuous (re)investments and taking acceptable risks the purpose of which is to generate turnover and making a profit. One of the instruments that can be used in this is Return On Investment or ROI. Return On Investment or ROI is used to indicate the ratio between the return that is realized and the money that is invested.
Prior to the question whether an investment should be made and whether this investment is the right investment, some questions should be asked, but even then the outcome depends on the questions asked and their mutual importance or interrelationship.
Examples of possible questions:
- To what extent is the investment effective, and does the organization get value for money?
- What are the direct costs?
- What are the indirect costs?
- What are the possible opportunity costs, if any?
- To what extent is the investment efficient; can we get more and better things with the same money?
- Is the investment justified; does this yield enough profit for our target group (in the case of a company for instance the owners, shareholders; in the case of a government institution for instance the citizens, the government itself)?
Return On Investment formula
The return on investment or ROI formula is as follows:
ROI = (Revenue from investment – Cost of Investment) / Cost of Investment
The result is represented as a percentage.
Return on investment and ‘payback period‘ are often mixed up with each other in popular parlance.
There is some confusion because return on investment or ROI is sometimes referred to as ‘payback period‘. However, there is a significant difference.
Return on investment or ROI versus payback period
The payback period of an investment indicates how long it takes before the cumulative sales (cumulative cash inflow) are higher than the cumulative expenses (cumulative outflow) that are linked to the investment.
It is a method of investment appraisal that is based on the liquidity of investments: the project with the shortest payback period (which therefore has the best liquidity) is rated the best.
Every advantage has its disadvantage
ROI can clearly identify the profitability of an organization or project. In this way, investments can easily be compared with one another. The profitability of a company is after all very important.
Although the return on investment or ROI is a prominent ratio in many annual reports, it also gives rise to some criticism. The objection is that the ratio is not very precise because it depends on a number of variables such as duration of projects, depreciation, payback period and organizational growth.
It’s Your Turn
What do you think? Is the Revenue on Investment formula applicable in today’s modern companies? Do you recognize the practical explanation or do you have more suggestions? What are your success factors for using a financial investment method?
Share your experience and knowledge in the comments box below.
- Leffingwell, D. (1997). Calculating your return on investment from more effective requirements management. American Programmer, 10(4), 13-16.
- Phillips, J. J. (Ed.). (1997). Measuring return on investment (Vol. 2). American Society for Training and Development.
- Phillips, P. P., & Phillips, J. J. (2007). Return on investment (pp. 823-846). John Wiley & Sons Inc.
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