What is the return on investment (ROI)? Have you heard of it? In running a business, you must fully understand what ROI is. The main reason is that ROI can be used as a benchmark for business profit. Financial experts define ROI as an asset or money gained or lost during the investment process. Furthermore, ROI can also be used to evaluate operational activities.
For those who are going to start investing in a business, it is essential to understand the ROI to avoid rapid losses. Read on to learn the definition of “return on investment” (ROI) and how to calculate it.
What is the Return on Investment (ROI)?
What is ROI? (source: Freepik)
ROI is a ratio that shows the gains and losses of the total assets of an investment compared to the number of assets or money invested. In simpler terms, ROI is the percentage of profit earned from the total assets or money invested.
ROI can also be used to calculate the funds needed for investment. For instance, investors require information about the value of the expected ROI from the investment before releasing the funds to the company. A company also uses ROI to measure the success rate of a particular project. If the generated funds are higher than the number of investments spent, it can be concluded that the project or program is making a profit. However, if you get the opposite result, the project or program needs to be evaluated because it is ineffective.
Also read: Understanding Investment Memo and How to Write One
The Factors that Affected ROI
Two factors may affect the return on investment (ROI): turnover and profit margin. What is the difference between turnover and profit margin? Have a look at the full explanation below.
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Turnover
The first factor is the operating asset turnover rate, or asset turnover rate. The pace of the operating asset rotation will influence the rapidity of investment over a certain period. The faster the turnover, the better the rate of return on the investment.
Profit Margin
Profit margin, commonly known as the company’s profit ratio, is used to measure the level of profit obtained and associated with the seller. The higher the profit margin calculation, the higher the ROI profit. Hence, the profit margin is the profit gained through presentations and net sales calculations.
Also read: What Does A Venture Capitalist Do? 7 Things You Need to Know
The Benefits of ROI Analysis
What is ROI? (source: Freepik)
A company that carries out good accounting practices will use ROI analysis techniques to measure capital, sales, and production efficiency.
If a company has industry data, it will get the industry ratio. ROI analysis can compare the efficiency of a company’s capital with other similar companies. Thus, the result will show whether the company is below, above, or even the same as others.
Additionally, there are many benefits of ROI analysis for a company, including:
- 1. Helping with project planning and control;
- 2. Measuring the efficiency of the performed programs by each section or division;
- 3. Measuring the efficiency of capital, sales, and production;
- 4. Measuring the results of several policies and decisions by the company for each product;
- 5. Used as a basis for decision-making, for growth and development;
- 6. Comparing the efficiency of the company’s capital with other similar competitors.
Also read: Short Term Investment: Definition, Risk, and The Examples
The Weaknesses of ROI Analysis
One of the weaknesses of an ROI analysis is the difficulty of comparing ROI with other similar companies since every company has different accounting practices.
Besides, ROI analysis also has other weaknesses or shortcomings. Some disadvantages of ROI analysis include the following:
Fluctuations in Value and Purchasing Power
The way the value of money changes in each country often affects a company’s profit margin. Since products bought during inflation will be much more expensive, the ROI analysis will definitely show different results.
Influencing The Perspective in Managing Investment
ROI analysis can help a company figure out which investments are best from a financial point of view. But if the company’s goal is more than just money, then ROI analysis cannot be relied on. ROI analysis will only show material gain from investment.
Also read: Long Term Investment: Definition, Risks, and The Examples
How to Calculate ROI
Calculating ROI is simple if you have already understood the formula. Below it will be shown how to calculate ROI using the following formula:
The ROI Formula
ROI = (Total Investment Income – Investment capital cost) / Investment capital cost x 100%
An example of the ROI formula is if the initial capital investment is Rp. 10,000,000, and the result in sales is Rp. 15,000,000, which means that the profit gained is Rp. 5,000,000. Then, the simple presentation using the formula:
ROI = (Rp15,000,000-Rp10,000,000) / IDR 10,000,000 x 100%
ROI = 50%
From the calculation above, the result is the same as the formula. Hence, it can be concluded that the ROI level is 50%.
That was the complete explanation of “return on investment” (ROI) and how to calculate it. I hope it helps!
