What is Return on Investment (ROI)?
Return on Investment, ROI, is the money an investor in a business earns for the injection of financial capital. Any return is from the net profit the business makes and is a mark of the efficiency of investing capital in the venture.
How to Calculate ROI
The easiest way to calculate ROI is to express it as a percentage, gain or loss, of the initial capital sum. To figure the ROI the investor will subtract the ‘cost of the investment’ from the ‘total gain on the investment’ and divide that by the ‘cost of investment’. For example if an investor puts $5,000 into a clothing store and at the end of the year they receive $6,000 in return, the ROI will come out as:
($6,000 – $5,000) / $5,000
ROI = 20%
The Uses of Return on investment
The Return on Investment figure once calculated has many uses both to the investor and to the store owner. For the investor it will tell them the potential ROI on an investment when looking at places to put their money. By comparing the ROI of a clothing store with that say of a shoe retailer they will see where their money will get the better return. For a store it may use the ROI figure when going to the market looking for investors. By showing that an investor may get 20% over the term of the money being in the store, the storeowner is making the business an attractive one in which to invest.
The opposite is also true. If the ROI is very low or in some cases even zero or negative, the store will not look very attractive to an investor and the owner may need to look at the workings of the store. While not the same as profit, ROI is a clear indicator of how the store is performing over time.
Not as Simple as it May Appear
A simple reading of a return of investment figure may be misleading. Time is also a factor and is important when considering investing in a business. A ROI figure of 30% from one store looks better than one of 20% from another for example. The 30% though may be over three years as opposed to the 20% from just the one, thus the one year investment obviously is the better option. On the other hand the one year investment may carry more risk than the three year one and the investor may be better off investing for the longer term.