Return on investment (ROI) is an important profitability ratio in finance. ROI expresses the relationship between the profits a company earns and its investments made to achieve those profits. Companies calculate ROI for future projects to determine the ones that show the most potential to earn a profit. Understanding how to calculate ROI and use it as a financial indicator can help companies and creditors make wise investment decisions.
ROI expresses in percentage terms the gains or losses on the company's investment projects. Investors can use several formulas to calculate ROI. The formula used depends on the project type. For capital investment projects, the formula is [(Gain on Investment - Cost of Investment) / Cost of Investment]. The formula for the traditional method of calculating ROI is [ROI = After-Tax Income / Total Assets]. Assets are considered resources invested to generate net income. The DuPont formula is [ROI = (Net Profit Margin) x (Total Asset Turnover)] or [ROI = (Net Profit After Taxes / Sales) x (Sales / Total Assets)]. Regardless of which formula is used, they all examine the profitability of investments.
Benefits for Managers
Managers and investors use ROI to determine the effectiveness of a company’s operations. ROI shows whether or not management is effectively doing its job in making the company profitable. Managers and investors compare a company’s ROI to similar companies' in the same industry to analyze the organization’s financial health and market share. To take the use of ROI a step further, management can calculate the ROI of individual departments within a company to determine the profitability of the department and its contribution to total profits. ROI allows managers to set financial goals by establishing budgets.
Benefits for Creditors
Creditors pay attention to a company’s ROI when making investment decisions. For the purpose of analysis, the ROI is most useful to a creditor when comparing the ratio to industry standards. ROI indicates a company’s ability to earn a good rate of return. Creditors can also determine the capabilities of a company’s management by analyzing the ROI for several time periods. If a company experiences a continual decline in ROI, it may indicate that the management of the company is not effective in producing a good return on its investments. A company’s ROI over a certain time period can also indicate the direction of future earnings. A company that increases its ROI in each period experiences a better chance of positive future earnings than a company with a declining ROI.
One limitation of ROI is that it shows managers the problem but fails to provide solutions on how to increase ROI. In effort to simply raise the number, managers may use methods to increase ROI that are not conducive with the strategy of the company. In an effort to reduce expenses, managers may choose to cut projects that are necessary for long-term productivity and profitability, such as research and development. A company that places too much focus on ROI may pressure managers to ignore investment opportunities that may benefit the company. Therefore, companies should use ROI as a part of a balanced scorecard. A balanced scorecard explains the strategy of a company to its managers.
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