Return on Investment(ROI) is the most important financial metric which is used to measure the possibility of profits on the investments. It is a proportion that compares profits or losses from investment which is cost relative. ROI is very helpful in evaluation of returns from investments as it’s a comparison between investments.
In business, rate of return is measured in cash flow and the returns on the investment. It is measured in terms of internal rate of return and Net present value. These are the metrics that do an evaluation of different options. This is expressed in the form of percentage which gives an idea of what is the outcome of the investment.
Understanding ROI
In general terms, ROI means returns that the business gets from investments. These returns are yielded from the assets or the projects. ROI is shown in the form of percentage as it is easy to understand. It is a return in the form of numbers and these numbers can be expressed in positives or negatives.
If the ROI for an entity is in positive figures then it means that returns are good as the return numbers will exceed the investment numbers. On the other hand, if the returns are negative then it means that there is a potential loss incurred in the business because of the particular investment. In other words, it is simply a loss for the investment that is made by the investor. For accurate results, the total outcome of investments should be taken into consideration.
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Calculating ROI
It is very easy to calculate the ROI just divide the outcome of the investment by the total amount you spent on the investment project. The resultant figure that you get will give you the returns that you arrived at. If the resultant number is a positive number then you gained on your investment and if you got a negative number then you incurred a loss on your investment.
The formula used for ROI calculation is,
ROI = Net Return on Investment/ Cost of Investment * 100%
To better understand this let us take a look at an example. Let us consider that a small company made an investment in buying a software for the business to increase their profits. The formula can be represented as below.
Business gain after software purchase = Cost of software/Total cost of software
This formula can be easily applied to forms of business and it can also be used to return earned on business departments. It can be either applied in the Human Resources or finance department or operations units. Finding out the returns on investment can be very difficult in a large scale businesses where expert advice will help you get the right answer for the investments.
While calculating the ROI, non-monetary factors are not taken into consideration. Overhead cost, fees and other factors can impact your ROI. The returns on investments will consider how much time you spent on software, usage of software, life, tenure durability, multiple access systems and other factors should also be taken into consideration while calculating return on investment. Similarly, other forms of business investments should also consider these aspects while calculating return on investments.
Usage of ROI
There are a number of advantages of ROI and the most important aspect is to find out the returns that you are getting from investment. Most businesses use ROI to find out the survival and success of business. If you find out that the investment that you made is not yielding good results then it is a business decision to continue the investments or not. ROI helps in business decision making which includes the following.
- Purchase of assets
- Employment decisions
- Expanding business
- Business decisions
- Status quo
1. Purchase of assets
Businesses can make decisions on purchasing the assets. Based on the returns calculation a business unit can decide on whether to buy an asset or not. The business can line up its investments in the right way. Decisions on buying the assets or renting can be decided by the business.
2. Employment decisions
Decisions on increasing or decreasing the staff by hiring new employees can be determined by the ROI. The contribution of the employees towards the business can be calculated by the salaries which are paid to the employees. If an employee is not yielding as expected then the business can decide upon growth or cost-cutting. It can either be in the form of promotions, hikes or sack the employees.
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3. Expanding business
Businesses can decide upon expanding their business operations or adding new departments to the business. It is a smart move to increase business operations or expand branches. Calculating ROI departmental wise will let the business identify the scope of expansion business unit operations.
4. Status quo
It helps in finding the existing state of condition of the business. If a company has made huge investments in assets it can find out if the investment is yielding good returns or not. It will help in increasing the sales target for the business. Tracking the production in units can be easy and cost-effective. It will give an idea for business profitability and success of the business.
Take away
Understanding the significance of ROI is very important and it will help businesses in decision making. Decisions can be made easily either in hiring a new manager or buying a new asset for business or decisions on business expansion and any other cost decision. The knowledge of ROI will assist businesses in business expansion, growth and success.
About the author
Vinay Kumar Goguru is a finance professional with more than 8 years of diverse experience as a researcher, instructor and Industry work experience with both public and private entities. Prior to MyMoneySouq, he spent 6 years in Berkadia, It's a commercial mortgage banking company. He has a "Doctoral Degree in Commerce" and two master's degrees with a specialization in Finance, one as Master of Commerce and other as Master of Business Administration. He has written several articles on personal finance, published by different International journals. He loves traveling, reading and writing is his passion. He has a dream of writing a book on his favorite finance topics.
