How To Calculate The Return On Investment (ROI)

How To Calculate The Return On Investment (ROI)

What is Return on Investment (ROI)?

ROI (Return on Investment) is used to measure the profit or loss generated on an investment in relation to the amount of money invested. Return On Investment is regularly expressed as a percentage (%) and is used to make personal financial decisions, to compare the efficiency of different investments or the profitability of the business.

The return on investment reveals how much profit a company made on a particular investment as a percentage. This normalizes the returns so an enterprise can compare two different investments having different costs.

For example, if a company has an investment that costs $10 and a return of $5 and another investment that cost $1,000 and returned $100. Although the $1,000 investment generated more money, the $10 has a better return.

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Steps to calculate return on investment (ROI)

STEP 1: Ascertain the original cost of the investment and the current price of the investment. For instance, Firm A buys stock worth $100 in Firm B. At the end of the year, Firm A's stock is now worth $150.

STEP 2: Next is to subtract the original cost of the investment from the current price of the investment. From our illustration above, $150 minus $100 equals $50 ($150 - $100 = $50)

STEP 3: Then you divide the number calculated in Step 2 by the original cost of the investment. Using the example in Step 1 and 2, $50 divided by $100 equals 0.5 or a return on investment of 50 percent.
$50 ÷ $100 = $0.5 or 50% (0.5×100)

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Return on investment (ROI) of a business isn't necessarily the same as profit. ROI involves the money you invest in the company and the return generated on that money based on the net profit (profit after expenses have been deducted) of the business. On the other hand, profit measures the performance of the business in a period. Don't confuse ROI with the return on the owner's equity, they are not the same. Only in sole proprietorships business does equity equal the total investment of the business.

How To Calculate The Return On Investment (ROI)

You can use ROI in several different ways to measure the profitability of your business. For instance, you can measure how your pricing policies perform, inventory investment, capital equipment investment, etc.

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Some other ways to use ROI within your company are by:
  1. Dividing net income, interest, and taxes by total liabilities to measure rate of earnings of total capital employed.
  2. Dividing net income and income taxes by proprietary equity and fixed liabilities to produce a rate of earnings on invested capital.
  3. Dividing net income by total capital plus reserves to calculate the rate of earnings on proprietary equity and stock equity.
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Factors affecting your return of investment

There are some factors that can affect and even completely determine the return on investment of your business. The largest of these is market share, because the higher the share of the market, the higher your profit margin.

As an average, companies with market share above 36% earn more than thrice as much as businesses with less than a 7% share of their market. At least three contributing factors come from high market share; economies of scale, market power and better access to quality management and talent. Better access to quality management and talent can increase your ROI as top performing managers are successful at achieving large portions of their respective markets.

The second largest factor that will determine your company’s ROI is the quality of your service or product. When customers are satisfied with the services rendered or products produced, they are more likely to return and patronize your company again. When a company has both a high market share and supply a superior product or service, there is an increased chance of high Return on investment.
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