ROI: How to calculate return on in­vest­ment

Business ad­min­is­tra­tion offers various prof­itabil­i­ty metrics. One of the most important in­di­ca­tors of this type is the return on in­vest­ment (ROI). The return on in­vest­ment measures the prof­itabil­i­ty of the capital employed.

What is ROI? Its meaning

The return on in­vest­ment is one of the most important metrics in ac­count­ing. It refers to the profit of a business entity (e.g., a company) in relation to the capital invested. Al­ter­na­tive­ly, ROI is also known as capital yield or capital prof­itabil­i­ty.

The sig­nif­i­cance of ROI is immense, as it sits at the top of the DuPont model, making it the cen­ter­piece of the world’s oldest business per­for­mance mea­sure­ment system. This model was in­tro­duced in 1919 by the American chemical company E. I. du Pont de Nemours and Co..

Where is ROI used?

Within the DuPont indicator pyramid, ROI serves as a key metric for eval­u­at­ing a company’s per­for­mance while con­sid­er­ing the total capital in­vest­ment. This value helps answer the question: How ef­fi­cient­ly was the capital invested during the given ac­count­ing period?

In principle, however, ROI can be used as a per­for­mance indicator in any scenario where success is measured by the return on invested capital. Ad­di­tion­al areas of ap­pli­ca­tion include:

• The eval­u­a­tion of in­vest­ments
• The com­par­i­son of in­vest­ment projects
• The analysis of in­di­vid­ual business divisions

How to calculate the ROI

Which in­di­ca­tors you apply to cal­cu­lat­ing your ROI value depends on whether you are de­ter­min­ing your entire company’s rate of return for a par­tic­u­lar ac­count­ing period or whether you simply want to calculate returns from single in­vest­ments or a specific business division.

The ROI formula

According to the DuPont model, your company’s ROI is cal­cu­lat­ed by mul­ti­ply­ing its return on sales by its asset turnover.

Al­ter­na­tive­ly, you can also calculate a company or in­vest­ment’s ROI by dividing the profit by the total invested capital and mul­ti­ply­ing the result by 100.

Both formulas produce the same result. This can be un­der­stood with the help of the following cal­cu­la­tion.

Formula for cal­cu­la­tion return on sales

With the return on sales, you determine your company’s share of the return on sales from the net sales.

Formula for cal­cu­lat­ing asset turnover

Asset turnover provides in­for­ma­tion on your company’s profit ratio with respect to the total assets (equity + debt capital).

Formula for cal­cu­lat­ing ROI

In the DuPont indicator pyramid, the return on sales and asset turnover are located directly under the return on in­vest­ment situated at the top. This is il­lus­trat­ed in the following graphic.

Example for cal­cu­lat­ing ROI

Below we use an example to explain the cal­cu­la­tion of ROI. For this we begin by assuming that a company has the following figures for the ac­count­ing period under con­sid­er­a­tion.

To un­der­stand how to calculate ROI, we first determine the company’s return on sales. This is done by dividing the profit by net sales and mul­ti­ply­ing the result by 100 to obtain a per­cent­age. For the example company, the return on sales is 6.15%.

In the second step, we calculate the asset turnover. This is done by dividing the net sales by the total capital. For the example company, the capital turnover is 2.24.

By mul­ti­ply­ing the return on sales by the asset turnover, we obtain an ROI of 13.8% for the given ac­count­ing period.

We obtain the same result when cal­cu­lat­ing ROI using the al­ter­na­tive method.

How to calculate the ROI of a single in­vest­ment

If you don’t want to determine your entire company’s asset turnover but would rather determine the prof­itabil­i­ty of a single in­vest­ment or that of a specific business division, then follow these in­struc­tions.

Divide the in­vest­ment or business division’s profit share by the re­spec­tive in­vest­ment and multiply the result by 100.

These types of cal­cu­la­tions are used in online marketing, for example, in order to figure out the success of ad­ver­tis­ing costs in relation to the profit they generate. In this context, it is referred to specif­i­cal­ly as the return on marketing in­vest­ment (ROMI).

Google rec­om­mends that website operators measure the success of ad­ver­tis­ing ex­pen­di­tures for Ad ad­ver­tise­ments by using the ROI it generates. The following example shows how to do this.

Imagine that you operate an online store and that you advertise your products in the search engine. For the purchase of articles, you incur a cost of 2,500 dollars which you use to generate 4,000 dollars in sales. The Ad ad­ver­tise­ments incur an expense of 500 dollars.

You can calculate the success of your marketing in­vest­ments by dividing the profit share by these ad­ver­tis­ing costs and mul­ti­ply­ing the result by 100. To do this, you can use the ROAS formula (return on ad­ver­tis­ing spend). It generates a ROI that refers to a specific profit share and the ad­ver­tis­ing costs that were spent to obtain it.

An ROAS of 200% is the result for this example.

Dif­fer­en­ti­a­tion from other prof­itabil­i­ty in­di­ca­tors

As the top indicator of the DuPont model, return on in­vest­ment (ROI) includes both the return on equity (ROE) and the return on assets (ROA), which consists of equity and debit capital.

Return on in­vest­ment (ROI)

Return on Equity (ROE)

Return on assets (ROA)

How to interpret the ROI

Return on in­vest­ment sheds light on the prof­itabil­i­ty of fixed capital. It can involve a company’s entire capital or the capital ex­pen­di­ture for a single in­vest­ment.

The ROI is a mea­sure­ment of this capital’s return. How you evaluate an ROI figure in the long run depends heavily on the sector in which the company is active or makes in­vest­ments. Many business pro­fes­sion­als aim for a return on in­vest­ment that is more than 10 percent. On average, however, higher ROI values are obtained in commerce than industry. Within a company, de­ter­min­ing the ROI value provides an op­por­tu­ni­ty to compare various in­vest­ment projects or business divisions in terms of their prof­itabil­i­ty.

Criticism of ROI

Cal­cu­lat­ing ROI is con­sid­ered one of the standard pro­ce­dures for eval­u­at­ing in­vest­ment projects, both in forecasts and in the sub­se­quent per­for­mance review. The indicator is quickly de­ter­mined and also implies re­pro­ducibil­i­ty. When it comes to de­scrib­ing financial im­pli­ca­tions, however, the ROI itself has limited in­for­ma­tive value: when con­sid­er­ing in­di­vid­ual cases, reper­cus­sions within the overall context can fall by the wayside. Flaws emerge both in the analysis of the company’s overall results as well as in the eval­u­a­tion of single in­vest­ments.

• ROI is a book-value based indicator that generally only allows con­clu­sions to be drawn about the past. ROI is not suitable for eval­u­at­ing future in­vest­ment projects.
• In­vest­ment risks and external influence factors aren’t taken into con­sid­er­a­tion when using ROI. These include economic and market risks, customer sat­is­fac­tion, and com­pe­ti­tion.
• As ROI refers to a specific period under con­sid­er­a­tion, it is difficult to compare in­vest­ments with varying terms. Fur­ther­more, it isn’t always possible in practice to clearly match a company’s sales and profits to specific in­vest­ment projects.

Please note the legal dis­claimer for this article.