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Return on investment (ROI) refers to an index that shows how much profit is generated from invested capital. It is derived from total assets divided by the amount of the investment. In Japanese, it is called toushi-rieki-ritsu.

Contents

Overview

ROI is an index of business management, which shows the rate of profits on investments. It is simply expressed as follows:

ROI = profits / investments

ROI shows how much output (profit) is produced from the input (invested capital), and it does show efficiency of producing additional value of a company or its business from the viewpoint of capital. High-ROI means that the company or the business is attractive to invest.

Te reciprocal of ROI shows how much time it takes to collect the investment. For instance, when 10 million yen is invested in a certain business and the profit is 2 million yen, ROI is 20%. The reciprocal 5 (years) is the required time for capital collection.

Usage

Stockholders, for instance, use ROI to judge whether a target company is worth investing by its generated profits. Also, ROI derived from an original calculation is often used when a company decides its activity projects or investments. For instance, when an investment into an information system is evaluated by using ROI, TCO (total cost of ownership) is used as the denominator, and it includes not only initial introduction expense such as license fee but also all costs necessary to use a system such as system management cost, user-training cost, troubleshooting cost, etc.

When you invest to an information system, you need to be careful not to invest if its ROI is low.

From the viewpoint of efficiency improvement of processes in BPM, making ROI from a KPI or a KGI of an activity or a Business Process is useful for optimizing a Business Process.

ROI from the Viewpoint of Accounting

ROI is just defined as profit on invested capital, and it is simply expressed as follows:

ROI = final investment value - initial investment value / initial investment value

This is usually expressed as a percentage per year.

However, in fact, the value of profit differs on whether tax is included or not, whether it is an operating profit or current profit, what is considered as the investment, and so forth. Therefore, the way to calculate ROI varies according to purposes. For instance, in order to compare efficiency of some companies, or to observe how a certain company changes as years pass, it is calculated on the basis of financial statements as follows:

ROI = (operating profit + depreciation expense) / (stockholders' equity + liabilities with interest) 
ROI = (ordinary profit + interest expense) / (stockholders' equity + liabilities with interest)
ROI = net income + {initial total assets + final total assets/2}

As is seen above, the definition of ROI is ambiguous. Therefore, regarding financial analyses in stock markets, EV/EBITDA (Enterprise Value/Earnings Before Interest, Taxes, Depreciation and Amortization) is often used rather than ROI because it is more independent from the rate of interest, tax, or accounting criteria, and because it enables comparison across markets. In addition, in the academic field, continuous compound is often used as follows to obtain the same value when the amount of profit and loss is the same. When the value obtained by calculation is small enough, error margin is little even if continuous compound is not used.

For instance, assume that you invest 100 yen and ROI is 50% in the first year, and -50% in the second year (continuous compound not used). At the end of two years, you lose 25 yen that is the balance of 100×1.5×0.5=75 yen. When you calculate it by means of continuous compound, ROI is 40.55% in the first year, and is -69.31% in the second year, and thus this shows you clearly that you suffer loss at the end of the second year. Also, assume that ROI is 50% in the first year, and -50% in the second year (continuous compound used). At the end of the second year, the balance is 100 * exp(0.5) * exp(-0.5)=100 yen. When you calculate it without continuous compound, they are 64.87% and -39.35% respectively, and this does not show you clearly that you receive neither profit nor loss.

Besides, for an accurate calculate, you need to convert past or future value into the present one, or you have to consider the inflation rate in order to appropriately reflect the purchasing power.

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