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Returns on Investment (ROI) is a profitability ratio that indicates the returns generated on total assets, or the overall profit made on an investment, expressed as a percentage of the amount invested. A high ROI means a lucrative investment. An ROI at less-than-normal interest rates shows under performance, and a negative ROI shows loss.
Image Credit: flickr.com/kevinzhengli
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Basic Formula to Calculate ROI
The basic calculate-ROI formula divides annual net profit by total investment, and multiplies it by 100 to convert the result into a percentage.
ROI = Net Profit / Net Investment x 100
Net Profit, also known as Net Earnings, is income after subtracting all expenses and losses from the total revenue for the reporting period. Net Profit is either before tax or after tax, and the ROI varies based on this factor. For investors, net profit equals increase in share value plus dividend during the reporting period.
Total Investment is the sum of debt and equity invested since inception to reap the net profit.
Assuming an investor invests $5,000 in a business venture or equity and receives $875 as her share of annual profit, her ROI for the year would be 875/5,000*100 = 17.5%.
Assuming an investor purchases $5,000 worth of shares, and it becomes $5,200 at the end of the reporting year, and in addition receives $20 as dividend during the period, the ROI is [(5,200-5,000)+20]/5,000*100=220/5,000*100=4.4%Investors normally calculate ROI annually, but it is also possible to calculate ROI for other time periods. For instance, if an investor who invests $5,000 receives a return of $25 in the first month, then his monthly ROI is 250/5,000*100 = 5%, and his estimated annual ROI is 5 x 12 months = 60%.
The traditional or basic ROI formula is a static measure and works well when the measurement is straightforward. It remains inadequate to calculate the ROI of large businesses where complex factors distort the simple straightforward equation.
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Du Pont Formula
The Du Pont ROI formula allows a firm to break down its ROI into a profit-on-sales component, based on net profit margins, and an asset-efficiency component, based on total asset turnover. This is useful for large firms where the amount of funds tied up in assets and returns from such assets are an important component of profitability along with sales and expenses.
The Du Pont ROI formula reads:
ROI = (Net profit after taxes / total assets) = (net profit after taxes / sales) × sales / total assets
Using the traditional formula, a company with $100,000 in total assets and $15,000 in net profit after taxes would have an ROI of 15%. The Du Pont formula factors in sales. If sales are $200,000, then ROI=
0.15=0.075*2=0.15 or 15%
Thus while ROI is 15 percent, this formula reveals the returns from sales as 7.5%, and an asset turnover of 2. Different combinations such as sales returns of 5% and asset turnover of 3 or sales return of 2% and asset turnover of 7.5 can also generate a same 15% ROI. The Du Pont formula thus gives valuable insight on the operations of the company and largely clears the distorting factors that influence ROI.
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An understanding of ROI provides greater power over investments.
ROI, however, offers flexibility in the calculation of net earnings. Different companies might calculate their income and costs incurred to realize the income differently, greatly distorting net earnings. For instance, many people, especially small business owners, fail to factor in the value of their own time when calculating the inputs or the costs that determine net profitability. This greatly inflates the ROI figures for small businesses.
This possibility of manipulating ROI to suit the user’s purpose is the biggest drawback of using ROI as a ratio to study the company’s financial health.
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- BNET. Calculating Return on Investment. Retrieved from http://www.bnet.com/2410-13240_23-66470.html
- Investopedia. Return on Investment. Retrieved from http://www.investopedia.com/terms/r/returnoninvestment.asp
- How to Calculate ROI (Return on Investment). Retrieved from http://www.captureplanning.com/articles/79375.cfm?