Profitability and Coverage Analysis
2.4. Return on investment (ROI)
Return on investment ratio (ROI) evaluates the profitability of an investment in relation to the invested capital. When talking about a company’s performance, return on investment is the net earnings divided by either average assets (similar to the return on assets ratio) or shareholder’s equity (similar to the return on equity ratio). The return on investment ratio is calculated by dividing (a) the gain from investment less cost of investment by (b) the cost of investment.
This ratio can be used to analyze different types of investments and can be applied by entities (e.g., to choose between multiple investment projects) or individual investors (e.g., to choose which stock to purchase). The return on investment ratio is considered good when it is positive and when there are no other opportunities (e.g., projects) that may provide a higher return on investment.
Return on Investment (ROI) Formula
Generally, to calculate the return on investment, net gain from an investment is divided by the total amount of the investment:
Return on Investment (ROI) = |
Gain from Investment – Cost of Investment |
Cost of Investment |
When financial statements of a company are used to analyze return on investment, these formulas can be applied:
Return on Investment (ROI) = |
Net Profit before Tax |
Average Shareholder’s Equity |
Note that the above formula is similar to the return on equity ratio.
Return on Investment (ROI) = |
Net Profit before Tax |
Average Total Assets |
Note that the above formula is similar to the return on assets ratio.
Return on Investment (ROI) Example
A company’s management can use the return on investment ratio in their decision-making process to accept or reject different projects: from the decisions of purchasing assets (equipment, machinery, building, etc.), marketing, recruiting, training programs to investment decisions about the company’s investment portfolio.
For example, Friends Company decides to buy new equipment. Two options are available:
(1) Equipment cost of $5,000 with an expected return of $7,000.
(2) Equipment cost of $3,500 with an expected return of $5,000.
Which option should the company select? To answer this question, let’s take a look at the respective ratios of return on investment:
(1) ROI = |
$7,000 – $5,000 |
= 0.40 |
$5,000 |
(2) ROI = |
$5,000 – $3,500 |
= 0.429 (rounded) |
$3,500 |
As the second option provides a higher return on investment (0.429 versus 0.40), the company would want to choose the second option (e.g., invest $3,500 in new equipment with an anticipated return of $5,000).
Important Notes
When evaluating the return on investment ratio, it is important to consider the following factors:
- What is the probability that expected returns and costs will be as forecasted? Quite often expectations about future returns (e.g., earnings of a company) don’t equal exactly what was anticipated.
- There are multiple ways to calculate the return on investment ratio. It is important to understand how a particular ratio was calculated when comparing it with other return on investment ratios.