Business, Legal & Accounting Glossary
A measure of the effectiveness and efficiency with which managers use the resources available to them, expressed as a percentage. Return on equity is usually net profit after taxes divided by the shareholders’ equity. Return on invested capital is usually net profit after taxes plus interest paid on long-term debt divided by the equity plus the long-term debt. Return on assets used is usually the operating profit divided by the assets used to produce the profit. Typically used to evaluate divisions or subsidiaries. ROI is very useful but can only be used to compare consistent entities — similar companies in the same industry or the same company over a period of time. Different companies and different industries have different ROIs.
For example, if you wish to set up a lemonade stand outside your house on a hot summer’s day, you may need to invest $10 in lemons, $1 in sugar and $1 in disposable cups.
That is a total cost of $12.
You are then able to make 21 glasses of lemonade, and sell them at $1 each, bringing you total sales of $21.
In our example, the ROI would have been
($21 – $12) / $12 = 75% ROI
The return on investment (ROI) is a calculation used in business used to determine whether a proposed investment is wise, and how well it will repay the investor. It is calculated as the ratio of the amount gained (taken as positive), or lost (taken as negative), relative to the basis.
In mathematical terms, the ROI is (Vf – Vb) / Vb, where Vf is the final value and Vb is the basis. Interestingly, to compensate for a negative ROI one needs a positive ROI that is higher in magnitude. For example, to recoup a 50% loss one needs to realize a 100% gain.
The analysis of the return on investment is either done by statical or dynamical formal methods, which may be distinguished by the role of time in the model chosen. Dynamic models take account of the fact that a later date of payment may be valued inferior in a model with interest rates. In other words, static approaches can be regarded as sufficient, if the distribution of payments in each period may be assumed as equal to others. All basic ROI-Models as deterministic, for instance, the well known TCO-model by the Gartners Group. Deterministic models assume the security of prediction. Abandoning this leads into the wide sphere of risk-aware-models, that is basically inspired by the mathematics of insurances.
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Definitions for Return (In Relation To Investment) are sourced/syndicated and enhanced from:
This glossary post was last updated: 27th March, 2020