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What is the rate of return on investment (ROI) and how to calculate it by steps?
the introduction
If you want to invest in any project or business, you need to know how feasible and effective this investment is, and what profits you can make from it. Therefore, you should use a financial measurement tool called ROI.
The rate of return on investment (ROI) is a ratio that expresses the amount of profit or loss that you get from a particular investment, relative to the cost of that investment. Generally speaking, the higher the ROI, the more rewarding and effective the investment.
In this article, we will explain to you the concept of rate of return on investment (ROI), how to calculate it in steps, and the importance of measuring it to evaluate the performance and profitability of businesses and investments.
The concept of rate of return on investment (ROI).
The rate of return on investment (ROI) is an indicator used to evaluate the efficiency and quality of an investment, by measuring the ratio between the net profit achieved from an investment and the cost of this investment. Net profit is the difference between the investment's total income and its total investment costs.
To calculate the ROI ratio, the following equation is used:
ROI = (Net Profit / Cost of Investment) x 100
The ROI ratio is usually shown as a percentage, as it expresses the amount gained or lost per unit of investment cost.
How to calculate rate of return on investment (ROI) step by step
To calculate the ROI rate of return for any investment, you must follow these steps:
1- Calculating the net profit from the investment
The net profit from an investment is the difference between the investment's total income and its total investment costs. The total investment income is the amount obtained from the sale or exploitation of assets, services or products resulting from the investment. Total investment costs are the amount spent on the purchase, construction, operation or maintenance of investment assets, services or products.
To calculate the net profit from investment, the following equation is used:
Net profit = total investment income - total investment costs
2- Calculating the investment cost
The cost of an investment is the amount you spend to purchase, construct, operate, or maintain investment assets, services, or products. The investment cost includes all direct and indirect costs related to the investment, such as the purchase price, taxes, commissions, interest, rents, salaries, subsidies, advertising, and others.
In order to calculate the investment cost, all of the above costs are collected.
3- Calculate the percentage rate of return on investment (ROI).
After calculating the net profit and investment cost, the ROI ratio is calculated by dividing the net profit by the investment cost, and multiplying the result by 100. The ROI ratio is shown as a percentage.
ROI = (Net Profit / Cost of Investment) x 100
The importance of measuring the rate of return on investment (ROI).
Measuring the rate of return on investment (ROI) is of great importance in evaluating the performance and profitability of businesses and investments, as it helps:
Determine the feasibility and effectiveness of investments, and if they achieve their desired goals.
Compare several different investments, and choose the best among them.
Identify points of improvement and development in business and investments, and increase their efficiency.
Monitoring changes in the business and investment market, and adjusting its strategies accordingly.
Making sound and informed investment decisions, based on financial analysis.
Examples of calculating the rate of return on investment (ROI).
To illustrate the method of calculating the rate of return on investment (ROI), we will give some applied examples in different fields:
1- A business example
Suppose that a company produces a new product with a production cost of 100,000 pounds. After a year of putting the product on the market, the company gets revenues of 150,000 pounds. So what is the ROI rate of return for this product?
Net Profit Calculation:
Net profit = total investment income - total investment costs
Net profit = 150,000 – 100,000
Net profit = 50,000 pounds
Calculating the investment cost:
Investment cost = 100,000 pounds
Calculating the ROI Ratio:
ROI = (Net Profit / Cost of Investment) x 100
ROI = (50,000 / 100,000) x 100
ROI = 0.5 x 100
ROI = 50%
This means that a company makes a profit of 50% of every pound it spends on producing the product.
2- An example in the field of education
Suppose that a student wants to obtain a university degree in a specific major, and that the cost of studying this certificate is 50,000 pounds. After graduation, the student gets a job with a monthly salary of 10,000 pounds. Assuming that the education cost payback period is five years, what is the rate of return on investment (ROI) for this certificate?
Net Profit Calculation:
Net profit = total investment income - total investment costs
Net profit = (10,000 x 12 x 5) – 50,000
Net profit = (600,000) - 50,000
Net profit = 550,000 pounds
Calculating the investment cost:
Investment cost = 50,000 pounds
Calculating the ROI Ratio:
ROI = (Net Profit / Cost of Investment) x 100
ROI = (550,000 / 50,000) x 100
ROI = 11 x 100
ROI = 1100%
This means that a student makes a profit of 1100% of every pound he spends on studying this certificate.
Feedback and recommendations
The rate of return on investment (ROI) is a simple and easy-to-use financial measurement tool, but it does not give a complete and accurate picture of the performance and profitability of investments, because it ignores some influencing factors, such as risk, inflation, time, and the financial value of assets.
Therefore, it is recommended to use ROI as a comparison tool between similar investments in the same field and period, and not as a definitive tool for making final investment decisions.
It is also recommended to use other financial measurement tools integrated with ROI, such as current asset value (NPV), internal rate of return (IRR), payback period (PB), and others.
Conclusion
In this article, we explained to you the concept of rate of return on investment (ROI), how to calculate it in steps, and the importance of measuring it
e To evaluate the performance and profitability of business and investments. We also presented some applied examples in different fields. Finally, we mentioned some notes and recommendations regarding the use of this tool.
We hope this article was useful to you, and if you have any question or comment, feel free to write it in the comments. 😊
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