What is Return on Investment (ROI) and How to Calculate It

Every investor and business owner wants to know what financial benefits it receives from a particular investment. Since the primary purpose of investing or starting a business is to make a profit, it is essential for companies and investors to accurately measure what it gets compared to what it puts in.

There are several financial metrics used by businesses and investors to track the profits they generate from an investment, one of the most popular metrics is the return on investment (ROI).

In this article, you will learn the meaning of return on investment, how to use the ROI formula to calculate return on investment with relevant examples, the benefits of the ROI formula, limitations of return on investment calculations, the impact of financial leverage on return on investment, and comparison between internal rate of return (IRR) and return on investment (ROI)

Let’s get started.

What Is Return On Investment?

Return on Investment (ROI) is a financial ratio used to measure the level of profitability possessed by an investment. It is a key metric or performance measure used to calculate the efficiency of an investment or compare several investments.

In checking out how well an investment has performed, ROI serves to be one of the most popular metrics. The Return on Investment (ROI) of an investment is measured in relation to the amount of investment cost incurred by the investor.

The Return on Investment (ROI) is usually represented in percentage form. It is calculated by dividing the net profit or loss by the initial investment cost. The higher the ratio or percentage, the greater the profit on the investment.

Comparing different investments is easier when you know the ROI on each. It is a standard way of determining which investment is the best among a host of alternatives. Businesses can also use it to evaluate the potential returns from a stand-alone investment.

Businesses and investors use ROI alongside other cash flow measures such as Net Present Value (NPV) and Internal Rate of Return (IRR) to evaluate the attractiveness of different investment alternatives. You can also use accounting software such as QuickBooks, Xero, FreshBooks, and other QuickBooks alternatives to calculate these three business key metrics.

However, one downside of using the ROI metric is that it doesn’t take the period of the investment into account. With this, the opportunity cost incurred from not investing somewhere else is unaccounted for.

How to Use the ROI Formula to Calculate Return on Investment (Including Examples)

There is one universal formula used to calculate ROI. However, it is represented in two different versions;

ROI = Net Income / Cost of Investment x 100

AND

ROI = Investment Gain / Investment Base x 100

The first formula is more popularly used than the second. Nonetheless, they both represent the universal formula:

ROI = (Current Value of Investment – Cost of Investment) / Cost of Investment x 100

OR

ROI = (Amount Gained – Amount Spent) / Amount Spent x 100

The “Current Value of Investment” refers to the proceeds accrued from the sale of the investment. It could be more or less than the cost of investment.

Where it is more than the cost of investment, a profit is obtained from it and this may signify a good investment. However, where the “Current Value of Investment” is lower than the cost of investment, the ROI would be a loss.

With a representation in percentage, different investments can be easily compared to each other using the ROI formula. Investors can know which forms of investments are more profitable.

Calculation of ROI: Example 1

If an investor purchases a real estate property for $1,000,000 and sells it for $2,500,000, the ROI is calculated thus:

ROI = (Current Value of Investment – Cost of Investment) / Cost of Investment x 100

ROI = ($2,500,000 – $1,000,000) / $1,000,000 x 100

ROI = $1,500,000 / $1,000,000 x 100

ROI = 1.5 x 100

ROI = 150%

The investor got an ROI of 150% profit from the real estate investment.

Calculation of ROI: Example 2

Let us assume that an investor bought a small business accounting software for $100,000 and after two years sold the company for $200,000. What is the ROI?

ROI = (Amount Gained – Amount Spent) / Amount Spent x 100

ROI = ($200,000 – $100,000) / $100,000 x 100

ROI = $100,000 / $100,000 x 100

ROI = 1 x 100

ROI = 100%

The Return On Investment (ROI) gained from the small business accounting software investment is 100% profit.

Calculation of ROI: Example 3

In the event where an investor invests $5,000 to purchase furniture but gets $4,000 after the sale of the furniture, here is what the ROI would be.

ROI = Net Income / Cost of Investment x 100

To find the net income, deduct the cost of investment from the current value of the investment.

Net Income = Current Value of Investment – Cost of Investment

Net Income = $4,000 – $5,000

Net Income = -$1,000

The negative net income means the investor did not make any income from the sale, instead she made a net loss of $1,000.

ROI = Net Income / Cost of Investment x 100

ROI = -$1,000 / $5,000 x 100

ROI = -0.2 x 100

ROI = -20%

The investor suffers a 20% loss in ROI for her investment in furniture.

If the same investor spent $5,000 in buying bicycles and gets $9,000 from its sale. What will be the ROI?

ROI = Investment Gain / Investment Base x 100

To calculate the investment gain, we deduct the investment base from the current value of the investment.

Investment Gain = Current Value of Investment – Investment Base

Investment Gain = $9,000 – $5,000

Investment Gain = $4,000

ROI = Investment Gain / Investment Base x 100

ROI = $4,000 / $5,000 x 100

ROI = 0.8 x 100

ROI = 80%

With this 80% profit, it is inferred that investing in bicycles proves to be a more profitable venture than investing in furniture that brings a -20% ROI.

ROI is simple to calculate and helps investors with future investment ventures. They get to easily know if a recurring type of investment would be worth it and how it compares to other types of investments in the same cost range.

Benefits of the ROI Formula

Benefit #1. Simplicity And Universal Acceptance

One reason why the ROI formula has so much popularity is its ease of calculation. Only the determination of two values that are very much recognized in accounting is required: the cost of investment and the current value of the investment. More times than not, these two values are readily available in accounting books or records.

The implications are also easy to infer from the final results of calculating it. A profit is very much distinguishable from a loss.

Due to its popularity, the term “ROI” is universally understood without a need to be spelled out or defined. It could be easily used in a conversation without slowing it down.

Benefit #2. Provides A Better Measure of Profitability

The ROI formula is as straightforward as formulas come. It compares the net income from an investment to the amount of money spent on it. This, alongside its representation in percentage, gives you an avenue to easily determine your level of profit or loss made from an investment.

Knowing the exact value an investment generates for you allows you to determine future investments. You easily know if the investment would be great or if it is one you should steer clear of.

Benefit #3. You Get Easy Comparative Analysis

As previously mentioned, ROI helps in making an accurate comparison between different investment ventures. The profitability of different investments on similar cost levels can be compared to determine which is a better option.

The ROI formula proves to be a good measure as it gives you a chance to easily compare the productivity of capital investments on different related projects. You easily decide the selection of investment opportunities that are best for you based on the comparative returns they bring.

Benefit #4. ROI Measures The Effectiveness of Investment Costs and Strategies

Determining your ROI helps you to measure the performance or effectiveness of other factors involved in the investment.

A good ROI may mean that other factors like cost management, asset management, selling price strategies, and promotional or marketing strategies, among others are also good. A bad ROI may indicate that activities regarding these factors need to change.

Overall, using the ROI formula gives you an easy means of determining the profitability of an investment. It also helps you determine the comparative value investment has with other investments and the effectiveness of certain investment strategies in returning a profit.

Limitations of Return on Investment Calculations

The ROI formula may prove effective and simple to use but the amount of information it presents to you is still limited.

Limitation #1. Disregard For Time

The main limitation to the ROI formula is that it does not take the investment time-span or time factor into account. While an investment that brings a return of 80% seems better than one that brings a return of 40%, what should be implied where it takes twice the duration?

In a situation where the 80% ROI takes up to two years to be accrued, it could be said that the 50% ROI accrued in a single year signifies a better investment.

However, there is a way to resolve this problem using the annualized ROI Formula.

The formula (which is a little bit technical) is represented thus:

Annualized ROI = [(Ending Value / Beginning Value) (1/n) -1]

In a situation where you already know the ROI, you can use this formula instead to calculate the annualized return on investment.

Annualized ROI = [(1+ROI)^1/n − 1] x 100%

Where “n” represents the number of years the investment lasted for.

So, if an 80% ROI was gained in 2 years, using the formula, the annualized ROI would be:

Annualized ROI = [(1+0.8)^1/2] – 1] × 100

Annualized ROI = [(1.8^1/2) – 1] × 100

Annualized ROI = (1.342 – 1) × 100

Annualized ROI = 34.2%

The annualized ROI is 34.2%.

For investments involving periods lower than a year, the relative fraction value can be used. For one year and 6 months, a value of 1.5 can be used in place of “n”.

Limitation #2. ROI Might Not Include All Costs

The cost of investment includes all expected and additional costs like, for instance, maintenance costs, property taxes, sales fees, stamp duties, and legal costs. These may not have been considered while calculating the cost of investment.

This gap leaves the ROI formula susceptible to manipulation. A good investor, however, takes every form of cost into account to arrive at the true profitability of an investment venture.

Limitation #3. ROI Does Not Represent The Risks Involved

Every investment has its own risk, with some having more weight than others. As a general perception, the higher the risks, the greater the return, both in loss and profit.

The ROI formula does not present the number of risks involved in getting a profit from an investment. This means that an investor may accrue a much different ROI than he had previously expected if he doesn’t take the risk factor into account.

Impact of Financial Leverage on Return on Investment

Seeking financial leverage to fund investment has a magnifying impact on your ROI. Where a profit is recorded, you would record an inflated ROI and where a loss is suffered, the effect is also inflated.

Impact on ROI: Example 1

For example, let us make use of a case where James funds investment in 1000 shares worth $10 each with a 50% margin (financial leverage of $5,000 and a 10% annual interest on the loan). One year later, James sells all his shares at $12.50. In the same timeframe, he earned dividends of $500 and spent a total of $125 on trading commissions.

When calculating the ROI for this scenario that deals with financial leverage, there are a few things you take to take note of. The first is that the interest on the margin loan (10% of the $5,000 financial leverage) should be considered in total costs. The second is that the initial investment is $5,000 because of the margin loan used.

ROI = Investment Gain / Investment Base x 100

To calculate the investment gain, you have to use the following steps.

1. Deduct the initial share price at purchase from the share price at sale multiplied by the number of shares purchased/sold.
2. Deduct the dividends earned from the trading commissions and the interest on the margin loan.
3. Add the figures you got in step 1 and step 2 together.

Investment Gain = [($12.50 – $10) x 1000 + $500 – $125 – $500]

Investment Gain = [$2,500 + – $125]

Investment Gain = $2,375

To calculate the investment base, you have to use the following steps:

1. Multiply the initial cost of shares by the amount of shares purchases
2. Multiply the initial cost of shares by the interest on the margin loan
3. Deduct the figures gotten from step 2 from step 1

Investment Base = [($10 x 1,000) – ($10 x 500)]

Investment Base = $10,000 – $5,000

Investment Base = $5,000

ROI = Investment Gain / Investment Base x 100

ROI = $2,375 / $5,000 x 100

ROI = 47.5%

If James did not take any financial leverage, what would be his ROI? Simply take out the interest on a margin loan (financial leverage) and consider the initial investment as $10,000.

ROI = Investment Gain / Investment Base x 100

Investment Gain = [($12.50 – $10) x 1000 + $500 – $125]

Investment Gain = [$2,500 + $375]

Investment Gain = $2,875

Investment Base = $10 x 1,000

Investment Base = $10,000

ROI = Investment Gain / Investment Base x 100

ROI = $2,875 / $10,000 x 100

ROI = 28.75%

From the two scenarios, we can see that even though the net dollar return was reduced by $500 on the first example on account of the margin interest, the ROI is still higher at 47.5% when you take financial leverage compared to $28.75 when you do not use financial leverage.

Impact on ROI: Example 2

If the shares James bought in example 1 fell to $8.00 and he decided to cut his losses and sell the full position. What is his ROI if he took a 50% margin loan with a 10% annual interest on the loan, and he earned dividends of $400 and spent a total of $125 on trading commissions?

ROI = Investment Gain / Investment Base x 100

Investment Gain = [($8 – $10) x 1000 + $400 – $125 – $500]

Investment Gain = [-$2,000 – $225]

Investment Gain = -$1,775

Investment Base = [($10 x 1,000) – ($10 x 500)]

Investment Base = $10,000 – $5,000

Investment Base = $5,000

ROI = Investment Gain / Investment Base x 100

ROI = -$1,775 / $5,000 x 100

ROI = -35.5%

If James did not take any financial leverage, what would be his ROI? Simply take out the interest on a margin loan (financial leverage) and consider the initial investment as $10,000.

ROI = Investment Gain / Investment Base x 100

Investment Gain = [($8 – $10) x 1,000 + $400 – $125]

Investment Gain = [-$2,000 + $275]

Investment Gain = -$1,725

Investment Base = $10 x 1,000

Investment Base = $10,000

ROI = Investment Gain / Investment Base x 100

ROI = -$1,725 / $10,000 x 100

ROI = -17.25%

The magnifying effect is even felt more in the case of a loss due to the need to pay back both the loan and interest on it. In this case, the ROI with 50% financial leverage of -35.5% is much worse than an ROI of -17.25% with no financial leverage.

Internal Rate of Return (IRR) vs Return On Investment (ROI)

The Internal Rate of Return (IRR) metric is another popular financial measurement used for the performance of an investment. ROI is only more popular and largely used because of its simpler format. IRR has a more complex and confusing medium for determination.

The internal rate of return (IRR) is the rate of growth that an investment is expected to generate annually. It is an ideal formula for measuring an investment with a long period and is used to compare the potential rate of return from an investment over time.

Businesses make use of both IRR and ROI when making budgets for capital investments. The decision of which metric is used may boil down to the length of the investment.

While ROI measures the total growth of investment from start to finish, IRR measures only the annual growth and changes every year. With this, the ROI and IRR on an investment may be about the same after the first year but will always differ in subsequent years.

The formula to calculate IRR is way more complex than that of ROI.

​The subsequent cash flow injected into the investment is one of the important factors taken into account and could be either positive or negative. This depends on the latest returns from the investment.

IRR is a discounted value represented by “r” and that is what is solved for. With the formula, the net profit value is equal to zero.

IRR is easier to calculate using IRR-programmed software like Excel.​ Due to the challenges in calculating the ROI on an investment over a long period, IRR is usually used as a resort for more accurate estimations.

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