Why ROI Might Not Be The Best Investment Measurement Tool

ROI tool can show you what you would gain from an investment, but it probably would not tell you what you can lose from it.

Return on Investment (ROI), is a common tool used by financial analysts and investors alike to measure investment progress. It helps the investor calculate the benefit that he or she will receive in relation to the investment cost that went into it.

Typically, this ratio is used to measure or quantify the amount of return made on an investment and this in turn is used to compare with other investments. The formula for measuring ROI is given as net income divided by the cost of the investment and the resulting answer is expressed as a percentage or a ratio.

Simply put, if you invested N10,000 and you made an additional N2,000, the ROI is given as 2,000/10,000 which is 20%. A positive ROI thus shows how much profit has been made while a negative one records the loss.

The ROI financial analysis tool is praised on the basis of being able to measure profitability better, its ease in comparative analysis, and how its goal borders on profitability – arguably the most important factor in investing.

However, as simple and rational as the formula seems, it also has its many disadvantages – the first of which is that its simplicity is only theoretical. For one, there could be a few challenges with determining what net income is.

In Accounting, and in the average financial statement, net income could mean earnings or profit before interest and tax, earnings or profit after interest and tax, profit after deducting all allocated fixed costs, and so on – and none of them are wrong as they all represent net income.

More so, as a result of ROI’s focus on profitability, it doesn’t take into account other non-financial aspects that could potentially benefit investors. The problem with this in an organization is that decision makers might only select investments with high rates of return without considering social factors like employee satisfaction and may be forced to cut spending on innovative aspects like research and development or advertisement.

To maintain high ROI, they might fail to spend additional funds that while temporarily reducing costs will increase long term profitability of a business unit. It thus focusses on short term results and profitability, ignoring long term profitability.

It fails to account for the period of time that the investment is held which would affect its long-term profitability. Periods of short term volatility could thus, make the investor lose sight of long term gains.

It also doesn’t take risk into consideration. A company might do something that could increase profit but affect the long term reputation of the company. The ROI tool can show you what you would gain from an investment, but it probably would not tell you what you can lose from it.

As an investor, it is important not to get carried away with ROI’s at least not in the short term. Also, towards making investment decisions, ROI should not be the only parameter to consider. It should rather be used together with other tools of analysis.

Written by Lawretta Egba.