Return on investment (ROI) is a financial ratio used to calculate the benefit an investor will receive in relation to their investment cost. It is most commonly measured as net income divided by the original capital cost of the investment. The higher the ratio, the greater the benefit earned.
The ROI is a simple metric which can be used to quickly evaluate various investment options. When comparing different projects we need to be careful to compare similar time periods. For example if you buy a piece of land for ugx 10 million and the price goes to ugx 15 million in a year then the return on investment is 50% ([15 – 5]/10).
There are other alternatives to the return on investment including Internal Rate of Return, Return on Equity, and Return on Assets.
The most detailed measure of return is known as the Internal Rate of Return (IRR). The internal rate of return is the required rate of return for a project to break-even. The internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows equal to zero in a discounted cash flow analysis. It’s basically the minimum return an investor should be willing to accept for a particular investment. The higher the internal rate of return the better the investment.
Other alternatives to ROI include Return on Equity (ROE) and Return on Assets (ROA). The return on equity is the net income expressed as a proportion of the shareholder’s equity in a business. The return on assets is the net income expressed as a proportion of the total assets deployed.
These ratios will vary from industry to industry. Some industries like manufacturing will typically have low returns on capital since they are capital intensive. Service industries like law firms for instance will have high returns on capital deployed because they are not as capital intensive.
Understanding the return on investment can help an investor decide which project to pursue and how to course correct when things go wrong.