What is Return on Investment (ROI)?
Return on Investment is the ration of net income to the investment. The term investment is used in three different types in financial analysis. This gives three different types of ROI ratios namely return on assets, return on owner’s equity and return on invested capital.
Return on Investment Ratios
1. Return on Assets (ROA)
It shows the firms earnings on the investment of all the financial resources committed to the firm. Thus the ROA measure is appropriate if one considers the investment in the firm to include current liabilities, long term liabilities and owner’s equity. These are the sources of funds invested in the business. One of the most useful measure to evaluate how efficiently the firm has utilizes its funds. However this return on investment ratio does not give any regard to the relative magnitude of the sources of those funds.
2. Return on owner’s equity (ROE)
It reflects how much the firm has earned on the funds invested by the shareholders. This ROE ratio is obviously of interest to present or prospective shareholder. It is also of concern to management because this measure is an important indicator of shareholder value creation.
3. Return on Invested Capital (ROIC)
Permanent capital is equal to non current liabilities plus shareholder’s equity and hence represents the funds entrusted to the firm for relatively long periods of time.
ROIC focuses on the use of this permanent capital. It already assumes that current liabilities will fluctuate more or less automatically with changes in current assets and that both will vary with the level of current operations. Permanent capital is also equal to working capital and non current assets.
4. Return on Capital Employed (ROCE)
This return on investment ratio is appropriate for those divisions whose managers have a significant influence on decisions with regard to asset requisitions,credit policy, cash management, etc.