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Glossary keyword - Return on Investment (ROI)

Return on Investment (ROI)

Return on Investment (ROI) measures the benefit an investor will receive in relation to their investment costs. To further simplify it, ROI is the indicator of how much money your money has earned. When you are investing in something, you are either improving your product, opening different locations, or putting money into marketing to promote your product or service. Every company that invests in something expects to earn something in return. Therefore, knowing where and how to invest is crucial. Otherwise, the returns can be lower than the investment itself, generating loss as a result. 

Different ROIs 

ROI has a number of meanings and is broadly used, so it is essential to define the term before proceeding. Return on investment is often used in a general sense by business people or entrepreneurs. ROI usually means assessing the excellence of an investment or business decision. “Return” usually implies profit, excluding tax, but it is essential to clarify this with the person who uses it. Profit depends on different circumstances. The profit is usually being generated thanks to the investment. The investment might mean the total assets of the business. In this case, the assets will equal to capital plus liabilities. Liabilities are debts in general sense. The investment could also relate to an element of a business, a new service, a new plant, a new piece of equipment, any activity, or an asset. 

Calculating ROI 

Return on Investment can be the net income divided by the cost of the investment, which is an annual form of return on investment. ROI can also be calculated by dividing total investment gain by the original investment cost base. Let’s look at some examples. Imagine an investor buys a property for half a million dollars. Two years later, it sells the property for $700,000, so its gain is 200,000 dollars. That equates to a return on investment of 40 percent. 

Now let’s look at the annualized return on investment figures. One of the drawbacks of traditional return on investment, as you saw in the previous example, was that the investor held a property for two years and got a return on investment of 40 percent. But we often like to think of performance in annual figures. So we can calculate an annualized return on investment. We take the ending value divided by the beginning value and raise it to the power of 1 divided by many years as a compound annual growth rate. You can look at the formula down below: 

Annualizing ROI 

Annualizing the return on investment is necessary for a bunch of different factors. The main reason is the comparison of different ROIs. For example, if a company buys a product and then sells it after just six months, its traditional return is, let’s say, 20 percent. But because the company held the item for less than a year, the annualized return on investment is going to be 40%. So it is essential to look at the regular or total return on investment and the annualized return on investment to accurately assess the overall quality of return on investment.


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