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 ROI (Return on investment)

To calculate ROI, the benefit (return) of an investment is divided by the cost of the investment; the result is expressed as a percentage or a ratio.

ROI= (gain From Investment-Cost of Investment)/Cost of Investment

Return on investment is a very popular metric because of its versatility and simplicity. That is, if an investment does not have have a positive ROI, or if there are other opportunities with a higher ROI, then the investment should be not be undertaken.

Uses of ROI

The general formula for computing ROI is income / invested capital. ROI can be computed on a company-wide basis by dividing net income by owners' equity. This measure indicates how well the overall company is utilizing its equity investment. Calculated in way, ROI provides a good indicator of profitability that can be compared against competitors or an industry average. Experts suggest that companies usually need at least 10-14 percent ROI in order to fund future growth. If this ratio is too low, it can indicate poor management performance or a highly conservative business approach. On the other hand, a high ROI can either mean that management is doing a good job, or that the firm is undercapitalized.

ROI can also be computed for various divisions, product lines, or profit centers within a small business. In this way, it gives management a basis for comparing the performance of different areas. One large division may generate much higher profits than another, smaller division, for example, which might encourage management to consider investing further in that division. But an ROI might reveal that a great deal more capital investment was required by the large division than by the smaller one. The smaller division may have generated a lower dollar amount of profit, but a greater percentage of profit on every dollar of investment. As Ronald W. Hilton wrote in his book Managerial Accounting, "The important question is not how much profit each division earned, but rather how effectively each division used its invested capital to earn a profit."