Return on Investment (ROI) Calculator
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What is ROI?
Return on investment (ROI) is a simple financial ratio which is used to measure return from a financial investment.
It is a percentage indicator of gain or loss incurred from a particular investment.
Return on investment ratio is critical in evaluating the effectiveness of multiple investments and influence future investment decisions.
A higher ROI ratio means greater returns earned on investment.
Return on Investment (ROI) Formula:
There are multiple methods to calculate ROI, but the most common method is to divide net profit by total investment. Formula for ROI is as follows:
ROI = (Final Return of Investment – Initial Cost of Investment) / Initial Cost of Investment.
- Final Return of Investment = Total return
- Initial Cost of Investment = Initial cost
You invested $ 50,000 in a project and got a return $ 60,000 after a specific period.
Here ROI would be,
ROI = Final Return of Investment – Initial Cost of Investment / Initial Cost of Investment.
ROI = $ 60,000 – $ 50,000 / $ 50,000
ROI = 20%
So your return on investment for that period for your investment is 20%
Difference between ROI and Profit:
ROI is often confused with profit. To calculate profit, total expense is subtracted from total income. While in case of ROI, the outcome of total income subtracted from total expense is divided by total expense. ROI is expressed in percentage and is subjected to negative outcome indicating loss.
Limitations of ROI:
Disregard to duration of investment- Time is an important factor to consider while calculating profit. Return on investment (ROI) calculation does not take duration of investment in consideration.
Let us understand this with an example: John earns $15000 on his investment of $10000 after a period of 3 years. Return on investment for project X is 50% with an annual return on investment of 16.66%. Meanwhile on another project Y, John earns $1400 on his investment of $1000 after a period on 2 year. Return on investment for project Y is 40% with an annual return on investment of 20%. Thus, annual profit ratio of project Y is higher even though it has a lower ROI.
This makes ROI ineffective and thus annualized return on investment should be used for more accurate results.
Vulnerable to manipulation- Return on investment (ROI) figures can be overstated / exaggerated if all expenses are not taken in account. ROI is often mistaken with cash flow or profit on a product / service while neglecting overall expenses. For accurate ROI, expenses such as employee salaries, maintenance and other overheads should be included along with invested amount.
Disregard to inflation- Money loses its value over time due to annual rate of inflation. Since time is not considered as a factor while calculating return on investment (ROI), rate of inflation is not taken in consideration while calculating ROI.
Risk analysis- Investments are correlated to risks, high risk investments tend to generate a higher return on investment. There is no mechanism to include risk factor evaluation while calculating ROI. Inclusion of risk factor on an investment can influence future business investments.
Average ROI is the mean returns earned annually on a particular investment. To calculate average ROI, total return on investment is simply divided by the number of years (period) of an investment. This is a simple division and does not consider compounding factor for calculation.
For example, ROI of 20% is earned over a period of 3 years. Average ROI for this project will be 20/3 i.e. 6.66%.
As discussed above, period of investment is not considered while calculating return on investment ratio. To overcome this limitation, annualized ROI is used for accurate results. Annualized return on investment as suggested by its name is the ratio of ROI earned over the period of years. Annual return is compounded over the period of investment while calculating annualized return on investment. Formula for annualized return on investment is as follows:
(1+ROI) ^ (1/N) – 1
Where, N= Duration of investment in years.
Continuing with an example to understand annualized ROI, where ROI is 20% and period of investment is 3 years.
= (1+0.20) ^ (1/3) – 1
= (1.2 ^ 0.33) – 1
= 1.0620 -1
= 0.0620 = 6.20%
The annualized ROI of 6.20% is earned on ROI of 20% invested for a period of 3 years.