How to calculate an accurate return on investment (ROI)
The return on investment for any investment you make is a crucial piece of information you need when you have limited funds to invest. The idea of return on investment is simple enough. It is the total net profit you expect to gain from your investment. The formula for determining return on investment is ROI = (gross sales or gain cost of investment) / cost of investment. Gross sales or gain minus cost of investment is your net profit. Dividing your net profit by the cost of investment can result in a number greater than your investment, less than your investment, or zero. When the value is zero, you have broken even: the amount
of money you invested has been regained. When the value is negative, you’re in the hole, and when it’s positive, you’ve actually made a gain.
Return on investment has a time dimension. The ideal return would be an immediate ROI. You put your cash down and you get the amount you invest plus something more a moment later. There may not be many such opportunities for an immediate return. Day traders come the closest, investing an amount in the morning on a piece of stock that’s heading up, and then selling it by the end of the day, for an amount that will at least cover the cost of the transaction and gain even a slight profit. Of course, if the stock goes down, you’re out of luck, unless you decide to go for the long term, but then you’re in different territory, one that requires careful analysis.
In some cases, a return on investment may be negative for months, or even years. For example, you may be running a manual accounting system in your firm costing you half a million dollars a year. A computer system is offered to you for a million dollars and promises to reduce your yearly accounting cost by a quarter of a million a year. The first year, your ROI will be less than the million you spent, that is, $250K. It will take four years before the new million dollar investment pays for itself. Every year thereafter, you’ll then realize a quarter of a million dollars in savings!
Calculating your return on investment can be tricky. The results always depend on your inputs, especially your cost of investment. It’s simple enough when you’re considering only the actual cash cost, but remember, cash has a value in terms of the interest it can earn you. Then, too, if you borrow the cash to invest, you’ll have to include the total cost of the interest you have to pay for borrowing the cash. Careful consideration of all the costs gives you a more realistic picture of what your ROI actually is. When assigning cost values, its best to be as inclusive as you can. Consider all the costs, not just the cash outlay. Better to have a lower return on investment then one that misleads you into investing more into that investment, when you could be investing in one with a true, higher return. When others attempt to get you to invest, use the ROI calculation given above to figure out just what you really stand to gain. Your return on investment, a ratio of money gained or lost to the money spent, should always be the principal means of determining what your best investment is.
