Return of InvestmentWhat is meant by Return of Investment
“Return of investment” also known as the return on investment, is a calculation designed to help support business decisions based on what matters – profits derived from some level of investment.
Return of investment formula
The formula for return on investment is shown below, but it is essentially the 1) returns in terms of profit 2) divided by the investment in dollars, 3) multiplied by 100%. This calculation produces a number that is typically just greater than 100%.
Identifying investments that deliver high return of investment
If it is greater than 0% than it is an investment that will or has paid off. If it is greater than 0% than it is greater than break-even and the profit generated by the investment is higher than the investment. These investments are generally worthwhile and should be executed given these caveats –
Break-even return of investment
If the resulting number is 0% or near 0% than the investment is basically a break-even investment. It means that the profits generated by the investment are just about the same as the investment. In most cases, this type of investment won’t or shouldn’t be done, unless there is a chance that some of the returns of investment or profits haven’t been fully added to the calculation.
A negative return of investment
If the resulting number is less than zero then the investment delivers a loss. Unless there is something that may not have been included, then these investments should be avoided.
Cost of Capital & Risk impacts a good return of investment
The ROI calculation, even though it is positive still may not be a good investment. There are two reasons –
1) The ROI is lower than the cost of capital. If the ROI isn’t enough to cover the cost of capital, it may not be a good investment compared to the cost of the investment that would otherwise be invested in. You may have to ask your team about the cost of capital for the company.
2) High-risk investments where the investment itself has significant risk. For these investments, it is advisable that an investment is evaluated with a higher ROI to compensate for the threat posed by the risk presented.
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