Return on investment (ROI) is a term used in business administration to describe the profitability of an investment. Companies can use this value to determine whether investments in certain business activities are paying off.
ROI, also known as capital return or interest on capital, indicates the percentage ratio between the capital invested and the profit generated. This enables companies to assess whether the investments they have made in a financial year have made a positive contribution to the company's success and should be continued or even intensified. The ROI also provides information on whether investments were a wrong decision, as they had a negative impact - i.e. resulted in a loss.
In simple terms, the return on investment is calculated using the formula (profit/total capital)*100= ROI in %
A company with a profit of € 20 million and total capital of € 180 million thus achieves an ROI of 11%.
The ROI puts a company's profit in relation to the capital invested. To calculate this ratio, only two values are required:
The return on sales is calculated by dividing profit by sales.
Example: The company generates 200 million in sales. The profit amounts to € 20 million. According to the profit/sales formula, the return on sales = 0.1%
The capital turnover is calculated by dividing the turnover by the total capital.
Example: The company generates sales of € 200 million. The total capital is € 180 million. According to the formula turnover/total capital, the capital turnover = 1.11%
The formula return on sales * capital turnover is used to calculate the return on investment ROI. In our example, this means
(20.000.000 / 200.000.000) * (200.000.000 / 180.000.000) = 0,11 * 100 = 11%
Since you can mathematically reduce the turnover (€ 200,000,000), this leaves profit (€ 20,000,000) / total capital (€ 180,000,000) * 100 as the formula.
In our example, the return is therefore 11%.
If you want to calculate the ROI of a single investment, you have to be more precise and first determine the profit that resulted directly from this investment. This value is then divided by the capital invested in it. As this is often not possible with such precision, an estimate usually has to be made. For example, the ROI of a project can be determined quite accurately. The ROI of software that is used by all departments, even by people who are not directly involved in product development or the provision of a service, may contain inaccuracies.
As mentioned at the beginning, ROI tells you whether an investment is good or bad and has had a positive or negative impact on the success of the company. It can therefore be used to answer the question of whether
Clearly the simple calculation with key figures that are available to every company. The evaluation based on the clear percentage figure is also unambiguous and easy to interpret.
So if a company wants to assess whether a certain investment was profitable, the ROI can be used for this assessment. Another advantage: if you can determine the efficiency with a key figure, you can also make comparisons and weigh up which measures should be invested in further and where a too low or even negative ROI may mean there is no benefit in continuing.
If the efficiency of several investments is to be compared using ROI calculations, it is important to look at the same time period and ensure that investments in the same category are compared. E.g. software investments, innovation projects, new customer acquisition or new machines.
The ROI can also be determined for a department or a branch of the company. Or for a single measure, e.g. in the marketing of a product. In this case, it can be useful to calculate the ROI at project level or to look specifically at the ROMI (return on marketing investment) or ROAS (return on advertising spend), for example.
As the return on investment is determined exclusively from the monetary key figures of the company or a division, a certain distortion can occur. This is because external influences that are outside the company's control but can have a significant impact on return on sales are not taken into account in the ROI indicator.
Such external factors can be:
In summary, the clear disadvantage of ROI as an analysis indicator is its sole focus on monetary success. It does not reflect the many other factors that influence the success of a company. For this reason, ROI can only be one of many variables when assessing the performance of investments.
The question of how high the ROI value must be in order to be classified as “good” varies from sector to sector. Although a value of 10% is generally aimed for, a value of 15% - 20% is considered good in industries driven by innovation and growth. In contrast, a value of 10% is very good in traditional sectors such as industry. In retail, however, it is rather low again.
But these are very general values. In principle, the company - or the shareholders and investors - determines which ROI it classifies as “good”. This is because there is also the question of whether strong growth is aimed for or whether, against the backdrop of a poor overall economic situation, slight growth is already considered a success.
If the causal relationship between the costs of an investment and the benefits for the business within a realistically set time frame is clear, the ROI actually provides information about the success of the investment. The ROI can also provide a good indication of performance when determining the overall performance of a company or company divisions. And the ROI is also a good basis for discussion when managing further investments.