Before making an investment, you need to look at the returns you’re likely to make on it. Will you get a profitable sum against your investment? To find out, you need to know: what is the return on investment (ROI), how to calculate ROI, how it works and what is a good ROI? Read on to learn all.
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What is Return on Investment (ROI)?
ROI is a financial metric to measure the efficiency or profitability of your investment. In simple words, it is the benefit an investor will receive, relative to the cost of investment. This performance measure can be used to evaluate any type of investment. Be it hiring a professional or buying tools and equipment for your business use.
By working out ROI, you can find out whether the money you have put in a business is paying you off or not. In addition, it also indicates the investments that have performed well and those that haven’t. Let’s see how you can calculate it?
How to Calculate ROI? Formula
Calculating ROI is a straightforward process. You just need to divide the return of investment (net income) with the cost of investments and then multiply the result by 100 to get the ROI percentage. Simply, you need to divide the benefits with the cost invested to get those benefits.
ROI = (Net Profit / Cost of Investment) x 100
Here is the second formula to work out ROI:
ROI = (Final Value of Investment – Initial Value of Investment)/Cost of Investment * 100%
Initial Value of investment refers to the initial value of the asset or money you invested at the time of investment. In the same way, the Final Value of Investment is the value of financial assets when the investment has ended.
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How Does ROI Work?
ROI is simple and easy to use metric to calculate the return on your investments. Whether you want to know the result of stocks investments or any other investments. This measure indicates whether your return on investment is getting positive or negative results. The higher your ROI, the more profit you earn from your investments.
In addition, ROI can also be used as a comparison tool. It compares the profitability and worth of one investment to others. This measure can be a useful tool for regular investors to analyse their investment portfolios. Moreover, you can assess any type of investment using it.
However, ROI can’t reflect the value of time that makes it difficult to do a comprehensive comparison between different types of investments as some investments take more time to generate profit. For this reason, investors use other metrics like Internal Rate of Return (IRR) and Net Present Value (NPV) to get a clear picture of their investments.
What is a Good ROI?
It depends based on your circumstances. However, you need to consider many things to know a good ROI. Typically, ask yourself the following questions to determine whether an ROI is good or not:
- What time does your investment need to generate a return?
- What is the risk factor of your investment?
- How much risk you can bear?
- What alternative do you have?
- What will happen if you lose the money invested?
Quick Sum Up
So you have got a basic overview of what is a return on investment, how to calculate it, how does it work and what is a good ROI? It is a simple performance metric to work out the efficiency or profitability of your investment. Bear in mind that you can not estimate the exact worth of investment only by this metric. For this reason, you need to use other metrics, like the Internal Rate of Return (IRR) and Net Present Value (NPP) to get better results.
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Disclaimer: This blog is intended for general information on ROI.