Return On Investment : What is it and How is it calculated?

Introduction

Everyone wants to increase their revenue or returns on money invested. That is why, we invest our hard-earned income to multiply its value. Whenever we receive a gain on our investments, we can say that we received Return on Investment (RoI). 

To understand RoI, we need to delve into terms such as Income Elasticity of Demand and Systematic Investment Plans. Let us study these concepts and RoI.

What is Income Elasticity of Demand?

Income Elasticity of Demand is an economic metric. It enables us to understand the sensitivity and responsiveness of quantity demanded for a particular good or service to the change in the real income of targeted customers. 

We can calculate it by dividing the percentage change in quantity demand for goods or services by the percentage change in income. Typically, normal goods that have Income Elasticity of Demand between zero and one referred to necessity goods and services. These are products and services that customers will buy or avail irrespective of the change in their income levels. For example, goods and services such as tobacco products, grocery, salon services, water, electricity and household services, among others.  

Businesses use these metrics to measure the impact of business cycles on their sales.

Types of Income Elasticity of Demand

There are five types of Income Elasticity of Demand. These include;

1. High: The rise in income leads to higher quantity demand for goods and services.
2. Unit-based: The rise in income is directly proportional to the increase in the quantity demanded.
3. Low: The quantity demanded is higher than the increase in income.
4. Zero: The quantity demanded remains the same, even if there are changes in the income.
5. Negative: The increase in income leads to a decrease in the demanded quantity.

What is a Systematic Investment Plan (SIP)?

As the name suggests, a Systematic Investment Plan (SIP) is a financial investment concept. Here, investors systematically invest money in smaller amounts at regular intervals to realise long-term advantages. 

Under SIP, the investors make small and regular investments into mutual fund schemes and trading accounts to de-risk their investment. At the same time, they wish to realise long-term benefits with systematic investments. 

SIPs work on the dollar-cost averaging principle; brokerages and mutual fund companies offer SIPs. Typically, SIPs require investors to make payments into plans consistently, i.e., weekly, monthly or quarterly. 

Moreover, SIPs are passive investment options wherein once you invest the money in a fund, you continue reinvesting into the same. This strategy is irrespective of how the scheme or funds perform.

There are many benefits of a Systematic Investment Plan (SIP). These pros include the following:

1. A SIP allows investors to invest in small proportions without feeling the effects of a lump sum investment figure.
2. There are less emotions involved. Hence, cutting out on risks and uncertainties you might face in other financial instruments such as bonds and stocks.
3. Once you set the sum and frequency, there is not much to do than sit back and relax.
4. SIPs are automatically funded; just the funding accounts need to have enough money.
5. SIPs bring in financial discipline, as you are investing small and regular amounts with a lowered exposure to risks and uncertainties.

There are also many disadvantages of the Systematic Investment Plan (SIP). These cons are as follows:

1. It requires a long-term commitment from investors.
2. SIPs can attract heavy sales charges.
3. Penalty on early withdrawals is very common.
4. SIPs can lead to a loss in terms of buying out opportunities and bargains in the financial market.

What is Return on Investment (RoI)?

Return on Investment (RoI) is a performance indicator. We use it to evaluate the profitability or loss from an investment or number of investments. 

It is represented as a percentage and has a wide range of applications to measure the efficiency or profitability of an investment.

How is Return on Investment (RoI) calculated?

We can calculate the Return on Investment (RoI) by first subtracting the initial investment cost from the final investment cost. Then we have to divide the computed number (net return) by the cost of investment. Finally, we multiply the result by 100.

We can calculate the RoI using various formulas. Let us see a few of them.

First Method

RoI = Net return of investment/Cost of investment * 100%

Second Method

RoI = Final Value of Investment / Initial Value of Investment

Third Method

RoI = Net Income / Cost of Investment

Fourth Method

RoI = Investment Gain / Investment Base

RoI Example

Let us take an example to calculate RoI using the Investment Gain formula (Fourth Method). Assume a real estate broker purchases a property A valued at Rs. 5,00,000 and after two years, sells the property at Rs. 10,00,000.

RoI = Investment Gain / Investment Base = (10,00,000 – 5,00,000) / (5,00,000)RoI = 1 or 100%

Uses of RoI

Investors or businesses can use Return on Investment (RoI) for the following:

1. RoI helps investors decide whether to participate in an investment or skip it.
2. It indicates if an investment will reap returns at the end of its period.
3. RoI predicts how an investment will perform over the period.
4. It helps investors and businesses to derive the value of their investment.
5. RoI enables firms and investors to control their investments and plans better.

Benefits of RoI

Using return on investment (RoI) has a slew of benefits.

1. Simple and Easy: Return on Investment (RoI) is simple and easy to calculate through the formulas mentioned above.

Uncomplicated: Return on Investment (RoI) is not difficult and easy to understand. This feature of RoI is widely used as the universal metric to measure the efficiency and profitability of investments.

Limitations of RoI

There are a couple of limitations in the measurement of RoI. These limitations include:

1. Disregards Time Factor: Return on Investment (RoI) does not take into account the investment period and hence could not mean the right status of investment or investments.
2. No adjustment for Risk: Return on Investment (RoI) does not consider the risk factor when there is a direct correlation between investments and risks. We can observe that higher potential returns attract possibly higher risk. It can lead to investment results different from what RoI indicates.
3. Easy to Manipulate: One can easily manipulate Return on Investment (RoI) deliberately or unintentionally. For instance, assume that a real estate company does not consider the mortgage interest, property taxes, insurance and other maintenance costs. It only goes without them to calculate RoI. Then the figure would be misleading and not the real picture of the situation.
4. Focus only on financial gains: Like many other profitability metrics, Return on Investment (RoI) emphasises just financial gains. It does not consider the social and environmental profit or loss of an investment or investments.

Key Takeaways

When it comes to Return on Investment (RoI), it is vital to understand the income elasticity of demand and SIP. 

Income elasticity of demand is an economic metric. It helps businesses determine how the change in the targeted customer’s income affects the market for a good or service. In this article, we saw how to calculate this metric.

SIPs or systematic investment plans are investment schemes. Here, the investors regularly invest a small, fixed amount from their income in mutual funds and trading accounts. It helps diversify their portfolio, reduce risks, and achieve long-term monetary aims. 

Investors invest weekly, monthly, or quarterly in a SIP fund. Thus, SIPs enable them to be consistent with their monetary goals.

Finally, Return on Investment (RoI) is a performance indicator.  Investors can use RoI to assess their portfolio to identify trends of profit or loss. In this article, we studied four methods of calculating the Return on Investment with an example. We extensively studied its advantages, disadvantages, and applications.

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