Return On Investment

Return On Investment

Before talking about Return On Investment ROI, it is recommended to define the meaning of the terms Investment and Return, as this is a necessary beginning to be able to clarify the rest of the subject elements.

The concept of Investment

There are two common investment concepts, which are:

First concept of investment

Investment means all the money invested in the project, i.e. its total assets. According to this concept, the return on investment is the return on assets.

Second concept of investment

Investment means the money invested by the owners of the project, that is, the rights of the owners of the project. And according to this concept, the return on investment means the return on the rights of the owners of the project.

In this article, the second concept of investment will be adopted.

The concept of Return

A distinction was made previously between the different concepts of profit, and the net profit of operations was referred to, and we said that it is the basis for measuring the efficiency of the institution’s performance in the use of its assets. Also, we used this concept to determine the revenue strength of the institution. The accounting net profit after tax, i.e. the comprehensive concept of profit, was also mentioned, and we said that this concept of profit is what matters to the investor, which will be used to measure the return on the owners’ equity here. For more details, review Financial Management Objectives (3) Profitability.

Calculating Return on Equity

The return on owners’ equity is calculated according to the following equation:

Return on owners’ Equity = Net profit after tax ÷ Net owners’ equity

The components of this equation are:

1. Rights of project owners

It is the paid-up capital in addition to the various reserves and undistributed profits.

These rights are equal to the total assets minus all long-term and short-term debts. It also subtracts any intangible assets if we talk about the net tangible equity of the owners.

2. Net profit after tax

It means the profit realized from the operations of the institution and from any other sources after deducting the tax, i.e. the net comprehensive profit.

There are those who see the calculation of this percentage before tax, considering that the tax is an element that the management of the institution has no control over, but the response to that is that the goal of the equation is to measure the final profitability of the investors, and this requires calculating the percentage after the tax imposed on the allocated profits.

The return on the owners’ equity or the rights of the owners of the organization reflects the efficiency of the organization’s management in managing both sides of the budget, or the skill in using assets to achieve sales (operating efficiency), as well as the skill in installing the left side (financial adequacy) to achieve the best possible return for the project owners.

This idea can be clarified by making some modifications in the equation for calculating the return on the rights of the owners of the aforementioned project, by multiplying both the numerator and the denominator by the total assets, and thus we get the following equation:

Return on owners’ equity = (Net profit / Owners’ equity) x (Assets / Assets)

or:

Return On Equity (ROE) = (Net Profit ÷ Assets) x (Assets ÷ Owners’ Equity)

That is:

Return On Equity (ROE) = (Return on Assets) x (Financial Profit Multiplier)

Example, Return on Assets and Return on Investment

Below is information about ABC Company:

The assumption in this example is that there are no taxes.

What is required is to calculate the following:

1. Profit Margin
2. Asset Turnover
3. Return on Assets (or Revenue Power)
4. Return on Investment ROI (on Equity)

Solution

Profit margin = Net profit from operations ÷ Sales

That is:

Profit Margin = 60 ÷ 210 = 28,57 %

Asset Turnover = Net Sales ÷ Operating Assets

That is:

Asset Turnover = 210 ÷ 180 = 1,167 times

Return on Assets = Profit Margin x Asset Turnover

That is:

Return on Assets = 28.5 x 1,167 = 33,3%

or:

Return on Assets = Net operating profit ÷ Net operating assets

That is:

Return on Assets = 60 ÷ 180 = 33.3%

Return on Equity = Net profit after tax ÷ Owners’ equity

That is:

Return on Equity = 61 ÷ 165 = 36.97%

The return on Equity (Investors) can be calculated using the long equation:

Return on Investors’ Equity = (Return on Assets) x (Financial Profit Multiplier)

or:

Return on Investors’ Equity = (Net Profit ÷ Assets) x (Assets ÷ Owners’ Equity)

That is:

Return on investors’ equity = (61 ÷ 180) x (180 ÷ 165) = 36.97%.

References

• Financial Management Encyclopedia, Multi Disciplines Research and Studies Center.