Accounting

Return on Investment (ROI): Formula and How to Calculate It

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When you invest in a business, one of the ways you can mark your progress is by measuring your return on investment (ROI). This is an important accounting figure to know and understand for your financial planning. Learning how to calculate your return on investment can help you determine how much you’re getting out of a business versus what you’re putting in. To get to this figure, you can either use the return on investment formula or a calculator. Read on to learn what ROI is, how to calculate your return on investment, and the various ways to use the formula.

What is Return on Investment (ROI)?

Return on Investment (ROI) represents a ratio that shows financial profits or losses. The ratio reveals the percentage of increase or decrease in an investment’s value. Investors calculate return on investment to check the likelihood of a profit or loss for a specific holding. A few common investments a business can measure include:

  • Marketing
  • Equipment
  • Building renovations
  • Loyalty programs
  • Software

Did you know that 88% of businesses don’t measure their ROI for social media marketing? While only a fraction of their business expenses, tracking these numbers is vital for a business’s financial health.

Understanding return on investment and how it affects your business

how to calculate return on investment

The return on investment formula will help you determine how the return for a certain holding will ultimately impact your business. Once you know the ROI formula, you can use a return on investment calculator online. If the answer is positive, that means you’re likely to make money from the investment and you should continue with your decision. However, if the ROI turns up a loss, you may need to reconsider your investment choices.

How to Calculate Return on Investment

It’s imperative you use the investment formula to make good decisions with your capital. First, you’ll need to learn how to calculate a return on investment. Apply this formula to a current investment or expense to see how it works.

Return on investment formula

There are two ways to calculate your return on investment.

1. ROI = Current Value of Investment – Cost of investment (net profit) divided by the Cost of Investment x 100

The first method represents the traditional way of calculating return on investment. When using this formula, the net income shows how much money was made on the initial investment. The initial cost reveals how much money was used to buy into the holding.

2. ROI = Final Value of Investment – Initial Value of Investment divided by Cost of Investment x 100

The traditional way of calculating ROI can leave out some of the costs assumed after the initial purchase of an asset. Therefore, this second method accounts for the costs an investor incurs after they make an initial purchase. Depending on the asset, costs may include salaries, taxes, labor, or materials.

If you’re not comfortable calculating the ROI yourself, you can always use a return on investment calculator you find online. There are several options out there that will help you find the figure quickly and efficiently.

Return on investment formula examples

Applying the traditional ROI formula to a real estate purchase may appear as follows:

ROI = $50,000 divided by $100,000 x 100 = 50%

In the example above, the property costs $100,000. However, the formula does not show that the investor paid $100,000 in renovations.

The second formula takes the initial cost for investment as well as the additional related costs into account. Therefore, the expanded formula offers a clearer depiction of how the money was spent and the expenses paid, thereby reducing confusion or error.

In the expanded version then, the $100,000 used to improve the property is included in the formula, changing the ROI percentage from 50% to 25%.

Here’s another example of method number two:

Suppose an investor buys a stock share for $100 and sells it for $150. A traditional ROI formula calculates the ROI as 50%. However, if there is a $5 commission for trading the stock, the ROI is actually 45% when you include the cost.

Advantages of Calculating Return on Investment

return on investment formula

Each method has distinct advantages, depending on the type of formula you use. Taking the net profit and dividing it by the initial investment before multiplying by 100 allows you to quickly check the initial costs versus the return.

The traditional method allows you to consider two businesses, for instance, with a common financial factor. By reviewing the ROIs, you can consider which company is more profitable and may end up being a better investment.

The second method for calculating ROI, or taking the final value of an investment and subtracting the initial value before dividing the cost and multiplying by 100 accounts for any expenses incurred. This formula gives you a more specific idea of the return and the value of an investment. Additionally, an online ROI calculator may allow you to include more complicated factors or help you calculate figures like your Return on Equity (ROE).

In summary, an ROI gives you:

  • A straightforward and simple way to check profits
  • A clear indicator of a return’s yield, positive or negative
  • The adaptability to use the calculation for various investments
  • An easy measure to optimize earnings and track results

Disadvantages of Calculating Return on Investment

One of the major drawbacks associated with using the traditional ROI formula is that it does not account for costs. Therefore, you really only gain a bird’s-eye view of the ROI. You need to include the costs to get a clearer idea of your return.

Also, each of the above basic formulas does not account for the amount of time you hold an investment. As a result, the traditional formula may be too basic unless you use a formula that includes annualization. A traditional ROI formula can also be manipulated if it does not include the costs incurred after the purchase of the investment.

In summary, calculating an ROI can be a drawback if you:

  • Need to pin down cash flow and profit, as you might figure a higher-than-expected return
  • Have to consider factors, such as net profit, interest, or taxes – variances that a simple ROI calculation does not include
  • Need to consider the factor of time – a 20% gain over a one year period surpasses the same gain covering two years

Alternative Methods to the Return on Investment Formula

There are several other methods you can use for calculating your return on investment. For instance, an annualized ROI is normally used for stocks and bonds and measures the ROI generated in a year. You calculate return on investment, in this case, by dividing the ROI by the number of years you hold the security or asset.

You can also calculate return on investment by gauging the net present value (NPV) of the investment. To calculate a return on investment using NPV, you take the current value of an investment and base it on inflation-adjusted estimates for future earnings. You can calculate most of these additional figures with a return on investment calculator.

Additionally, some investors use a return on assets (ROA) formula. This calculation takes into account a business’s profit for each dollar of the assets owned. Moreover, a Return on Equity (ROE) calculation shows how much profit a company makes for each dollar its shareholders hold. Finally, you can also figure the real rate of return (RRR) of an investment by making adjustments for external factors, such as taxes and inflation.