Return on Investment (ROI) is a valuable ratio to look at when comparing two different investment’s returns.

Here is an example:

If you invested in two seperate business ventures, one produces footballs and the other produces basketballs, and the football business had a return of $100,000 and the basketball business had a return of $200,000, which one would you say is better?  Your answer should be, “I don’t know yet, what is the ROI for each business, how much was invested in each venture?”  If you knew that $500,000 was invested in the football business and $2,000,000 was invested in the basketball business then you would be able to give your answer, you would be able to compute the ROI.

The equation for computing return on investment (ROI) is:

ROI = Operating income/Average operating assets

In our example of footballs and basketballs the ROI for the football business is .2, or 20%, (operating income of $100,000/average operating assets of $500,00) and the ROI for the basketball business is .1, or 10%, operating income of $200,000/average operating assets of $2,000,000).  Obviously the football production business is better than basketballs, its ROI is 20% compared to 10%; double!  Think if you used that $2,000,000 that you invested in the basketball venture to invest in more football production ventures at $500,000 per venture with the 20% ROI on footballs you would have had a total return for the period of $500,000 instead of $300,000 an ROI of 25% (operating income of $500,000/average operating assets of $2,500,000) instead of your original ROI of 12% (operating income of $300,000/average operating assets of $2,500,000) when you were investing in basketballs and footballs.  Good thing you understand ROI so you know to move your money out of basketballs and into footballs!

ROI does not always come out of cash, even though in our example it did, an investment can of course include other assets such as securities, inventory, land etc.

Operating income is explained in detail in this article here and average operating assets are explained in detail in this article here.

It should be noted that ROI can also be calculated by multiplying margin against turnover.  However, because margin and turnover both include sales in their calculation the equation can be simpliflied to operating income/average operating assets.