We all analyze past returns generated by the company before investing to ensure that it is providing decent profits to its investors. One of the best parameters investors use to do so is the return on investment.
In this article, we are going to understand everything about ROI in detail.
So, without further ado, let’s get started!
Table of Contents
What is Return on investment?
Return on investment is a key financial ratio to analyze the returns generated by investing in an asset. In simple words, the ratio indicates how much return you have earned from the investment after deducting the costs.
It is one of the most widely preferred profitability indicators because of its reliability and clarity. The ratio makes it simple and clear to evaluate the effectiveness and sustainability of investments. And hence, the return-on-investment ratio has a great influence on the financial decisions of investors and business owners.
The reason we call it “return on investment” rather than “profit or gain from investment” is because the returns can be negative as well. Of course, for profitable outcomes, a positive ROI is preferred.
How to calculate ROI?
The return on investment is calculated by dividing net profit (the current investment value less the investment cost) by the investment cost. It is often expressed as a percentage or ratio.
The formula is:
ROI= Net profit / cost of investment * 100
To understand the calculation better, let’s take an example,
Example:
With an investment of Rs 4,50,000, a marketing agency generates a net profit of 100,000 rupees per year.
Net profit: 10,00,000 Rs
Cost of Investment: 4,50,000 Rs
ROI= 10.00,000 / 4,50,000 * 100
ROI= 222.2%
This is how we calculate the return on investment for a business. The calculation is not at all complicated, and it is quite easy to interpret the ratio. If the answer is positive, then the business is profitable, whereas if it’s negative, the business is at a loss and not generating any profit.
Here, we are generating a return of 222.2%, which is higher than normal; hence, we can interpret that the marketing agency has the potential to generate profitable returns for its investors.
What is the Best Return on Investment?
Now, this is a difficult question to answer because the return on investment differs from business to business and industry to industry.
The net profit and cost of investment used to calculate the returns on investment of a food business will be different from those of a marketing agency.
To understand which company or stock is generating the best ROI to invest in, compare the returns with those of its competitors in the industry. This will give you a complete understanding of the overall profitability of the entire industry.
You can do the same for industries by analyzing the industry returns.
Don’t worry; we have done all the hard work for you!
Here’s a list of industries with best returns as per the CSI Market Research:
| Ranking | Return On Investment Ranking by Sector | Roi |
| 1 | Energy | 19.99 % |
| 2 | Technology | 12.64 % |
| 3 | Capital Goods | 9.25 % |
| 4 | Retail | 9.21 % |
| 5 | Consumer Non Cyclical | 8.56 % |
| 6 | Basic Materials | 8.05 % |
| 7 | Conglomerates | 7.04 % |
| 8 | Consumer Discretionary | 5.93 % |
| 9 | Transportation | 5.61 % |
| 10 | Healthcare | 4.74 % |
ROI Analysis: Pros and Cons
We cannot deny the fact that everything has pros and cons. By understanding the basics of ROI, we can claim that it is one of the best parameters to judge the profitability of a company, but it has its pros and cons too. Let’s understand them in detail:
Advantages:
- Easy Calculation: The formula calculating return on investment requires fewer inputs and gives us results in a few steps making it easier to calculate.
- Results are quite straightforward: The ratio gives a straightforward result for every calculation. A positive number denotes profit, whereas a negative number denotes a loss.
- Adaptability: ROI is applicable to a variety of investments, including stock investments, understanding the profitability of a business, mutual fund returns, automobile sales, property renovation, and much more.
- Simple to Track: Because the ratio calculates the return on a specific investment, businesses can monitor the growth of each company branch to streamline and automate operations and increase profits.
Drawbacks:
- Income and profit errors: ROI is calculated on the profits and not the income. Majority of the time, the financial statements show high sales and high profitability but there are no cashflows. This makes it a misleading parameter to show profitability.
- Fluctuation: Net Profit/cost of investment * 100 is the basic formula for calculating return on investment, however depending on a company’s financial policies, the values of those variables may change. It can be challenging to compare businesses correctly because variables like debt, taxation, and profit margin vs. gross margin might have an impact on the result.
- Manipulation: Management team of a company can manipulate the returns by modifying financial statements and analyses, reducing production costs, or even getting rid of outdated but still useful machinery. Even if the activities are bad for the organization as a whole, this strategy can lower costs or boost profits to give the false idea of incredible performance.
- Overlooking Time: A 15% return in one year of investment is preferable to a 15% return in two years, but ROI ignores the holding period when calculating the profits. A Holding period refers to the duration in which an investor holds the asset. This makes it hard for investors to judge the overall profitability and potential returns.
These are some drawbacks of the return-on-investment ratio; hence, it’s preferred to check multiple factors like cash flow, net sales, etc. before investing in any company. With this, you can understand whether the business is actually generating profits or creating an illusion.
Here’s a quick tip: Avoid investing in companies that are trying to manipulate their financial statements and fool investors.
Bottom Line:
With this, we come to the end of our article on the return on investment. I hope you found this post informative and interesting.
Did I miss something? Let me know in the comments below. Also, feel free to ask your doubts, will try to address them as soon as possible.
Have a nice day!