Everything About Return on Investment (ROI)

For anyone seeking to open up a business or invest in a project, their main goal is to attain a great profit. But at times due to poor or rush making of decisions, some businessmen incur great losses and this is usually very devastating. One essential thing that is key for someone setting up a business or investing in a particular project who wants to achieve great profit, is to first determine the performance of your investment. The one thing that will help you with this is ROI (Return on Investment).

  ROI is a term known to some of us, but for those to whom it might be the first time to hear it worry not. In this article, we are going to break down for you not only the meaning of ROI but also its business advantages and if not well effected some of its disadvantages.

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Meaning of ROI (Return on Investment)

ROI is a performance measure that is used by investors to evaluate the efficiency of an investment or the differences between several investments. Basically, in simple terms (ROI) tells you how much profit or loss one’s investment has made after accounting for its cost. ROI is simply calculated by dividing the profit earned on an investment by the cost of that investment.

 For example, an investment with a profit of $150 and a cost of$100, would have an ROI of 1.5

One good thing about ROI is that it is meant for any kind of business either big or small. When investing one can either have a high ROI or a low ROI. High ROI means that the gains from the investment compare favorably to its costs, while a low ROI means that the investment produced low returns, in short, the money invested was lost.

From this, we can tell ROI clearly has its advantages but when not well affected it can have some disadvantages. In this article, we are going to look at both the advantages and disadvantages.

Advantages of ROI (Return on Investment)

Better Divisional Probability

It correlates net income to investments made giving it a greater profit attainability. It also ensures that assets acquired are sure to bring compatibility with the policy. ROI, maximizes profit with the available resources and this is advantageous to a business person since the profit they will obtain is up to its maximum.

Easy and Simple

As we have shown in this article, ROI calculation is straightforward. It is easy for everyone and can be used by all, even those without an accounting background. Whereby they simply calculate and determine the performance of their investment and this can also be made easier by maintenance software.

Ranging of Multiple Projects

ROI helps to evaluate differences between several investments. These investments are ranked from the most profitable to the lowest profitable, with this one can allocate funds based on the investment hierarchy.

As a Performance of the Investment Division

ROI measures the efficiency performance of an investment division, which focuses on making sure that the profit attained is up to its maximum. About the acquisition and disposal of capital assets, appropriate decisions are made.

Helps in Analysis Comparison

ROI helps in the comparison of several investments in profitability and asset utilization. Investments are ranked from the one with the highest profitability to the one with the lowest, and this helps with the decision of the right investment selection and the right cost of capital to be used.

Achievement of Goal Congruence

Goal congruence is the agreement of individual goals with company goals. ROI ensures the goal congruence between the different divisions and the firm. An increase in divisional ROI brings overall improvement.

Complements with Accounting Measurements.

ROI is based on financial accounting measurements. All numbers required for calculations are easily found in financial statements prepared in the accounting system, which makes it easy to calculate.

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We have looked at the benefits of incorporating ROI in our business, now we will look at the limitations that also come with it.

Disadvantages of ROI:

Ignores the Time Value of Money.

The time value of money is the amount that one could earn between today and the time of further payment. ROI does not include the time value of money. An investment that generates profit over the long term has more advantages and the profit made is not that small.

Lack of Agreement on the Optimum Rate of Return.

This at times brings disagreements and discourages managers whose opinion is that the rate is set at an unfair level.

Excessive Preoccupation with Financial Factors.

This is due to constant attention to ratios and trends, which tend to distract management’s interests from technical and other responsibilities.

Business Units Having Higher ROI and Some Others Have Lower ROI

Some units are favored by ROI while others are not. With this most profitable units are demotivated to invest in projects that don’t exceed their ROI, although the project might have a good return. This may seemingly bring conflict in goal congruence and interests of the firm as a whole.

Some Divisional Managers Select Investments Only Above Their Target ROI

These types of decisions are less optimal and can distort the overall allocation of resources, making an investor invest just to preserve its existing ROI.

Hard to Compare with Other Companies.

Due to differences in accounting treatment in each company y, it is usually hard to compare ROI. Profits can be various base depending on each company, thus making it hard to compareTo sum it up, we have seen both benefits and limitations of ROI, and as one can depict it’s more advantageous leading to greater profits in one’s investments or projects. You can also make matters easier by using a Software ROI calculator to do the hard work for you swiftly.

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