Analyzing Investment Decisions through Return on Investments
Created on 17 Aug 2020
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Updated on 11 Sep 2022
Before deciding to invest money in a company, a potential investor must analyze the company's ability to provide returns to its shareholders. Investors, business managers, and stock advisors analyze this ability by calculating various ratios and percentages based on the company's financial statements.
This analysis enables an investor to analyze a company's financial status and health. By converting the original financial numbers to ratios, it becomes easier to analyze the risks and trends in the market and the potential risks involved with the company.
Understanding a company's ability to provide returns to its shareholders can be done by calculating the company's return ratios. These ratios take into account a company's financial figures from its financial statements, such as net income, equity fund, market price per share, dividends, to analyze the profits a company can provide in return and the risks associated with it.
Return ratios show how efficiently a company generates profit and value for shareholders. For investment purposes, higher return ratios are obviously more favourable. However, the return ratios also facilitate the comparison of the company's return values to its competitors, market, or the company's previous performances. Evaluating the return ratios helps the investors make better decisions.
The first step to understanding and evaluating the returns on any investment is to get an idea of the amount of return an investment can generate. This is done by calculating the general return on any investment.
Return on Investments (ROI)
Return on Investments is a measure of financial calculation used to evaluate the efficiency of an investment or the expected return rate from that Investment. Return on Investment is also known as the rate of return or accrual accounting rate of return.
ROI can also be used to compare the efficiency of a number of different investments as well. ROI is a means to calculate the amount of returns on Investment as compared to its cost.
Return on Investments is a general measure of understanding an investment's profitability. This measure is simple to evaluate and can be used across different types of investments. ROI can be calculated on stock investments, any capital investment of a company or individual on an asset, or an ROI simply generated from a transaction.
The ROI result can be positive or negative. If the result is positive, the Investment will be profitable, and if negative, the Investment is likely to incur a loss. A comparison of the ROIs of different investments can facilitate better decision-making for investors by helping the eliminate lower ROI investments. The higher the ROI, the better the profitability of that Investment.
Return on Investments, Return on Assets and Return on Equity
The best measure of a company's financial health is its profitability. Higher profitability will indicate that the company will be able to pay off dividends and returns to its investors. Profit ratios of ROI, ROA, and ROE all give an insight into the profits and returns the generating capacity of a business.
Despite this, all three ratios serve different purposes. While return on Investment expresses a company's ability to generate the expected return based on using and managing the invested resources by the shareholders, return on assets gives an indication of how well a company can utilize its invested assets into earning profits. Return on Equity measures the shareholder's rate of return on their Investment in the company.
All three ratios express the company's ability to generate returns on its assets, shareholders' equity, and how well it can use them to generate profits. The calculation of all three ratios can give a clear insight into the company's overall capacity of generating profits and returns.
Calculating Return on Investment
The return on investment formula is as follows:
ROI = Income of business unit / Assets of the business unit
For example, company ABC Ltd has a net income of Rs 74 in the financial year 2019-20, with assets worth Rs 500 recorded in the balance sheet. To calculate the Return on Investment of ABC Ltd, an investor will divide the net income by the total assets:
ROI = Net income/ Total assets * 100
ROI of ABC Ltd. = 74/500 * 100
Hence, the return of Investment from investing in ABC Ltd will be 14.8%.
Types of Assets and ROI
There are different ways of computing ROIs for different purposes. The above formula is the most commonly used and is used to understand the profitability of the business. It takes into consideration the net income of the business unit, which remains after deducting the taxes and other expenses, and the total assets of the business unit.
There are some types of assets that are of different nature than normal assets. Their inclusion in the calculation of Return on Investment is often different. Here are a few such assets and how they affect the ROI:
- Intangible assets of the company. Intangible assets are those who cannot be physically seen, but their presence can be felt. These include things like goodwill, trademark, patents, copyright, etc. They do not have any book value, nor do they appear on the company's balance sheet. However, the cost incurred in their maintenance or acquisition is mentioned on the income statement as a cost, and thus, it affects the net income. Depending on their accounting methods, companies either choose to include them in their total assets or don't.
- Non-operating assets are not essential to the ongoing operations of a business but may still generate income or provide a return on Investment (ROI). These assets like unallocated cash and marketable securities, loans receivable, idle equipment and vacant land, etc., are listed on a company's balance sheet along with its operating assets, and they may or may not be broken out separately. Since they affect the balance sheet, these assets are often taken into consideration while calculating the ROI.
- Depreciation is the cost incurred as a result of the ageing as well as wear and tear of tangible assets and is a direct expenditure. Depreciable assets will directly impact the company's return on investment ratios or any other profitability ratio. Since depreciation is a direct expense, it will reduce the company's net profit. The lower the net profit, the lower the return on total assets will be. Therefore, depreciation and the rate of return on total assets are inversely correlated.
Apart from the consideration of these assets in ROI calculation, the total costs and total results should be taken into consideration. Also, while using ROI for the comparison of different investments in different companies, one must consider annualized ROIs.
Limitations of ROI
Calculation and comparison of ROI can have its own limitations. While ROI gives a near-perfect idea of how profitable an investment would be, one should not be completely reliable on just the ROI for making an investment decision.
When comparing the ROIs of different companies, one must ensure that similar accounting methods and policies are used in all the companies compared to put them on the same comparison scale. Also, while making a decision through the ROI, an investor might just make the call based solely on the returns and can ignore other investment decisions that might be beneficial in the long term.
Similarly, a division manager may just invest based on the ROI and ignore the investing decision, which might benefit his firm as a whole. Such decisions are sub-optimal and can disturb an enterprise's overall allocation of resources.
ROI mostly focuses on short-term results and returns and often ignores long-term profitability. ROI takes into account the current period's revenue and cost and often tends to overlook those investments and expenses, which will increase the long-term profitability of the business.
Also, basic ROI calculation does not take into the length of the investment period, also known as the holding period. The most common limitation of using ROI for investment decisions is that it can be easily manipulated and distorted. Firms or individuals can influence their ROI by changing accounting policies, determining investment size or assets, and treating certain items as revenue or capital.
However, these limitations can be easily overcome by adding up other methods while making an investment decision so that the investor can make a better decision.
The Bottom Line
Return on Investments is the most simple and effective way of calculating any investment returns or comparing investments. Return on Investments is not necessarily the same as profits. It gives an idea of how much money will be realized from the money one has spent on Investment. Despite its limitations, ROI is still a key factor in understanding what an investment holds in return and the possible profitability from it.
It is widely used by business analysts to evaluate and rank investment decisions. However, the calculation of the return on Investment will only give a broad idea of the company's return capabilities. It is important to know the Return on Assets (ROA) and Return on Equity (ROE) ratios to make a well-informed investment decision. Hence, the next step in this series will be the ROA analysis.
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