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Return on Investment (ROI): Meaning, Formula, Significance and Illustrations

Last Updated : 23 May, 2023
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What is Return on Investment (ROI) ?

Return on Investment (ROI) is a measure that is used to estimate the amount of profit that can be earned or has been earned from the different types of investments. It not only determines the profit but also the loss generated on the investments. In other words, ROI lets you know how much returns you get on your investments. It does not consider the time for which the amount is invested in a particular type of instrument. It is a type of financial calculator. ROI is expressed in percentages. ROI is also known as Return on Capital Employed (ROCE). It is a type of Profitability Ratio.

The statement of profit and loss is used to determine the profitability of the business or organisation. The earnings of a business are based upon the utilisation of resources in the business and thus Profitability Ratios are calculated for analysing the earning capacity of a business. 

Formula to Calculate ROI

ROI=\frac{Net~Profit~or~Return~on~Investment}{Cost~of~Investment~or~Capital~Employed}\times100

Significance of ROI

Return on Investment is calculated to serve a variety of objectives. From helping management to know about the profitability of the investments to building trust in the eyes of outsiders, here are some of the importance:

  • ROI helps businesses to compare the returns on various investments and order them according to their needs.
  • It helps businesses to make a better choice to invest their money and helps diversify their portfolios.
  • ROI helps businesses to price their products effectively in order to get the maximum profit and also satisfy the needs and demands of the customers at the same time.
  • It helps everyone understand the proper allocation of resources.
  • ROI guides all investors in making important decisions by comparing high-price and low-price investments.
  • It also helps to research and analyze the benefits of various opportunities.
  • It also teaches organizations to calculate costs and understand threats in the market.

Illustration 1:

Calculate Return on Investment from the following information:

 

Solution:

Return~on~Investment=\frac{Net~Profit~Before~Interest~\&~Tax}{Capital~Employed}\times100

Capital Employed = Non-current Assets + Current Assets – Current Liabilities

Capital Employed = 1,50,000 + 80,000 – 54,000

Capital Employed = 1,76,000

Return~on~Investment=\frac{29,000}{1,76,000}\times100

Return on Investment = 16.47%

Illustration 2:

Calculate Return on Investment from the following information:

 

The net profit after tax is 1,00,000, and the amount of Tax is 20,000.

Solution: 

Return~on~Investment=\frac{Net~Profit~Before~Interest~\&~Tax}{Capital~Employed}\times100

Profit before interest and tax = 1,00,000 + Debenture Interest + Tax

= 1,00,000 + 60,000 + 20,000

= 1,80,000

Capital Employed = Equity Share Capital + Preference Share Capital + Reserves + Debentures

= 5,00,000 + 1,50,000 +  2,00,000 + 3,00,000 

= 11,50,000

Return~on~Investment=\frac{Net~Profit~Before~Interest~\&~Tax}{Capital~Employed}\times100

Return~on~Investment=\frac{1,80,000}{11,50,000}\times100

Return on Investment = 15.65%


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