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Return on Investment (ROI)

Introduction

Return on investment (ROI) measures the rate of profitability of a given investment. The ROI is one of the most widely used performance measurement tool in evaluating an investment center.

In a Nutshell

The most common measure in evaluating the performance of an investment is return on investment (ROI).

Return on investment is equal to income made from the investment divided by the amount invested.

There are many versions of return on investment. In evaluating investment centers, a very common ROI calculation is: operating income divided by average total assets.

An investment shall be accepted if the ROI exceeds a set benchmark, such as cost of capital or industry standards.

An investment center is a subunit of an organization that has control over its own sources of revenues, the costs incurred, and assets (investments) employed. An investment center acts like a separate company.

Return on Investment (ROI) Formula

The basic formula in computing for return on investment is:

ROI = Income
    Investment

Income could be one of the following: operating income or EBIT (earnings before interest and taxes), net income, or net cash inflows.

Investment could be: total assets, working capital, stockholders' equity, or initial cash outlay. If possible, the average amount for the period is used.

Examples: Computation of ROI

1. Calculate the return on investment (ROI) of an investment center which had operating income of $500,000 and operating assets of $2,500,000.

ROI = Operating income
    Total assets
     
  = $500,000
    $2,500,000
     
ROI = 20%

2. Compute for the return on investment (ROI) of a subunit which had operating income of $240,000. It had total assets of $1,500,000 at the beginning of the period and $2,500,000 at the end.

ROI = Operating income
    Average total assets
     
  = $240,000
    ($1,500,000 + $2,500,000) ÷ 2
     
ROI = 12%

Analyzing the ROI

The higher the return on investment, the better. The management may use benchmarks in evaluating the ROI. For example, say in a particular industry, the average ROI is 20%. If the subunit's ROI is 8%, then that is not even half of the acceptable rate. The management may decide on how to improve the subunit's ROI or drop it and invest in more profitable ventures.

Also, in evaluating investments, the return on investment should exceed the cost of capital to be considered a profitable and an acceptable investment.

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