It's impossible for your business to flourish if you don't invest in its growth. However, it can be hard to determine whether investments will be worth it in the long run. For business owners looking to make smarter financial decisions, this guide outlines everything you need to know about calculating your return on investment (ROI). We cover the difference between a standard and an annualised return rate, run you through the calculations step by step, show you how to interpret the results before addressing the formulas various pros and cons. We conclude by mentioning Kriya's offerings and answering some frequently asked questions.
Whether you're looking to hire new staff or move to bigger premises, if you're a small business on the rise, it's likely you're making a lot of investments. As critical as these expenditures can be, sometimes it's hard to know if you're getting your money's worth. This is where the return on investment, or ROI, comes in.
ROI is one of the best metrics for monitoring your businesses performance. Since its inception in 1914, the formula has helped business owners all around the globe make smarter financial decisions. Specifically, it’s helped individuals and companies take the guesswork out of financing by measuring their return on a potential investment.
Despite its clear benefits, however, many entrepreneurs are yet to familiarise themselves with the formula. Therefore, to clear up any potential confusion, this guide covers everything you need to know about calculating your return on investments. Specifically, we show you how to calculate your basic and annualised ROI and how to interpret the results before outlining the various pros and cons associated with its use.
Before we address its uses, however, what exactly do we mean when we talk about ROI?
WHAT IS A RETURN ON INVESTMENT (ROI)?
In simple terms, ROI is a financial metric that measures the return on an investment relative to its cost. It helps companies and individuals to compare the efficiency of different investments, so they're able to understand if the rewards will outweigh the risks.
Generally speaking, the lower the cost of investment and the higher the net profit, the more positive the ROI. Subsequently, the higher the percentage, the more favourable an investment is likely to be.
The metric is used widely because it’s relatively easy to calculate and can be applied to any type of business or personal investment. It’s specifically popular in the field of marketing because it helps leaders work out if their marketing campaigns are worth investing in.
WHAT’S THE BASIC FORMULA?
The formula for calculating your basic ROI is as follows:
- ROI = 100% * net profit / cost of investment
HOW TO CALCULATE YOUR RETURN ON INVESTMENT (ROI)
Working out your ROI is a relatively straightforward process, especially for small businesses. This means you should be able to analyse your investments in-house without the help of external financial advisors. Depending on the end goal of your calculation, a return on investment can be measured in a number of different ways. However, the formula we've listed above is the most commonly used ratio.
To work out the ROI of a particular expenditure, you can follow the following steps.
1. Determine your net profit from the investment
The net profit represents the total amount of money gained from your investment. In other words, it’s the benefit you and your business will receive if you go through with the -. To work out this figure, you simply deduct the total expenses of the investment from the total revenue.
2. Calculate the cost of investment
Once you’ve established your net profit, it’s time to work out the cost of your investment. To calculate this figure, you simply add the fixed cost of your expenditure to its variable costs. This will provide you with your total cost of investment.
3. Divide the net profit by the cost of investment
In line with the ROI formula, next, you need to divide your net profit figure by the total cost of your investment.
4. Multiply this figure by 100%
Finally, you multiply this decimal number by 100, and you will have your final ROI ratio in the form of a percentage.
WHAT’S AN ANNUALISED RETURN ON INVESTMENT (ROI)?
While the basic ROI formula is the most effective way to measure your immediate returns, it doesn't consider the holding period of the investment. Therefore, if you're looking to analyse your returns over a specific length of time, it may be more appropriate to work out your annualised return.
As the name suggests, an annualised ROI represents the average of an investment's earnings over a year. It's expressed as a time-weighted annual percentage, and types of returns can include capital, interest payments and dividends. The calculation also includes adjustments for compounding interest, so many experts believe it is more accurate than the basic formula.
WHAT IS THE ANNUALISED RATE OF RETURN FORMULA?
The annualised rate of return formula is as follows:
- The annualised rate of return = ( ending value of investment/beginning value of investment) x 100
How to calculate your annualised return
To work out your annualised ROI, you follow the steps below.
1. Determine your beginning value
Your beginning value represents how much your investment portfolio was worth before the capital changed hands. In simpler terms, it’s how much money you put into an investment.
2. Calculate your ending value
Once you’ve established your beginning value, it’s time to work out your ending value. Your ending value is how much you stand to gain from the investment over the period of your annualised return. As stated above, aside from the basic amount of capital, this figure should also include interest payments and dividends.
3. Work out your annualised return
Once you have both of these figures at hand, you can calculate your final annualised return. To do so, you need to divide your ending value by your beginning value before multiplying this number by 100. This will provide you with your final annualised ROI ratio.
HOW TO INTERPRET YOUR ROI
There isn’t much point in calculating your investments basic or annualised ROI if you can’t make sense of the end result. Luckily, interpreting your return is pretty simple: the higher your basic or annualised ROI is, the more fruitful your investment is likely to be.
Since the nature of each investment differs so heavily, there is no benchmark of what a ‘good’ or ‘bad’ ROI ratio is. There are, however, other ways you can interpret your results. By researching other small businesses in your industry and recording the average ROI on their investments, you can gauge what a standard return may look like for a company similar to yours.
You can then compare your results against this figure to establish your business’s performance. You should, however, understand that this comparison will only give you a rough indication of your ROI’s value.
WHY ARE THESE FORMULAS SO IMPORTANT?
By now, you should understand the basics of the standard and annualised ROI formulas. If you are new to the world of profitability ratios, below we explain why they are such a valuable tool for businesses.
They help you to determine profitability
When people invest, they are looking to get more out than they put in. However, due to a whole host of variables, business owners can’t guarantee that this risk will pay off. By calculating the ROI of an investment before they split with their cash, they can calculate its rough profitability. This lowers their chance of encountering negative returns.
They help you to understand risks
Every financial investment involves some degree of risk, and it’s the role of business owners to manage these risks as much as possible. Fortunately, by using the ROI metric, you’re able to avoid risky investments and make the smartest decisions possible for the future of your business.
They are simple to use
Finally, another reason ROI formulas are beneficial is because they're so easy to use. If you're calculating your basic or annual returns, all you need are two key figures. Compared to other financial metrics; these formulas are extremely straightforward. Therefore, it's unsurprising that they're such a staple for business owners trying to manage their finances.
WHAT ARE THEIR LIMITATIONS?
Despite the clear advantages of these formulas, however, they’re far from perfect. To give you a more balanced view of the metrics, here are some limitations to their use.
They aren’t 100% accurate
Return formulas aren’t able to provide accurate financial projections because the formula is based on too many variables. They instead give companies and individuals a rough estimate of their profitability. With this in mind, to avoid getting caught out, business owners shouldn’t base crucial business decisions on these results.
The basic formula doesn’t account for time
As we’ve already addressed, the standard ROI formula only considers the immediate outcome of an investment. This makes it hard to predict how an investment will pay off later down the line. Fortunately, if you’re looking to understand your investments return over a 12 month period, you can use the annualised ROI formula.
Results can be inconsistent
While the standard ROI metric is the most popular way to calculate returns, many other formulas exist. And since every formula generates slightly different results, it’s impossible to obtain an objective measure of your ROI. Because of this, investors should always stick to the basic formula when possible and check which formula was used when comparing the results of other companies.
INVEST IN YOUR BUSINESS WITH FLEXIBLE FINANCING
No matter how long you’ve been in the game, investments are always a bit of a gamble. However, by using these tools above, you can invest in your business’s future in the safest and most secure way possible. If you’re currently lacking the capital needed to make valuable investments, Kriya may have a solution for you.
From recovery loans to embedded financing, Kriya offers a wide range of funding options to business owners up and down the UK. We truly believe that small businesses are the future and that cash flow barriers shouldn’t prevent them from reaching their potential. If you’re serious about investing in your businesses long term growth, you can learn more about what we do here.
FREQUENTLY ASKED QUESTIONS (FAQS)
What is a return on investment (ROI)?
ROI is a financial metric that measures the return on an investment relative to its cost. It helps companies and individuals to compare the efficiency of different investments, so they're able to understand if the rewards will outweigh the risks. Generally speaking, the lower the cost of investment and the higher the net profit, the more positive the ROI.
How do you calculate your return on a business investment?
The basic ROI formula is ‘ROI = 100% * net profit/cost of investment'. In accordance with this formula, to calculate the ROI, you need to determine your investment's net profit and its total cost. Then, you divide the net profit by the total cost and multiply this result by 100. The figure you are left with is your final ROI ratio.
What is an annualised rate of return?
An annualised ROI represents the average of an investment's earnings over a year. It's expressed as a time-weighted annual percentage, and types of returns can include capital, interest payments and dividends. The calculation also includes adjustments for compounding interest, so many experts believe it is more accurate than the basic formula.
How does a business analyse its ROI ratio?
Since the nature of each investment differs so heavily, there is no benchmark of what a ‘good’ or ‘bad’ ROI ratio is. There are, however, other ways you can interpret your results. By researching other small businesses in your industry and recording the average ROI on their investments, you can gauge what a standard return may look like for a company similar to yours. You can then compare your results against this figure to establish your business’s performance.
What are the benefits of the return on investment (ROI) metric?
Return on investment (ROI) formulas are an indispensable tool to businesspeople all around the globe. This is because they are a reliable way to measure the profitability of an investment, they help to keep financial risks to a minimum, and they are simple and easy to use.
