Define the Net Return on Investment
You want to make the most money possible on your investment, and that means you either have to increase the investment's worth or reduce the cost to operate it. Investors rely on a formula to show them the net return, so they know whether their investment is increasing in value or decreasing in operating cost. But some factors can confuse the total figure for return on investment and make it appear that there is a profit when there isn't.
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Formula
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The net return on investment, also known as ROI, is determined when you use the following formula: net operating income divided by average operating assets, according to the text "Managerial Accounting" by Ray Garrison, Eric Noreen and Peter Brewer. That means that if you make a financial investment in a business, your profit (return on your investment) is going to be only as large as the difference between what the company makes versus what it costs to operate it.
Significance
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Your net return on investment will reflect the actual amount of return (profit) you realized from the investment after interest and taxes were deducted, as well as operating expenses. Otherwise, it really isn't a true net return on investment.
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Function
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You need to know your net return on your investment to decide whether it is good enough to continue investing. This net return on investment formula can help you determine what the rate is for this investment, and whether it is wise for you to keep putting new money into this investment.
Misconceptions
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For a business, the average operating assets (the denominator in the ROI formula) include cash, accounts receivables, business inventory and any plant equipment. But you can get an inflated idea about your true ROI if you calculate your average operating assets total using the net book value of plant equipment. For example, if you own equipment worth $5,000 and it depreciates by $1,000 every year, your average operating asset total will go down by $1,000 every year. This makes your ROI percentage go up. When your ROI goes up, it usually indicates a profit. But that isn't the case in this instance, since your equipment is going down in value; it isn't that your assets are costing you less. It is that they are worth less.
Considerations
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You must make sure that you and your banker or accountant are in agreement about whether to include depreciation items (such as plant machinery) in your average operating expenses by applying net book value to them, or by choosing to assign them the same value year after year (for instance, $10,000 the first year, $10,000 every year thereafter).
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