Blog #03 - Return on Investment

 

In Blog #02 we discussed about profitability ratios and that ratio was classified into two categories namely return on sales (that was discussed in blog #02) and return on investment. In this blog we are going to take a look at Return on Investment.

Whenever you made a decision to for investment in project or business then it becomes important to calculate Return on Investment or RoI. It is not a rocket science to calculate return on investment it can be easily done. Today, as I saw, people invest blindly without knowing the financial background. They lose their ability to think rationally. We not going to look return on investment technically here we will see RoI in simple language. Let understand this by an example.

Return on Investment

Suppose you want to invest in project/business/stock market/FD etc. while investing there are two ends, from first end we made investment and from second end we get return or from first end our cash goes in and from second end our cash goes out or comes to ourselves and cash that comes to us becomes return and cash that goes in becomes investment. And we want good returns. We are talking about per year returns whenever RoI comes. In simple terms Return on investment is equal to cash you getting per year divided by cash you put in. Or a little bit technically, profit/year divided by investment and this formula is applicable for all types of investments like FD, Share market, investment in business, mutual funds, provident fund etc. If you are saying you get a 7% return on FD it means you are saying RoI is 7% in case of FD. In FD, Mutual funds, provident funds you know very well how much RoI is going to be in your hand annually as these are promised to you. But if you are going to invest in some businesses or project or something else where there is no data available or there is uncertainty we have to calculate the RoI, in this case there is chance of mistake that can be made by us. 

Partnership : Business vs. Project

 

It happens frequently that we don’t compare two businesses or project properly. Let take a example, suppose there is project 1 (Gym) where we to invest amount of $1,00,00000 and we can have $15,00,000 profit per year. In this case the RoI will be $1500000 divided by $10000000 which is 0.15 or 15%. Not so bad. Let compare our project 1 with project 2 (Coaching Center). Say the investment is same in this case also which is equal to $10000000 and profit per year that you will get is $1000000. If you calculate RoI in this case it will be 10% and for a common man who is investing its own money, project 1 will be beneficial. But the game changes when “loan” comes into play, if “loan” enters in the game means it is cost of capital because you will not get loan without interest and this interest is cost of capital of loan that you took. 

Investment

Let change the scenario, suppose you invested loan of $10000000 in project 1 (Gym) whose interest rate is 18%, then you have to pay $1800000 as interest per year and your profit per year from investment was $1500000. Here the governing equation will change in this case your RoI < CoC (Return on Investment is less than Cost of Capital). Definitely you will bear loss of $300000 in this case. Let go to project 2 (Coaching Center). Here coaching center is basically a training center and govt. will give you loan at 7% (subsidized loan). Now in this case you have to pay a loan of Rs 700000 per year and your profit/year is Rs 1000000. So RoI > CoC in second case that means you are in profit of Rs 300000 per year. Now the game is totally changed as loan enter in the game. So whenever on is going to invest, it should be kept in mind that RoI>CoC.

Whenever you are going to invest RoI should be greater than CoC  (Return on Investment > Cost of Capital). Sometime return on investment is also called return on capital.