Limitations of ROI

 

What are the Limitations of ROI?

ROI is used to evaluate their portfolios. It helps you to judge or analyse almost any type of expenditure. In our previous post we discussed what to the use of ROI and how it is calculated. In this blog we will discuss about several limitations when using ROI, particularly when comparing investments or the value of different projects.

If one considers that the duration of the second investment was half as compared to the first investment, it becomes apparent that we should have questioned our predicted conclusion that the second investment was financially less feasible.  When you are comparing these two projects on an annual basis, adjust the ROI calculation accordingly. We as a best financial advisor in Lucknow observed that the first investment project returned more total financial benefits than did the second one, the second investment was the more beneficial choice since its annualized ROI was higher. 

Given that simple ROI does not inherently account for time as there comes a question in mind while investment. This metric can often be used in alliance with Rate of Return, which necessarily pertains to a specified period of time, unlike simple ROI. Investors can also incorporate Net Present Value (NPV), which accounts for differences in the value of money over time due to inflation. NAV is useful to calculate even more precise ROI calculations. The application of NPV is often called as the Real Rate of Return.

If one investment had an ROI of 20% over five years and another had an ROI of 15% over two years, than basic ROI calculation will not help you to determine that which of the investment was best because it does not take into account compounding returns over time. ROI calculations can be easily manipulated to suit the user’s purposes. ROI results can be expressed in many ways. 

Annualized ROI can help avoid this limitation. One need to employ a little bit of algebra for calculating annualized ROI. In the formula the value of n is key; as it represents the number of years the investment is held.

Annualized ROI = {[1 + (Net Profit / Cost of Investment)] (1/n) – 1} x 100

Annualized ROI calculation depends upon factoring in all costs. For ROI calculation do include transaction costs, taxes, maintenance costs and other ancillary expenditures. Therefore, the ROI calculation depends on estimated future values. It does not include any kind of assessment for risk. And can be a problem for investors. It can be tempted easily by high potential ROIs. But the calculation itself does not indicate that how likely that kind of return will be. This means investors should invest carefully.

Advantages and Disadvantages of Return on Investment

Return on Investment (ROI) is the financial ratio that is used to measures how well your investment is. ROI is the percentage of the profit your get over the initial cost. A good investment will always generate a high return on investment and will be able to recover in a shorter time.

Company ranks the investment projects on the basis of its rate of return. They are looking for higher return projects which help them to maximize their profit. Moreover, they want to get their initial investment return as soon as possible to minimize the risk which can happen at any time.

A. Advantages of Return on Investment

1.     You can range multiple projects. Your financial advisor can allocate funds base on the investment hierarchy.

2.     With limited available resources, we want to ensure maximum profit.

3.     Calculating ROI is very simple and straightforward. Most of the people can calculate ROI easily even they do not have any accounting background.

4.     We can use ROI to compare the external and the internal project in order to maximize the overall profit of the company.

5.     Focus management’s attention upon earning the best profit possible on the capital available.

6.     Serve as a yardstick in measuring management’s efficiency and effectiveness in managing the company as a whole and its major divisions or departments.

7.     Afford comparison of managerial results both internally and externally.

8.     Develop a keener sense of responsibility and team effort in divisional and departmental managers by enabling them to measure and evaluate their own activities in the light of the results achieved by other managers.

9.     Aid in detecting weaknesses with respect to the use or non-use of individual assets particularly in connection with inventories.

 

B. Disadvantages of Return on Investment

1.     ROI does not include the time value of money. Your investment project may not provide any profit if we consider the time value of money.

2.     Different companies may use different components like gross margin and other can use the investment gain instead of profit to calculate the return on investment.

3.     Lack of agreement on the optimum and accurate rate of return might discourage managers whose opinion is that the rate is set at an unfair level.

4.     Proper allocation requires certain data regarding sales, costs, and assets. But the accounting and cost system might not give such important details.

5.     Excessive preoccupation with financial factors due to constant attention to ratios and trends might distract management’s interest from technical and other responsibilities.

Managers may be influenced to make decisions that are not the best for the long-run interests of the firm merely for the sake of making the current period rate of return on capital employed “look good.”

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