Definition
The term return on investment, or ROI, is used to describe a number of financial metrics that are used to measure the profitability of a company. All of the return on investment metrics use variables found on both the income statement and balance sheet.
Explanation
Return on investment is used by analysts and investors to understand management's ability to utilize available resources efficiently. Regardless of the size of the company, capital is always considered a scarce resource. Return on investment measures can be applied to the company's capital structure as well as in the evaluation of a subsidiary, a department, or even an individual project.
The three most common measures using the return on investment concept are:
Return on Assets: also known as ROA, this measure evaluates the net income produced by all of the assets owned by the company.
Return on Equity: also known as ROE, this measure evaluates the net income produced by stockholder's equity. In doing so, ROE eliminates debt from the ROA calculation. Increased use of leverage (debt) is sometimes used to increase ROE.
Return on Invested Capital: also known as ROIC, the calculation of return on invested capital is more complex than ROE and ROA. The equation for this measure uses net operating profit after taxes and invested capital (fixed assets plus non-cash working capital).
When drawing conclusions about the relative performance of a company, benchmark comparisons should be made with competitors in the same industry.
Additional information on this topic can be found in our publication: profitability ratios.
Related Terms
balance sheet, assets, net income, return on assets, return on equity, abnormal return
