Calculating ROI: formula

2024 Author: Howard Calhoun | [email protected]. Last modified: 2023-12-17 10:16

The role of investments for the macroeconomic system is difficult to overestimate. They affect many areas of society, regardless of the object of investment. However, the goal of any investor is to obtain an economic result, i.e. profit, therefore, to assess the possibility of obtaining income from investment activities, indicators of return on investment are used. They reflect the possible amount of profit that the investor will receive and the payback period of the invested assets.

Assessment of investment attractiveness

Before evaluating the effectiveness of the project, investors study the attractiveness of the investment object. To do this, use the following methods:

• method of analyzing the financial condition (assessed financial stability, liquidity of assets, availability of receivables and payables, profitability of production);
• method of economic analysis of activity (assessment of the state of production assets, their level of utilization and degree of wear, study the business activity of the enterprise, the organization of business processes, the efficiency of the use of human capital, the qualifications of personnel);
• method for assessing the profitability and risk of economic activity (investment risk analysis is carried out).

The purpose of assessing the attractiveness of an investment project is to determine the ratio of profitability to risks.

Efficiency of investment

Assessing the effectiveness of an investment is a critical step in the process of deciding whether or not to invest in a particular project. Since investment activity affects all spheres of life of the macroeconomic system, the effectiveness of investments should be considered from different angles. The larger the project, the more performance parameters should be considered: economic, commercial, technical, social, environmental and budgetary. Of course, economic efficiency is of paramount importance for an investor.

Economic evaluation of return on investment

Economic ROI includes:

• analysis of the production capacity of the investment object;
• analysis of the level of technical depreciation of fixed assets and the need for modernization;
• analysis of the efficiency of production processes and automation;
• analysis of the application of scientific developments, know-how;
• analysis of the efficiency of labor use, including the number of employees and their qualifications, the social climate in the team, the availability of social benefits for employees.

Investment activity is associated with risks, and the economic analysis of return on investment allows you to thoroughly study the possible risks and predict the final result of investments.

Static and dynamic indicators are used to assess the profitability of investments.

Static investment performance indicators

This group of indicators allows you to evaluate the profitability of the project as a whole and at each specific point in time. These include:

• The payback period, illustrating the period of time during which the invested assets will return to the investor in full.
• The return on investment ratio (ARR), which shows the ratio of financial investment to the total amount invested in the project.
• Net financial investment is the amount of monetary assets received as an investment less the cost of taxes, raw materials and supplies.

Calculation of return on investment based on static indicators is quite simple, but does not take into account many risks and does not provide a realistic assessment of the profitability of investments.

Dynamic investment performance indicators

This group of indicators allows you to monitor the dynamics of project efficiency and makes it possible topredict the return on investment. Dynamic indicators include:

• Project net present value (NPV), which reflects the net income from the project for the period.
• Profit Index (PI), shows the ratio of the net present value to the total volume of investments.
• Internal rate of return (IRR), which allows you to determine the marginal level of project profitability.

When calculating by the dynamic method, the bank deposit rate and the weighted average cost of capital are taken into account. If the interest on a bank deposit is higher than the expected profitability of the project, then investing in the project does not make sense, since investment risks are always higher than on the deposit.

The concept of profitability

ROI reflects the level of return on investment. It allows you to assess how effectively the funds invested in the project have been mastered. It is defined as the ratio of net profit received in the course of economic activity to the amount of funds invested in this project. Due to its versatility, the profitability indicator is widely used in assessing the efficiency of production in general, individual types of products and investment projects.

Calculation of return on investment

The formula for return on investment (ROI) is as follows:

ROI=(Return on Investment - Value of Investment) / Value of Investment100.

This indicator helps to assess how effectivelyfunds invested in the project.

To assess the profitability of a project for the full cycle of its life, the return on investment ratio (ARR) is also used. This indicator is often used to assess the feasibility of investing in a particular object and for a comparative analysis of investment projects.

ARR=Average Annual Net Income / 1⁄2(Investment Amount - Project Liquidation Value).

The relative return on investment is calculated using the ROI index (PI):

PI=NPV / Investment amount.

This indicator reflects the level of income for each invested ruble of investment. If the index is less than one, the investment in the project is inappropriate.

A more accurate indicator is the discounted return on investment index. Discounting is used for long-term projects, investments in which have a run-up in time.

Project profitability assessment

It is important to evaluate the return on investment at all stages of the existence of an investment project: before investing, when comparing alternatives, during the project implementation and after its completion.

If the project's return on investment is greater than one, then the invested assets will pay off and bring profit to the investor. If the indicator is equal to one, a deeper analysis of the effectiveness of the project should be carried out in order to make a decision on investment. If the return on investment is less than one, then the project, with a high degree of probability, will beunprofitable.

At first glance, the assessment of investment profitability is simple, but in practice there are many factors that affect profitability that are difficult to predict, therefore, when making a decision on investing assets, a set of indicators is calculated: return on investment, net present value and internal rate profitability of the project.

Profitability of investments is of paramount importance for the investor. To evaluate the return on investment, static and dynamic indicators are used. Static indicators are easy to calculate, but do not take into account the timing of investments and the influence of external factors. Dynamic illustrate the change in the level of profitability over a time period. The evaluation of the return on investment is carried out at all stages of the project's existence. The return on investment proves how effectively the assets were mastered and what financial result the investor can expect.