Return on investment (ROI) is used to assess how profitable an investment is in relation to its cost. This ratio expresses the amount of profit or loss an investment generates in relation to its beginning cost.

A positive return on investment (ROI) signifies a profit, whereas a negative ROI denotes a loss on the investment. It's an essential indicator that companies and investors use to evaluate the effectiveness and profitability of investments, enabling them to compare various investment options.

ROI is expressed as a percentage. 

Formula

The formula for calculating ROI is:

ROI = (Net Profit/Cost of Investment) × 100%

Where:

Net Profit = Total gains (or returns) from the investment minus the cost of the investment

Cost of Investment = The initial amount of money invested

Example

Let's say you invested Rs. 1,00,000 in a stock and sold it after a year for Rs. 1,20,000.

To calculate the ROI:

Net Profit = Selling Price − Cost of Investment

Net Profit = Rs. 1,20,000 − Rs. 1,00,000 = Rs. 20,000

Now, using the formula for ROI:

ROI = (Net Profit/Cost of Investment) × 100%

ROI = (20,000/1,00,000) × 100%

ROI = 20%

In this example, the return on investment for the stock would be 20%.

What Is The Importance of ROI?

ROI is crucial for several reasons:

Performance Evaluation: It's a critical tool for assessing the performance of marketing campaigns, new product launches, or any other business initiative. It helps in understanding whether the investment in these activities is yielding positive returns.

Decision Making: Businesses and individuals use ROI to make informed decisions about where to allocate their resources. It helps in determining which projects or investments are most profitable and worthwhile.

Risk Assessment: ROI helps in assessing the risk associated with an investment. A higher ROI might indicate higher potential returns but could also involve higher risk. Comparing ROI across different investments can assist in understanding and managing risk levels.

Resource Allocation: Companies use ROI to allocate budgets effectively. By analysing the ROI of various projects or departments, they can decide where to invest more or where to cut costs.

Limitations

Although a reliable metric, ROI has certain limitations.

Limited Scope: ROI primarily focuses on financial gains and fails to account for non-monetary factors. Certain investments might yield intangible benefits such as brand recognition, customer loyalty, or employee satisfaction, which are challenging to quantify in monetary terms. Consequently, relying solely on ROI might undervalue investments that bring significant non-financial advantages.

Time Consideration: ROI assumes a linear relationship between investment and return over time, but in reality, returns might not accrue consistently. Some investments may take longer to yield results, while others might show quick returns. The time frame used in ROI calculations might not accurately reflect the actual life cycle or future fluctuations in returns, leading to potential misinterpretation of the investment's success.

Inability to Capture Risk: ROI calculations often overlook the element of risk associated with an investment. Higher returns usually come with higher risks, yet ROI treats all returns equally without factoring in the level of risk taken. Ignoring risk can lead to a skewed perception of an investment's attractiveness and might encourage decisions that expose individuals or businesses to undue risk.