Calculating return on investment
When there is some income it is to be depicted in relation to investment which is made to earn that income. Thus, the income earned is to be described in relation to investment. If the return is revealed in its absolute terms it does not have much significance.
Rather than using the absolute figures of return or the income, a ratio known as Return on Investment is more functional. Return on investment is the income relative to the investment made to earn that income.
Return on Investment is one of the imperative business formulas which we can spot in every annual report.
It is a ratio which is used by the decision makers to discover the magnitude of the income or the earnings in comparison with the investment made.
Return on investment is an approach, which is used to take various types of decisions for example, the concept of ROI is used in most of the traditional investment decision making, such as management of the stock portfolio or it is used by various business organizations while making the decisions regarding purchase of assets or can be used by the companies to take decisions while conducting various programs, for instance if a company wants to conduct a training program for the employees, it can make a decision by applying the ROI approach, as to what shall be the benefits or the increase in the income of the company if it go for the training program relative to the investment it has to made for conducting any such program.
Calculating ROI-
If we take ROI in its simplest form, it is just the incremental income divided by the cost of investment made to earn that income.
So, Return on investment = The Increase in the income/ Cost of the Investment
For example, a business organization has two different alternatives A and B. For selecting the better alternative ROI can be calculated.
Lets suppose the total cost for alternative A is $200000 and incremental income is $20000. The cost for second alternative is $100000 and the incremental income is $5000. In this case-
ROI for Alternative A = 10% and ROI for Alternative B = 5%
Thus, the Alternative A is more productive for the organization.
The organizations can always take steps to improve the ROI. This can be done either by increasing the numerator or reducing the denominator. If there is an increase in the net income or the income generation is accelerated or if the cost is reduced the ROI can be amplified.
Thus, in the situations where the income and the cost of investment can be known ROI can be calculated.
Lets observe some basic situations where the concept can be used.
Suppose, a business organization have various alternatives and it has to select the most productive alternative, ROI is calculated for all the alternatives than, all the other things remaining same the alternative with the highest ROI is selected as described in the above example.
In some other case, where an organization has to decide on the viability of a project it can just calculate the ROI and than compare the ROI with the standards set by the organization. If the ROI is in accordance with the standards the project is viable and if its not steps can be taken to increase the income or reduce the cost.
So, ROI is an important concept used by the organizations while taking financial and other business decisions. But this was ROI in its simplest form as ROI can be more complicated than this.
The income which is taken while calculating the ROI can be over a period of time and if it is during several years time period than, it is be decided whether the discounted value that is, the net present value is to be used or the non discounted values are to be used.
Also, the cost is always not only affected by direct factors there may be some indirect factors affecting the cost. All these factors have to be considered before calculating the ROI to make it more accurate.
While calculating the return on investment for a particular organization or a company the ROI is the income earned by the company after deducting the expenditure (Net Income) divided by the book value of the assets.
So, in that case the formula for ROI will be-
ROI = Net Income/Book value of the assets
The Net Income means the Income after deducting all the expenses and this income should also include interest income earned by the company after taking into consideration the tax factor.
After considering the interest income discounted by the tax rate the formula for ROI will be-
ROI = Net Income + Interest (1-Tax Rate)/ Book value of Assets
ROI is an important concept and is used by every business organization, as the concept makes sense even in its simplest form. ROI in its simplest form is also used by the individuals in making decisions, for instance it can be used while managing ones portfolio.
If ROI is calculated by the organizations steps can be taken to further improve it either by accelerating the income, increasing the income or reducing the investment cost.
So, ROI is a wide term. It can be used as a whole approach in the decision making or as a business ratio to show up in companys annual report.
ROI is the used by the companies to understand the business value of the investment.
It is similar to other concepts which are used to calculate the business value of investment as the concept of Payback period, Internal Rate of Return or Net Present Value.
ROI is not just calculating some numbers. It demonstrates the cost benefit analysis. It shows the benefits or the return in relation to the cost or investment made to earn that return. It adds more sagacity to the otherwise absolute figures of income. It is one of the important tools in the hands of the organizations which it uses for decision making.
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