ROI – Return on Investment

ROI or return on investment is a performance indicator employed to measure the efficiency of investments or to weigh the efficiency of investments one against another. To calculate it, the return or benefit from an investment should be divided by its cost. The result is in the form of a ratio or percentage. ROI is a commonly used metric due to its ease of use and versatility. In brief, it can be concluded that if some investment doesn’t have a positive ROI or other investments come with a higher ROI, the first investment opportunity should not be taken.

The flexibility of this instrument has its downside as computations are easy to manipulate, suiting the user’s purpose. Another drawback is that the result can be expressed in a variety of ways. If this metric is to be employed, one should be aware of the inputs used.

With that in mind, the calculation and definition of ROI can be changed to suit a particular situation. Everything depends on what will be included as costs and returns. In its broadest sense, return on investment tries to evaluate the profitability of investments. No calculation can be regarded as the right one in this sense.

From the perspective of marketers, two products can be compared by dividing their gross profits by the required marketing expenses. Financial analysts, however, can take a different approach. They may divide the net income generated by some investment by the total value of employed resources that were required to sell the product.

The rate on investment, also known as rate of return, measures loss due to an investment or cash generated by it. ROI establishes the income stream or cash flow from investments relative to the invested amounts. The cash flow may take the form of dividends, interest, profit, or capital gain or loss. The latter occurs if the resale or market value of an investment goes up or down. Here, the return of the invested capital is not included in the cash flow.

ROI can be used for multiple purposes. The ROI values are often relied upon when making personal financial decisions. They usually include the annualized rate of return and the annual rate of return. In view of nominal risk investments, e.g. certificates of deposit and savings accounts, investors evaluate the effect of compounding or reinvesting the increasing savings balance over a period of time. For investments whereby the capital is at risk, for example, home purchases, mutual fund shares, and stock shares, investors take into account the effects of capital gain and loss on returns as well as price volatility.

Profitability ratios are often employed to compare the profitability of a business over time or the profitability of different companies. Different indicators can be employed such as the net profit margin, the return on equity, the dividend yield, etc. Then, for the purposes of capital budgeting, businesses compare the ROI of various projects as to choose ones to pursue, generating maximum profit or return. Businesses take into consideration the present value, payback period, average rate of return, the profitability index, and more.

Over the last couple of decades, return on investment has become one of the major financial metrics for asset purchasing decisions. Assets can range from service vehicles and factory machines to computer systems. Naturally, ROI is considered for the approval and funding of programs and projects of different types. These can be training programs, recruiting programs, or marketing programs. Finally, ROI is also used for the purposes of more traditional investment choices – the use of venture capital or stock portfolio management.