Accounting Basics: Understanding Return on Investment (ROI)
Accounting Basics: Understanding Return on Investment (ROI)
Return on investment (ROI), sometimes referred to as return on assets, is a measure used to assess the profitability of a company. On the most basic level, ROI shows return on investment. Understanding why ROI is important, how it is calculated, and what the resulting numbers indicate is an important step in acquiring financial literacy.
Why ROI is important
Income and expenses reveal only part of a company's performance. ROI puts income and expenses in perspective and shows how effectively a company's managers have used its assets to produce income. ROI also helps an investor to interpret the information presented in a company's financial statements. Ultimately, ROI can help an investor decide whether or not to buy or sell stock in a company.
Calculating ROI
ROI is a ratio that is determined by dividing net income by the average of total assets. It is presented as a percentage. Stated as a formula, ROI equals net income divided by average total assets.
The first step is to determine net income. Net income reflects a company's revenue for a period of time, usually 1 year. To figure out net income, subtract all of an organization's expenses from its total sales, also called net sales. Expenses include the direct costs involved in producing a product or performing a service as well as other expenses incurred in running the company, such as rent, advertising, and salaries. Interest and taxes are also subtracted from net sales to reach the figure for net income, though they are sometimes omitted. This information can be found in a company's Income Statement.
The next step is to calculate average total assets. Total assets, by definition, include all of the assets of an organization. Cash, accounts receivable, inventory, property, and equipment are all part of total assets. Average total assets are calculated for the same period of time as net income. The total assets at the beginning of the period are added to those from the end of the period, and this sum is divided by 2. The information needed for this calculation can be found in a company's Balance Sheet; a Balance Sheet is required for both the beginning and the end of the covered period.
Once net income and average total assets have been determined, the final calculation of ROI can be made.
Expanding the ROI formula: the DuPont model
The DuPont model expands the basic ROI formula. In this model, (1) net income is divided by sales and (2) sales are divided by average total assets; the resulting numbers are then multiplied to calculate ROI. Net income divided by sales is referred to as margin, and sales divided by average total assets is called turnover. Presented as a formula, ROI equals margin times turnover.
While the final percentage achieved will be the same as with the basic formula, the DuPont model presents a more-detailed perspective on a company's activities. Margin directly links sales to net income and thus to profitability. Higher margins can be achieved by increasing price or volume, by reducing expenses, or by a combination of these methods. Turnover looks at the amount of sales generated in relation to the total assets held by the company. This is an indicator of how well the assets are being used. Higher turnover can be achieved by increasing sales, decreasing assets, or increasing sales and decreasing assets.
Margin and turnover are interdependent. For instance, a reduction in inventory will reduce assets, but it may also impact sales, thus altering margin as well as turnover. Since ROI is determined by both margin and turnover, a decrease in one might be offset by an increase in the other. So ROI could increase even if one of these components decreased.
What the numbers indicate
While higher is certainly better than lower, there is no set standard for a good ROI, and big numbers are not common. Apart from individual numbers, ROI provides a means for comparison. A comparison of a company's ROI over several years will show whether or not its performance is improving. ROI also enables comparisons of a company with others in its industry or outside it. When making comparisons outside of a company, it is important to determine which formulas and accounting methods each company has employed. For instance, the calculations for ROI will be slightly higher if interest and tax expenses are not subtracted from net income.
ROI is not the sole indicator of a company's health, its value, or its long-term potential as an investment. It is, however, an important marker and one that can help an investor make an educated investment decision.
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