Return on investment (ROI) is a financial ratio intended to measure the benefit obtained from an investment. Time is usually of the essence in this measurement because it takes time for an investment to realize a benefit. An ROI calculation can be illustrated by the purchase and subsequent sale of a house. Let us assume a cash purchase of a residence for $100,000. The house is held for 10 years and is then sold for $150,000; during its 10 years of ownership, maintenance costs have been $1,000 per year, so that the net sales value is $140,000. This sum, less the purchase price, nets out to $40,000. That $40,000 divided by the purchase price produces 0.4 or 40 percent. The ROI of this transaction has therefore been 40 percent. This elaborate example is presented with a purpose. ROIs are typically calculated in different ways. In this example, for instance, the owner may have rented the house for $200 per month and realized a 10-year income stream of $24,000 as well. If that income is factored in, the net benefit will be $64,000 rather than $40,000, and the ROI will be 64 percent.
The general rule to keep in mind is that ROI is the ratio produced when all gains from a transaction, less the costs associated with that transaction, are divided by the initial investment. The most common use of ROI is to assess the profitability of a company (or an operation within a company) based on investment. There are other measures of profitability—as a percent of sales, for instance, or as a percent of total assets used. ROI is of special interest to those who put their money into stocks or invest their savings into their own business: they have different choices available, and ROI can help to guide them to where to put their money.
ALTERNATIVE WAYS OF CALCULATING ROI
The general formula for computing the ROI of a business is to divide the company's net income for a period by its invested capital. But the term "invested capital" does not have a universally or uniformly accepted definition. It is sometimes defined as net work or owners' equity. Other definitions include the company's long-term debt on the principle that, for operational purposes, money derived from debt is equivalent to paid-in capital. Barron's Dictionary of Finance and Investment Terms (1985), for instance, includes long-term debt in its definition of "return on invested capital," which it uses synonymously with ROI. When the company has no long-term debt, the measure becomes Return on Equity. MSN Money uses the same definition as Barron's and showed, in mid-2006, that the average return on capital (ROI including long-term debt) of the S&P 500 companies was 7.9 percent. Return on equity was 12.4 percent.
The small business can, thus, calculate its ROI simply by dividing its after-tax income by its net worth (the residue after total liabilities are deducted from total assets on the balance sheet) or can use net worth plus long-term debt. Consistency in the use of the formula is, of course, advisable. When asked by a lender or investor for the company's ROI, the owner might be well advised to find out the party's own definition. ROI will be lower if long-term debt is present.
ROI calculations are also typically employed to monitor the performance of divisions or of product lines within a company. The approaches used tend to be varied, but a common form of measurement is to use operating income for the division (income before taxes) as the "gain" and a composite measure to represent investment—funds expended on behalf of the division's operations including the depreciated value of capital equipment, the value of inventories carried, and the net value of receivables less payables. When all divisions are measured the same way, comparisons are possible across the board.
ROI can also be used to evaluate a proposed investment in new equipment by dividing the increase in profit attributable to the new equipment by the increase in invested capital needed to acquire it. For example, a small business may be able to save $5,000 in operating expenses (and thus raise profit by the same amount) by spending $25,000 on a piece of new equipment. This yields an ROI of $5,000 divided by $25,000 or 20 percent. If this figure is higher than the company's cost of capital (the interest paid on debt and the dividends paid to investors) prior to the investment, and no better investment opportunities exist for those funds, it may make sense to purchase the equipment.
In addition to the various uses ROI holds for small business managers, it is routinely used by investors in the stock market to compare the performance of different companies and by people buying and selling companies in merger and acquisition activity.
Albrecht, W. Steve, James D. Stice, Earl Kay Stice, and Monte Swain. Financial Accounting. Thomson South-Western, 2005.
Baker, H. Kent, Erik Benrud, and Gary N. Powell. Understanding Financial Management. Blackwell Publishing, 2005.
Bernstein, Leopold A., and John J. Wild. Analysis of Financial Statements. New York: McGraw-Hill, 2000.