Whenever you are thinking of doing any business or want to invest money you must calculate the ROI (Return on Investment). Calculating ROI is not that tough task. In this article, I will discuss what is ROI and how to calculate it. I will also tell you the things you should keep in mind while calculating ROI so that you can make informed decisions on your investment.
Many times I have seen people are not even doing ROI calculation while they are investing money into any project. Rather investment decisions are being taken emotionally or carried away by passion.
Whenever there is a matter of investing money one must think rationally rather than emotionally.
What is the Return on Investment [ROI]?
Here when we are talking about return on investment, we will not be talking about the conventional account return on investment. We will talk in simple terms about return on investment.
Here we will calculate the money we put in the business and what we gain from the business.
Let’s take an example of investing money in business. We will take the example of investing money in the restaurant business.
For opening and running a restaurant, we need ₹. 1 crore. So we need to invest this ₹. 1 crore into the business.
Whatever we will earn out of the business will be called a return from the business or return on investment.
ROI will be calculated on a yearly basis. So whenever we will talk about return on investment it will be on a yearly basis.
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ROI = Return from the business or Investment / Cash you have deployed
Here the net profit means all the income – all the expenses of the business/investment.
Many people are making a mistake in calculating ROI by not considering all the expenses of the business. These expenses are:
- Salary of the employees
- Business running cost
- Interest cost
- Legal cost
This formula is applicable to all types of investment. Let’s take the example of fixed deposits in the bank.
You are getting 7% interest on the capital you are putting in fixed deposit in the bank. So this 7% will be the ROI for the fixed deposit. Since there is no additional cost or salary you have to pay the simple 7% will be the return on your investment in fixed deposit.
Now let’s talk about the ROI on mutual funds investment. Let’s say we are getting 15% of the return on the mutual fund investment. Out of that 2% is the cost of a mutual fund company. So mutual fund company will pass on you 13% as return on your investment. Here this 2% is the cost or the expenses of the mutual fund company. It is basically known as expense ratio in terms of the mutual funds.
Same way in public provident fund, the return on investment will be around 8.5% per year. These are simple calculations of ROI. But while investing in the business, there are many more factors which you need to consider to derive accurate ROI.
ROI calculation – Things you must consider
Below are the points you must check while calculating ROI.
You must calculate the realistic return on your investment. Realistic return means, what is a logical and acceptable return. You can not have an ROI of let say 200% on your investment. These types of returns are usually unrealistic. Thus making the whole ROI calculation wrong.
Consider progressive ROI
Most of the time while starting a new business, the expenses are on a higher side during the first year. This is mainly due to the one time cost/expenses that occur during the first year of the business. These types of expenses are like business registration cost, property lease deed registration charges, furniture cost and so on.
So while calculating the ROI for the first year, the return will be lower due to this one time expense. Looking only at the first year ROI you may reject the business case but in reality, that business has the potential of getting higher ROI from the 2nd year onwards.
Always do due diligence
While making a business decision, we consider past performance as a benchmark or as a reference. Everybody can predict an ROI, but nobody can see the actual future. So going just based on the past performance can be fatal in the future. Only a well-thought-out investment will see positive returns. Blindly investing without your due diligence is never a good idea.
Dig into the financial history and all documentation. Without due diligence, your investment is doomed to be filled with not-so-fun surprises around every corner.
Consider all the cost
While calculating ROI, you must calculate all the costs pertains to the investment or the project. Many times we forget to consider the cost of capital as an expense.
The cost of capital means the cost incurred for getting that required capital. Suppose you are taking a loan for starting a business. so you must consider the loan interest cost as an expense for your business.
Same way if you are deploying your own capital then also you must consider the opportunity cost of the capital. If the return after considering the cost of capital comes positive then only you should go ahead and invest your money in that project.
FAQs – Return On Investment [ROI]
A simple formula for calculating ROI is: ROI = Return from the business or Investment / Cash you have deployed
No, they are not the same.
Yes, ROI can be different for different years based on the business model and external factors.
Yes, you. must consider opportunity cost while calculating ROI.
What is the point if you are not even getting a return which can beat inflation? You should not invest in such a project where the returns are lesser than inflation.
Calculating Return on Investment for any project of investment decision is must check to conclude whether the investment decision is right or wrong. It will give you a fair idea about the business case and the future return from the investment.