Return on Investment (ROI)
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Return on Investment (ROI)
Companies should calculate return on investment when they spend a lot of money on something that they expect will make money in the future. These things they spend money on are called capital assets. Capital assets should make money over many years.
Depending on the business, capital assets can be things like buildings, equipment, computers, and vehicles. They can also be intangible things like patents or trademarks.
There are four methods to analyze return on investment:
• Payback – This is the simplest method. It measures how long it takes for the money from the project to pay back the initial investment. It doesn’t include any interest in the calculation.
• Net Present Value (NPV) – This method compares future cash flows to the initial cash spent, taking into account the value of money over time. It uses the company’s Cost of Capital to calculate. If the result is a positive number, it means the investment should be made.
• Internal Rate of Return (IRR) – This method calculates the rate of return when the Net Present Value is zero. Then it compares it to the company’s cost of capital. If the IRR is higher, the investment should be made. Most managers find this method easy to understand.
• Profitability Index – This is used to compare different projects with different initial investment requirements. It helps make fair comparisons.
In financial statements training classes, you learn about present value, future value, and the four methods to calculate return on investment. This helps you evaluate your investments better.
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