Return on Investment (ROI)

Updated: 02/02/2007 11:31
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Nowadays many companies work with the so-called Return on Investment system, with which they quote the profitability of their investments. For the first time this system was introduced by engineer Donaldson Brown in 1919. Thus, investors can quote a new acquisition's duration with this well thought-out financial ratio system, until the developed costs will be again earned.

With other words we can say that the Return on Investment (ROI) is a financial ratio which explains the relationship of investment and profit, namely, the costs of an investment are set in relationship of the amount of the expected profit. The ROI indicates the proportion of the investment profit and also its value that will flow back from an investment.

The Return-on-Investment analysis is one of different methods of the investment valuation. Presently the ROI is one of most frequently used financial ratios. In the past years the ROI preserved by purchase decisions for computer systems and also by "Go"- and "NO-go"-decisions for measures of marketing, recruiting and of training. Moreover, the Return on investment kept from traditional investment decisions like the management of share depots and the use of risk capital.

The calculation of this financial ratio system proves to be quite simple. The quotient of the accounting income and the inserted capital is called Return on Investment (ROI). Therefore, investors can quote the financial success of an enterprise with this periodic system. However, a meaningful valuation is only possible if the result can be split-up because the ROI can be applied only to the overall picture and not to single investments.

As a result of the popularity of this system, nowadays there are various modern views of the long-proven systems which make possible a periodic, long-term or also a single investment calculation. Exactly in the today's time, in which a misdirected investment can cause large income wastage, the Return on Investment can be very important as system. Many companies use it to get a clear overview of their financial situation and resources.

Another yield strategy which plays an important role in the ROI is Cash Flow Return on Investment (CFROI). This goal ratio can be formed within yearly planning. In this case the gross operating result/ EBIT (= Earnings Before Interest and Taxes) would be referred to the invested fortune (employed capital in the sense of totally assets).

This defines the Return on Investment as start of the ROI family tree. If investors add the budget of the annual writings-off now, thus the CFBIT (Cash Flow Before Interest and Taxes) develops. The CFROI, which is related to the same basis invested fortune, develops as financial oriented ratio more strongly.

An alternative is to discount interest on the future cash flow. In such a way designated CFROI corresponds to IRR (namely, Internal Rate of Return). Thus the question is which discount rate can develop, if investors make up the present value of the future cash flow and compare this CF with the invested fortune. On the other hand, the capital cost set (CCS) would stand and we can judge whether investors determine this CFROI equally or under the capital cost rate.

Our next question is, whether the employed capital needs to be formulated in the sense of total assets (or the company necessary assets"). Or whether it has to be balanced to the Working Capital by the circulating capital (these examples are often in American investment industry)? The outside capital which is free of interest is taken off (for example, commitments for supplies and achievements or pre-payments from customers).

In conclusion we mention that although the value can be investigated by means of the ROI that is managed by an investment, it should not serve as exclusive decision basis because the ROI does not permit statements about possible investment risks and about the dimension of income from matured investments.

Of course, this system has its disadvantages (like also every different one). The ROI does not take into consideration the nowadays important future-oriented developments and changes (for example, the purchase behaviour of customers or also demand and market saturation).

There is another example, namely, also the risk investments are not accounted at the stock exchange. As a result of this statement we can say finally that this system can have a very important meaning to evaluate investments and make correct decisions finally if we clarify the aspects of the future and the risk before in every detail.


About the author

Nicole Berger has over seven years experience writing and editing for online and print media. She has held various editor and associate editor positions in some of forefront independent media publications. A consistently dependable team player, I thrive in a high-pressure environment, enjoy the challenges of meeting deadlines and managing a team, and am comfortable researching, writing and editing on a wide range of topics.
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