The Return on Investment Ratio Explained
The return on assets ratio also called the return on investment ratio (ROI), is a profitability measure that evaluates the performance of a business or investment, or the potential return from a business or investment, by dividing net profit by net worth, with the result expressed as a ratio or percentage.
Return on investment, or ROI, is the most common term. There are several ways to determine RO I, but the most frequently used method is to divide net profit by total assets.
The reason that the return on assets ratio is also called the return on investment ratio is because "investment" refers to the firm's investment in its assets.
ROA/ROI can be seen as a returns ratio, allowing the business owner to calculate how efficiently the company is using their total asset base to generate sales. Total assets include all current assets such as cash, inventory, and accounts receivable in addition to fixed assets such as plant and equipment.
ROA/RO is a very popular metric because of its versatility and simplicity. Essentially, it can be used as a rudimentary gauge of an investment’s profitability, is very easy to calculate and to interpret, and can apply to a wide variety of kinds of investments. That is, if an investment does not have a positive ROI, or if an investor or business owner has other opportunities available with a higher ROI, then these ROI values can instruct him or her as to which investments are preferable to others.
Calculating the Return on Assets / Return on Investment Ratio
The calculation is as follows:
Return on Assets / Return on Investment = Net Income (Net Profit)/Total Assets = ______%
Interpretation of the Return on Assets / Return on Investment Ratio
In order to interpret the Return on Assets ratio, you need comparative data such as trend (time series) or industry data.
The business owner can look at the company's return on assets ratio across time and also at industry data to see where the company's return on assets ratio lies. The higher the return on assets ratio, the more efficiently the company is using its asset base to generate sales.
For instance, let's say Joe invested $1000 in his start-up, Joe's Super Computer Repair. He has a buyer for the business for $1200. The ROI for this is his profit or $200 divided by his initial investment, $1000, for a 20% ROI. Joe also invested $1000 in Sam's New Computer Sales, and a buyer is looking to pay $1,800. The ROI for this is the profit of $800 divided by his investment of $1000, or 40%. From this comparison, selling Sam's New Computer Sales appears to be the wiser move - 20% vs. 40%.
What this doesn't tell you, and one of the short-comings of the ROI ratio is the time involved. This metric can be used in conjunction with Rate of Return, which does consider the period of time. One may also incorporate Net Present Value (NPV), which accounts for differences in the value of money over time due to inflation, for even more precise ROI calculations. The application of NPV when calculating rate of return is often called the Real Rate of Return.