The return on investment is a key performance figure to measure and analyze the profitability of one company.
It says how efficient one company is using its capital in order to generate profits. A return on investment of more than 12% is considered as a good result for most sectors. For lower return on investment figures the rating will be worse. The golden rule says that the higher the return on investment the more efficient one company uses its total capital invested.
Return on Investment (RoI) = (Net Profits + Interest on Loan Capital) / Total Capital * 100%
For the calculation of the FScore fiananzoo.de puts the net profits in relation to the total capital thus arriving to the operative returns. There is no sector smoothening in favor of capital intensive sectors. Consequently capital intensive sectors are treated the same way as less capital intensive sectors when calculating the FScore. The return on investment (ROI) has a share of 17% within the Fscore.
When using the return on investment as a key performance figure it is very important to have a clear distinction to other profitability measurement methods. Mainly the following performance figures become relevant in this context:
- Return on Equity = Profit / Equity * 100%
- Turnover Profitability = Profit / Turnover * 100%
- Profitability = Profit / Capital * 100%
When calculating the return on investment different results may occur in some cases due to the fact that different accounting standards are being used. The following possibilities are most common: HGB (for Germany), IFRS and US-GAAP. Furthermore different depreciation methods and different useful live methods may also influence the profit shown in annual reports. This makes the comparison of different companies difficult based only on the analysis of the return on investment.
For example some analysts claim that capital intensive sectors face a systematic disadvantage compared to e.g. companies in the industrial sector as financial companies generally have much lower capital assets which will then also lower their return on investment. Also some investors argue that knowledge companies such as pharmaceutical and software companies very often do not activate their investments in the balance sheet but rather show these investments as research and development activities. This will as a result reduce both the profits shown as well as also the total capital and the balance sheet total. Therefore also in these cases a cross-sector comparison of companies is not straightforward.
But as the return on investment is a figure that takes the interest on the total capital into consideration it is very often seen as a more significant key performance figure than the equity ratio and also than the equity profitability. The return on investment measures the efficiency of the total capital invested of one company. Independently of the type of financing.
It also becomes obvious that the return on investment can be improved with two main measurements. Firstly by increasing the profits and secondly by any measurements that will reduce the total capital, e.g. by any kind of equity release.