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.
For any financial advice do consult:-
Best financial advisor in Lucknow
best mutual fund advisor in Lucknow
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