How to Use the Return on Investment Profitability Metric
The return on investment (ROI) is an extremely common measure that determines how well a company is using investments to generate profits. When a company raises funds, either by incurring debt or by selling equity, it invests those funds in purchasing the things necessary to make the company operate.
In other words, ROI determines whether it was worth the company’s time and efforts to raise those funds in the first place. Use this equation to calculate ROI:
To put this equation to work for you, follow these steps:
Find net income near the bottom of the income statement.
Use the balance sheets of the current year and the previous year to calculate average long-term liabilities and average equity:
Add up the long-term liabilities and the total equity from the current year and the previous year, and divide the total sum by 2 to get the total average long-term liabilities plus average equity.
Divide the current year’s net income by the answer from Step 2 to get ROI.
Make sure that net income has already taken into account interest expense, or else you’ll end up with an artificially high return because interest expense is a cost of capital that doesn’t add value to the company.