Return-on-investment (ROI) is a crucial financial metric that is used by both investors and businesses. It is when companies set annual financial goals and then determine how many returns they’re going to make on their investments during the fiscal year. In this article, we’ll show you how to calculate a ROI not just for one investment but a number of them and in several ways at that.
But first, let’s go into what ROI is.
What is the ROI?
ROI is a financial metric that directly measures the number of returns on a particular investment. It’s a ratio that compares the gain or loss from an investment relative to its cost. It’s quite handy in helping companies analyze a possible return from a single investment just like it is in comparing returns from various investments.
ROI is mostly measured as net income that is divided by the investment’s original capital cost. The bigger the ratio, the more benefit will be earned. Now let’s look into how to calculate a ROI.
How to calculate a ROI
Here’s the formula for calculating ROI:
ROI = (net profit / cost of investment) x 100
Of course, this is only one method of the formula. It’s quite flexible and can be manipulated in various other ways. A company would use this calculation to compare their ROI on several possible investments, whereas an investor may use it to calculate a return on their stock.
Let’s say you’re a house flipper. You recently bought a house for $65,000 and paid $35,000 for renovations. Then after expenses, commission and sales, you netted $150,000 on the sale for the property you renovated. What will be the ROI?
First, to acquire the net profit, you need to subtract the amount you had netted ($150,000) from that which you had spent ($65,000 + $35,000), giving you $50,000. The total investment is the amount that you had used up ($65,000 + $35,000), which is $100,000. So, if we were to apply these values in the formula for ROI, we’d get:
ROI = 50,000 /100,000 * 100
ROI = .5 * 100
ROI = 50%
ROI = investment gain / investment base
Advantages of the ROI formula
Using the ROI calculation formula yields a number of benefits, including:
1. Quick and Simple to Calculate
This metric is used quite frequently as it’s quite simple to calculate since it only requires two figures – the cost and the benefit. Because “return” can mean a number of things to several people, the ROI formula is relatively easy to use since there isn’t any strict definition of the word “return.”
2. Universally Understood
Since the return on investment is a concept that is universally understood, it’s virtually guaranteed that people will know what you’re talking about when you use it in a conversation.
3. Lets You Know Where Improvements Need to Be Made
Once you get a glimpse of your financial statements and investments, you can determine which department needs to improve their performance and which requires an increase in technology or staff to boost their productivity and efficiency.
- ROI helps in measuring and exploring potential returns on various investment opportunities
- It allows companies to measure the competition around the market.
- It helps in measuring and understanding investment benefits in specific departments as well.
- It gives investors and financial professionals a quick insight about the possibility of an investment without wasting any money or time.
But despite the benefits that it grants companies and investors, there are certain limitations of ROI that you need to be wary of, including:
Limitations of ROI
- Calculating ROI will be different between two separate companies or individuals depending on how the formula was used. For instance, a marketing manager may use the formula for calculation of property investment, as we mentioned earlier, but without taking into account the property taxes, sealed fees, maintenance costs, legal costs, and stamp duties.
An investor, on the other hand, looks at the real ROI by taking into account all of the possible costs that are incurred, especially when the investment increases in value.
- There is no definitive meaning of investment and profit. Profit, for example, has several concepts, like profit before tax and interest, profit after tax and interest, profit after deducting every allocated fixed cost, and controlled profit. Likewise, investment has several connotations to it, such as net book value, gross book value, the ongoing cost of assets, the historical price of assets, etc.
- ROI doesn’t adjust for risks. It is common knowledge that returns are directly correlated with risks: the higher the potential returns, the greater the risks in the process.
All in all, ROI models are simple, yet imperfect tools on how to calculate a ROI. So be sure you understand what is within each model, and the limitations that it comes with. If anything, you can use several ROI models to get a better understanding of your company’s financial opportunity. And when you do evaluate a potential profit opportunity, be sure to look into whether cash flows will match predictions, measures the strength of an investment, and include a qualitative analysis of any tangible cost and benefit along with any ROI analysis.
Feel free to use the box below to comment on this article.