Return on Investment Ratio Analysis

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A business needs a certain minimum level of profitability to survive over the long term. Return on investment is a statistic that reveals how well a business is performing by dividing a company's net profit by its net worth. ROI indicates how efficiently the money you invest in your company is contributing to your profits. You can use ROI to evaluate your investments in various assets, including land, inventory and equipment. It also can help you determine if you've set the right prices for the goods or services you sell.

Understand the Calculation

  • When calculating the return on investment, an investor should understand that both the definition and the calculation have some flexibility in determining what comprises both the return and the cost. This flexibility provides the use in a wide number of cases; however, the use of return on investment needs to have similar platforms or rules so that the comparisons are true and fair. The return on investment calculation, in the broadest sense, attempts to measure the profitability of an investment.

Investment Bias

  • Some investors have a tendency to routinely favor certain investments over others. This favor can cause the investor to look for self-serving biases. The flexibility of the return on investment calculation does have some downside. The investor can manipulate the calculation to suit her purpose. To avoid this manipulation, the investor should understand the inputs of the calculation and try to standardize her metrics.

Calculation Methods

  • Two different ways exist for the calculation of a return on investment. The traditional way examines the net profit after taxes divided by the total assets or total costs. The second way, or the DuPont Formula, uses two factors: net profit margin and total asset turnover. This calculation measures the success of the investment with recognition of the fact that excessive funds tied up in assets become just as much of a drag on profitability as excessive expenses.

Benefits of Calculating ROI

  • The simplicity and versatility has made return on investment a very popular metric. The opportunity with the highest return on investment should have the highest priority. Many different occupations have taken on this metric as a decision tool. A marketing firm can use the return on investment analysis as a tool to decide between two different marketing products. A manufacturing company can use this tool by examining the estimated profit and dividing the results by all the resources required to make and sell a product. This can help the company to decide which product can provide the most profit.

Considerations

  • While performing a return on investment ratio analysis emerges as an inexact science, analysts and investors need to find a way to compare investment opportunities. This comparison should include some metrics into the decision-making process and less emotion. Each time he makes a comparison and chooses an opportunity, a review session should follow and the investor or analyst needs to continue to refine the input metrics for an increasingly accurate calculation.

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References

  • Photo Credit investment image by Kit Wai Chan from Fotolia.com
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