What is Return on Investment (ROI)?
ROI stands for Return on Investment and is a financial metric used to measure the profit or loss that any investment might deliver in the future. It can be calculated for various investment options and the most standardized measure to judge an investment option or compare two different investment options.
Formula for Calculating ROI
Net Return on Investment is the amount of gain or loss that any investment might make in the coming years.
Cost of Investment is the amount of money that is invested.
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Let us understand through a real-world example how you can calculate the return on investment for any investment.
So let us suppose that you run a taxi business. Now you are planning to buy a new vehicle. Let us assume that the car is costing you 5,00,000 INR. Let us suppose the maintenance cost for the car is 10,000 INR every year. Let us also assume that you can sell the car for 50,000 INR after ten years. In this case, if you calculate the total cost of the vehicle for ten years would be 5,00,000 + 1,00,000 (maintenance) - 50,000, which is 5,50,000 INR.
Now let us suppose that after our costs are covered, we can earn 25,000 INR per month from the taxi. This means that in 12 months our profits would be 3,00,000 INR. This means that the gain over the life of the vehicle would be 30,00,000 INR.
Now, let us calculate the return on investment on this deal.
Net Return on Investment = 30,00,000 - 5,50,000 = 24,50,000
Cost of Investment = 5,50,000
Therefore, Return on Investment = 2450000 / 550000 * 100
It is essential to notice that this return on investment is for ten years.
The annual returns would be different from this number. It is essential to understand how the return is calculated and what insights you can get from it.
Advantages of ROI
The most significant advantage of using return on investment is that it is a straightforward metric and can be used across almost all types of investments. It is standardized and easily understood by all related stakeholders.
Disadvantages of ROI
There are two main disadvantages of using this metric:
- Does not account for risk - The metric only tells you in percentage terms the benefit that you will get from a particular investment; however, it does not account for the chance that you will be assuming to generate that return. In finance, we all know that risk and return are positively correlated, so if risk goes up, returns also go up, and if the risk goes down, returns also go down. However, there is no exact metric to measure risk, and when someone is comparing two investments based on return on investment, then there is no consideration of the risk involved.
- Does not account for time - If you understand the concept of the time value of money, then you will understand the importance of taking time into account. Even though there is a general standard of comparing investments for one year, return on investment does not necessarily mean one year. So, for example, if you are a yarn trader and you invest Rs. 100 in buying one roll of yarn. If you sell this yarn for Rs. 120, your return on investment will be 20%. However, this does not mention how much time you generated this return. If you sell the roll in 3 months, then also the return on investment is 20%, and if you sell it in 8 months, then also the return on investment is 20%.
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