Monday, May 25, 2020

Return On Investment (ROI) - Definition,Formula,Advantages,Disadvantages and Example

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Return on Investment(ROI)
Return on Investment(ROI)

Return on Investment(ROI) means a tool which is used to identify their financial results in percentage term and compare those results with their targeted ROI or other businesses ROI. Most organizations focus on their ROI instead of purely focus on the absolute size of a division's profit. Hence it is important to calculate it's ROI for every organization to identify their final results.

What is Return on Investment

Return on Investment is commonly known as profitability ratio. In this method, we need return and investment of an organization which we will put on formula of ROI.Formula of ROI is as under:-

Formula For Return on Investment:

Profit after tax but before interest *100
 Capital Employed


ROI expresses the profit of an organization as a percentage of assets employed in the organization. This tool is a divisional performance measurement tool with the help of which an organization can easily find out, in how many years they are able to recover it's capital investment.

How to calculate ROI

As the name suggests return on investment means how much our return in comparison to our Investment. We are taking return after-tax but before interest. We also have to understand that Return always includes only those income which is controllable by the manager. Let's explore formula for more understanding:

Return:- 

Sr. No Particular Amount
1 Profit before tax and interest(Controllable) XXX
2 Less: Interest (XXX)
Profit before tax but after interest XXX
3 Less: Tax (XXX)
Profit after Interest and Tax XXX
4 Add: Interest XXX
Profit after tax before interest XXX

Capital Employed:-

We can calculate Capital employed by using below said formulas:-

#1 = Equity share capital + Preference share Capital + Reserve + Long term Loan + Debenture
                                    Or
#2 = Fixed Assets + Current Assets - Current Liability
                                    Or
#3 = Fixed  Assets + working Capital
                                    Or
#4 = Total Assets - Current Liability

* We have to remember that Capital Employed also includes only those assets and liability which are directly controlled by the organization manager.

** We also have to remember carefully that head office expenses apportioned given would not be considered for calculation of Return on Investment.


Return on investment(ROI)
Source

Examples of Return on Investment

Example  : Suppose we have given following details of M Division.

Revanue - Rs.30000, Profit - Rs.5000 , Head office Exp. - Rs.2000 , Non-current Assets - Rs.20000 , Current assets - Rs.5000 , Current Liability - Rs.3000

Calculate Return on Investment(ROI)

Solution : a) Calculate return of M company

Return = Rs.5000


*we will not deduct H.O expenses from profit because it is not controllable by manager of M division.

b) Calculate Capital employed

Capital employed = Rs.20000 + Rs.5000 - Rs.3000 =Rs.22000

c) Now put all details into the formula of ROI

ROI = Return/Capital emploed *100

        =Rs.5000/Rs22000 *100

        =22.72%

Advantages of Return on Investment

a)  All division or organization can easily calculate their return on investment and it is easy to understand for everyone.


b)  By the ROI method we can easily compare two different sizes of division. Which may be helpful to identify the best division.

c)  Further we also can compare two different types of organizations.

d)  By this method we can ensure that our capital would be recovered.

Disadvantages of Return on Investment

a)   We will charge depreciation on assets every year due to which assets value will be reduced so that, ROI will increase every year. We can understand this by an example as given below:

Year Profit After Tax Fixed Assets Working Capital Capital Employed(c+d) ROI(b/e*100)
a b c d e f
1 20 100 20 120 16.67%
2 20 80 20 100 20%
3 20 60 20 80 25%
4 20 40 20 60 33.33%
5 20 20 20 40 50%


*Depreciation charged on fixed assets on straight-line basis @20%

b)  ROI method gives misleading info if we are comparing the current year and previous year data. 

c)  Divisional managers will not agree to replace it's old assets because it will help to decrease it's capital employed. Due to decrease in capital employed ROI would be increased. Every manager will try to show his performance better in terms of increased ROI.

d)  The divisional manager would work with low working capital reason being due to low working capital it's capital employed will be reduced. Reduced capital employed will leads to high ROI.

e)  ROI is not appropriate for making decision sometimes. We will understand this by an example:

Particular Division X Division Y
Actual ROI of the Division  25% 15%
Targeted ROI 20% 20%
New proposal in which ROI estimated 22% 18%
Company decision should be Accept Reject
Manager decision is taken Reject Accept

In the given scenario even though the proposal of Division X gives better ROI but managers of Division X rejected this proposal and accepted the proposal of Division Y which gives less ROI.

Let's understand why?

Division X's new proposal giving higher ROI in comparison to targeted ROI  despite the manager rejecting this proposal only because of their average ROI would be reduced by accepting this proposal. On the other hand, the manager of Division Y accepting a new proposal that gives less return in comparison to Division X's new proposal because by accepting this proposal by Division Y their average ROI would increase. 
This would benefit the managers of the division but the company would run into losses overall.

how is return on investment calculated all this we write in this article. Hope ROI article is beneficial for you.return on investment formula.Return on investment calculate all we explained well.

Written by - Pankaj Kumar

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