No individual or organization goes into selling products or services with the goal of losing money. Every business person wants to make a profit, not only to recover the costs initially spent for starting the business, but also the costs spent on daily operations. Although it is natural for a company to lose money in its first few months or even its first few years of doing a business plan, it should not become a trend that will eventually cause the company to close down. You may also see investment agreement template.
There are numerous tools and methods that business owners and finance personnel (certified public accountants, MBA graduates, financial advisors, auditors, etc.) use to analyze the profitability of products and their eventual net income. The ROI formula is one of these tools. You may also see investment contract templates.
This formula is commonly used in creating financial assumptions and forecasts. Basically, ROI measures the amount of time the investor or business owner recovers the funds he invested during the early stages of the business.
How do you compute for ROI?
The computation for return on investment is very simple. ROI is a profitability ratio, so it is computed as a percentage. It does not involve multiple steps and it certainly does not turn your brain upside down and inside out in confusion. Here is the return on investment formula:
ROI = (gain from investment – cost of investment) / cost of investment
Gain from investment refers to your net income or profit for the year while the cost of investment refers to the total amount you invested. One use of ROI is that it is a profitability ratio, so you need to compute your financial forecasts ahead of time, specifically your income statements, as you will be basing your ROI from that data. When you are computing the return on investment for your startup business, make sure your other financial statements are already in place. You may also see investment sheet templates.
Another usage of return on investment is when you are investing a certain amount of funds in a company. Not all individuals have the opportunity to start their own business, so they just invest and get their investment with interest after a few months or a few years (depending on the agreement between the investor and the business owner). These individuals who earn from investing in other companies are called “angel investors” as their main responsibility is just to fund other companies and corporations. You may also see writing the perfect investment proposal.
Here is a return on investment sample computation. Jack invests $10,000 in Rose’s computer repair shop business (investment cost). Rose’s business earned $15,000 after Jack’s investment (gain from investment). Subtract Rose’s net income from Jack’s investment and divide it by Jack’s investment (15,000 – 10,000 / 10,000). The total is 0.5 or 50%, which means that Jack had an ROI of 5% from his investment in Rose’s computer repair business. You may also see how inventory Investment affects profits and cash flow
Advantages and disadvantages of using ROI
As you can see in the sample computation above, computing for the return on investment is very simple and does not require much effort. That is already one advantage of the ROI formula as even a student can calculate it as long as the numbers and items are laid out.
Although ROI is a simple and effective metric to use, it poses some problems, too, as it does not really provide the investor with detailed information of the investment templates. One disadvantage of using ROI is that it only states the profit of the company, not the entire condition of the company itself. An ROI for a project may take more than ten years to break even which may cause the investor to back out. Various environment changes may even cause the company to go under which makes the ROI invalid.
We hope that you learned and understood the basic concept of ROI and how to compute it. ROI is one of the easiest financial ratios to compute and also one of the most used metrics by investors and financial advisors. So, use it now for your next investment project or company analysis.