Return on Investment (ROI) – a ratio that indicates how efficiently investments are used in terms of earning income (return to stockholders). It reflects the amount of earned profit in relationship to total investments (long-term liabilities and equity). In other words, it reflects gain (or loss) of the business comparing to the investments made in it.
Return on investment is an indicator that is commonly used for the estimation of different investments' efficiency, or for different entities' profitability comparison. The computation formula can be either general, measuring the profitability of total investments, or flexible, measuring the profitability of some specific investment type. For example, company's investors can use this ratio to measure the return on stockholders' equity, while company's management can be interested in estimating the potential return on some upcoming investment activities.
Due to the flexibility of its elements return on investment ratio calculation results may vary between different companies, and if there is a need to compare a few entities, it is important to pay close attention to the figures included to measurement. Higher ratio values indicate higher returns from investments made, while ratio values below 1 reflect an unprofitable use of investments.
Return on Investment = Net Income before Noncontrolling Interest and Nonrecurring Items + Interest Expense ÷ Average (Long-Term Liabilities + Equity)
Return on Investment (Year 1) = 480 ÷ 1040 = 0,46 = 46%
Return on Investment (Year 2) = 474 ÷ 1062 = 0,44 = 44%
Firm’s return on investment was 0,46 in year 1. Year 2 witnessed a slight decrease of this ratio to 0,44. This means, that the ability of investments (long-term liabilities plus equity) to generate the net income has declined.
In general, return on investment is a ratio estimating the possible financial consequences (profit or loss) of investment activities. Being a part of the profitability ratio analysis, it is a useful measurement tool for those users, who want make an investment into their own business or to invest their money into some already existing company's stock.