Return on investment (ROI)

Last updated: 17.03.2016

Return on investment (ROI) is the indicator used to evaluate the investment profitability. It is calculated as the accounting profit arising as the consequence of the investment divided by the investment costs.  The higher is the calculated return, the better.

 

ROI formula is either the same or very similar to ROCE. The differences between the two indicators can reside in

  • nominator: ROI mostly uses net profit, while ROCE EBIT (but not a condition!)
  • denominator: ROI is used to evaluate the investment projects or performance of parts of the company (i.e. invested amount is in the denominator), while ROCE evaluates the profitability of the entire company (i.e. capital employed is in the denominator)

 

ROI formulas 

 

The resulting ROI for the viable investment shall be higher than

  • minimum return defined in investment directive
  • return of alternative projects/investments (unless other methods are used for evaluation)
  • in case of total profit / total investment formula higher than 1 (incremental profit is higher than the investment)

 

Advantages of ROI

  • ROI is easy to understand and the calculation methodology is in line with the overall company ROCE formula (if the same measure of profit is used)
  • it considers all costs and incomes incurred over the entire life of the project

 

Disadvantages of ROI

  • it is not based on cash-flow, but profit which is easy to manipulate
  • timing of costs and benefits is irrelevant and profit is not discounted, therefore time value of money is ignored
  • it ignores to evaluate the length of the project and longer projects are more risky – possible solution: when compared to alternative projects with different life, it can be resolved by calculating average annual ROI (i.e. by dividing ROI by the number of years included)

 



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