Return on investment (ROI)
Return on investment (ROI) is a financial ratio that measures the profit generated from investments.
Since it can be difficult for companies to establish investment priorities, ROI helps you determine the profitability of a potential investment and compare it to other projects.
Dimitri Joël Nana, Director, Portfolio Risk at BDC, explains what is ROI is and how it can help you manage your company’s investments.
What is ROI?
ROI is a general financial ratio that calculates the return on an investment in relation to the capital that must be invested. It can be used for any type of investment (a business acquisition, stock purchases, real estate, etc.).
How to calculate the return on investment:
Formula
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Using ROI to assess return on a company
“If we want to calculate the performance of a company, we can use the return on total assets ratio, which is, in a sense, a specific application of ROI. ROI is more of a general formula,” says Nana. “ROI is calculated by dividing a company’s net income by its total assets.”
ROI formula:
Net income
Total assets
X 100
Using ROI to assess return on a real estate purchase
Let’s say we use ROI to assess the return on a home purchased for $1,000,000 and sold a year later for $1,100,000.
Net income from operations (gain on sale) = $1,100,000 - $1,000,000 = $100,000 Total assets (initial investment) = $1,000,000
Return on investment:
Net income from operations $100,000
Total assets $1,000,000
X 100
= 10%
How to interpret ROI?
Since ROI can be used for any type of investment, the nominator and denominator must always be adapted to the situation to calculate correctly.
Let’s look at the example of an income property purchased for $1,000,000 that generates annual rental income of $50,000.
Net income from operations (rental income) = $50,000 Total assets (initial investment) = $1,000,000
Return on investment:
Net income from operations $50,000
Total assets $1,000,000
X 100
= 5%
“Before entering your numbers into a calculator, make sure you understand the nature of the investment so you can properly determine the nominator and denominator of the ROI formula,” notes Nana.
What is the rate of return on investment?
The rate of return on investment is the result, as a percentage, of the ROI calculation.
“The higher the rate, the better,” says Nana.
Obviously, to compare two rates, you must ensure that they correspond to the same investment period (number of days, months or years).
How to calculate the annual return on an investment?
To compare different ROIs, it is ideal to bring them all back to the same time period, such as one year. Let’s go back to the example of the income property that has an annual rate of return of 5%.
Let’s compare this ROI with $1,000,000 investment in 10,000 shares worth $100 each. After six months, the shares are sold for $106 each (no dividend having been paid during the six months). To determine the six-month rate of return on investment, you need to make the following calculation:
Net income from operations (capital gain on each share) = $106 - $100 = $6 Total assets (initial investment for each share) = $100
Return on investment (six months):
Net income from operations $6
Total assets $100
X 100
= 6%
To calculate the rate over 12 months, multiply it by two. The annual rate of return on the investment is therefore 12%.
“If we compare this with the example of the person who invested in the income property with a one-year return of 5%, we can see that the investment in shares with a 12% return was much more profitable over an equivalent period of one year,” explains Nana.
Why is ROI important for businesses?
When managing a company, you may need to decide between different investment projects. For example, a manufacturing company might have two new products in mind, each requiring the purchase of a new piece of machinery. Which one will be more profitable after one year?
To make an informed decision, compare the two ROIs.
Product A
Net income from operations (Product A after one year) = $100,000Total assets (cost of purchasing the machinery) = $1,000,000
Return on investment:
Net income from operations $100,000
Total assets $1,000,000
X 100
= 10%
Product B
Net income from operations (Product B after one year) = $300,000 Total assets (cost of purchasing the machinery) = $2,000,000
Return on investment:
Net income from operations $300,000
Total assets $2,000,000
X 100
= 15%
Therefore, Product B will yield a higher ROI, but management will have to take into account that it will require a greater initial investment.
In addition, when someone wants to invest in a company, or if a company wants to make an acquisition, they will always look at what profits are generated in a year in relation to total assets. “In this kind of situation, we look at the return on total assets,” says Nana. “But whether it’s that or any other variation of ROI, it’s a very useful ratio for assessing the profitability of an investment.”
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