ROI is a financial tool used to assess the feasibility of a certain investment.  ROI, or the return on investment, is calculated by dividing the returns expected from a certain investment by the amount of the investment.

Suppose Rami wants to invest in buying a piece of land.  He wants to buy it today and sell it in a year. Rami needs to research this business venture and one of the things he should try to forecast is how much he will be able to sell the land for in a year.  Let us assume he is going to pay JD10,000 today and expects to sell the land in a year for JD12,000, then the return on investment is 0.2, assuming there is no inflation and regardless of fluctuations in currency value.  He will be making an extra twenty piasters for every dinar he invests. 

Calculating this number helps an investor to examine different investment opportunities.  The higher the ROI, the more interesting the investment opportunity will be.

In real ROI calculations, especially those involving longer periods of time for the returns to materialize, the inflation rate has to be taken into account. Some take into consideration the bank interest rate or an interest rate set by the organization to account for what is called “the time value of money.” You see one thousand dollars ten years from now will not have the same value (or buying power) as that of today. Therefore, it is good to make use of interest or inflation rates to determine a future value.

For instance, considering a 4 per cent annual inflation rate, one thousand dollars ten years from now amounts to $675 in today’s money. So, paying $675 today to get one  thousand dollars ten years from now is not a profitable investment. 

Companies also use ROI for a myriad of other purposes besides external investing.  They use ROI to calculate the returns they are getting from performing work on a client’s project and to determine which clients’ proposals to respond to. 

ROI is also used to assess the value of investing in internal improvement projects, like quality improvement initiatives, training, or buying a certain piece of software.  This type of ROI calculations is a bit more complex than the ones above.  However, the ROI estimate serves as a good number to show how important an improvement initiative is.  For example, training usually has a high ROI for organizations. In general, improvement values can go up as high as three and sometimes up to tens of times the original investment. So, even if these calculations are complex, they do give a good indication that a certain improvement is worthwhile or not.

The higher the ROI, the more attractive the opportunity is, but the ROI is not the only factor used for decision-making.  Other strategic and financial considerations may play a role.  For example, I may decide to go for project (A) rather than (B) even if its ROI is lower, because it serves the strategic plans of the company. 

A company trying to choose between two different software solutions may also opt for the software solution that provides less ROI because it cannot afford the one having a higher ROI.

In addition to ROI, there are other financial indicators used to evaluate investments.  These include the net present value, benefit / cost ratio, the internal rate of return, and the payback period calculations. Usually, companies use a combination of these to assess the viability of an opportunity from a financial perspective.