How to Measure Return on Investment for Your Business?

Are you looking to invest in a business to make profits? If yes, then as an investor, the first thing you should be calculating is the return on investment or ROI. As the name suggests, return on investments gives you the profit you will be getting back on your investment.

ROI can be calculated for any kind of business. There are different methods of calculating the ROI of a business. It depends on the type of business you are getting into. Although it is not very difficult to calculate the return on investment, you can contact a financial advisor who can help you calculate the ROI of any business or investment.

Benefits of Calculating ROI

Since the return on investment should be the initial ratio that you should calculate, it has many benefits in financial planning. Here are some of the benefits of using ROI:

· First and foremost, it indicates the profitability of an investment. It is the key use of this indicator. If any investment has a positive ROI, it is profitable. On the other hand, a negative ROI means investing in that project will result in losses to the investor.

· Return on investment is very easy to understand. You don’t have to be a finance guru or from the finance sector to understand this.

· It may be very simple to calculate and understand but it is very effective. A good investor always calculates the return on investment before making his decision.

· This will help you make the right decision. If you are confused between two or more different types of investment, ROI can help you solve it. You can calculate the return on investment on each project and choose the one which has the highest returns.

· Return on investment helps to measure the competition in the market.

· It will help you in measuring and understanding the benefits of investing in specific departments as well.

· The risk is minimized to some extent. When you calculate the ROI, you are minimizing the risk of losing your money since you get an idea of what kind of returns you might get.

How to Calculate ROI?

There are many ways to calculate ROI. However, there are two methods that are used most commonly. They are:

Method 1

The first method is

ROI (%) = Net profit / investment * 100

Example:

Suppose you buy a home for $100,000. Now, after using it for some years, you decide to sell it. You sold the house for $120,000. So, you made a profit of around $20,000. Now, let’s calculate the ROI for this investment.

As per the formula:

ROI = 20,000/100,000 *100 = 20%

This means you are getting a return of 20% by investing in this house. You invested $100,000 dollars, and in return, you got $120,000.

Method 2

ROI = (gains – costs) / costs

Example:

Taking the same example where you bought the house for $100,000, and you sold the house for $120,000.

ROI = (120,000-100,000)/100,000 = 0.2

Here again, you can see, the ROI is 0.2 times of investment amount. So, for investing $100,000 you are getting $120,000.

This method can be used to calculate ROI for investment in stock markets as well. Let’s see how with an example.

Suppose, you buy stocks worth $1,000. You sell that for a profit of $100 at $1,100. Now, let’s calculate the ROI for this investment.

ROI = (1,100 – 1,000)/ 1,000 = 0.10

Here, the return on investment is 0.10 of the investment amount. So, your investment of $1,000 has become $1,100.

Method 3

Apart from these most commonly used methods, there are other methods too. One such method is using the discounted cash flow method. It is used when you have different cash flows over a period of time.

The future cash flows are discounted based on the inflation rate. Then, all the future cash flows are added and subtracted with the present outflow. If you get a positive return, that means the project is profitable and if the returns are negative, it means you will incur losses in this investment.

Limitations of Return on Investment

There are some limitations when you are using this ratio. Here are some of the limitations that you may face while using this ratio:

· To calculate an exact ROI of a business, you need to know the expenses of your business. If you are dealing with properties or shares, it’s very easy to calculate ROI. However, for a business, you need to know the future expenses to come to an exact return on investment.

· The company’s cash flows are not reflected in the ROI of a business. It is still possible for a company to have a positive ROI but a negative cash flow. This could be very costly for the company and the investors.

· With ROI, you can only measure the financial success of the company. Investing in new technology and computers may make the employees happy, but the ROI will become negative. ROI ignores the non-financial benefits that maybe there for investment.

· Different methods to calculate can confuse a person. You may be confused in selecting the correct method to choose for calculating the return on investment.

On a Final Note

Return on investment is a fundamental financial ratio that is used by any good investor before making any investment. It is also used by financial institutions in calculating the performance of a company and comparing it with its peers. Companies use it for research into the finances of the companies before investing.

So, before making any investment decisions, you should always look at the returns on investment for that project.