Ask Money: ROI

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All of your financial questions answered by Harry Clough.

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Question: What is ROI? How is it different from profit, and why should I use one over another?

ROI stands for return on investment, a popular measure used to work out the efficiency of an investment and what you can expect to gain or lose from it. The calculation, which is simple to grasp and carry out, handily shows the profitability of any given investment.

Take your end earnings and subtract your original investment. Then divide by the original investment. To ease matters even more, divide net profit by total assets. If an investor were to look at various kinds of investments using ROI, he or she could work out which investments are going to be more profitable than others, thereby making better investment decisions.

An example will help visualise the simplicity of the metric. If I were to invest £3,500 in British Airways this year and sell my acquired stocks a year later for £4,750, I can use the calculation thus: (£4,750-£3,500) / 3,500, which equals 0.35 or 35% ROI. When compared against an investment that gave an ROI of less than 35%, you could decide to go forward with the investment that gave the most profitability.

ROI differs from profit, however. I would say that ROI gives a more objective way of looking at possible investments as opposed to profit. Profit is a financial gain, namely the difference between the amount of money earned and the amount spent.

If you decided which investment to proceed with based purely on the profit, you are not seeing the entire picture and may not choose the most rewarding investment. On the other hand, ROI allows you to see the investment that makes the most profit considering how much money was invested in the first place.

Consider these investments: investing 10,000 and getting 12,000 return, and investing 4,000 and getting 7,550 return. The ROI for these investments show that the first investment’s ROI is 20% but the second investment’s ROI is 80%, meaning that there is a far greater return on the second, less profitable investment.

To sum up, when considering investments, don’t only look only for profit, but the percentage return as well using the ROI calculation. This will yield more successful outcomes whether you are trying to beat the stock market or embark on your own entrepreneurial adventure.

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