ROI stands for return on investment. This commonly used financial ratio helps investors and entrepreneurs assess different business options to see which may give the highest profits over time.
Put simply, it’s how you work out which of your choices may give you the biggest bang for your buck.
|This handy guide will cover everything you need to know about ROI and how to calculate it - including:|
We’ll also take a brief look at how you can save your business money - and help to improve your ROI - with a TransferWise business account. Let’s dive right in.
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Working out your return on investment means you need to take your net income or profit, and divide it by your initial outlay, investment or capital cost. You can then express the return you made in a percentage, or as a ratio - the higher the number, the greater the benefit you’ve derived.
The easiest way to calculate ROI as a percentage is as follows:
|ROI = ((Return – Investment) /Investment) х 100%|
We’ll take a look at some example calculations in a moment. But if you want to skip ahead and figure out your own ROI numbers, it’s good to know that calculating ROI doesn’t need to be a headache. A simple way to do your ROI calculation is to use an online ROI calculator. You just enter the details of your calculation, and get your ROI figures right away.
ROI is a popular way to assess different investments because it is simple and easily understood. With a few variations, the same calculation could be used by a teenage student working out whether to run a bake sale or not, and by an experienced real estate investor looking to buy a million dollar property.
You can use ROI to assess stock investments, marketing campaigns, business opportunities and more. In every case the basics are the same - an investment with a positive ROI is probably worth considering. A negative ROI implies you’ll make a loss - and should be avoided. By finding out the potential ROI of different opportunities, investors can eliminate and prioritize options, to find the ones best suited to their needs.
Let’s look at an example:Imagine an auto dealership sold 100 cars at a price of $5,000 each. That means the total revenue for the business is 5,000 x 100 = $500,000.
To calculate the ROI of the company, you need to work out the profit - the total revenue minus the investments made in the business.
The dealership buys cars at an average price of $2,000 each. That makes a total bill of $200,000 in purchase costs. You’ll then also need to add in all the additional costs involved in running a business - things like employee payroll, marketing, and property rental. Let’s say that this adds an extra $200,000 in costs.
So, the total revenue is $500,000, and the investment in both cars and overheads is $400,000.
|ROI in this case = (500,000 - 400,000) / (400,000) x 100% = 25%|
This means the return on investment is 25% - a positive ROI. But here’s the million dollar question - is that actually a good return on investment?
One downfall of ROI calculations is that there is no absolute answer to the question - what is a good ROI? The return on investment available will vary from field to field, so you’ll need to analyze a few different options to get a feel for what’s a good number for your business or opportunity. Just remember - in broad terms, a higher ROI is better, and net zero, or negative ROIs should generally be avoided.
A common problem for investors is that ROI doesn’t necessarily take into account the amount of time taken to achieve the return described.
Let’s go back to our example above, of the auto dealership achieving a 25% ROI. Sounds great. But what if one dealership took a full year to sell 100 cars - and get the 25% return, whereas another business could connect with more customers, and sell 100 cars in just a month. It’s pretty obvious which company would be the better investment - but if both businesses have the same overheads, the simple ROI of each could actually be the same.
That’s where an annual ROI comes in handy. An annual ROI calculation takes into account the amount of time taken to achieve a return. Here’s the formula:
|Annualized ROI as a percentage = [(1+ROI)^(1/n)-1]×100|
In this case n = the number of years, or parts of a year, for which the investment is held.
You can work out the annualized ROI for your business, using a free online annualized ROI calculator, or do the math yourself using the formula above. The online tool has smart features, allowing you to either enter a specific number of years, or use a date range to make the calculation as simple as possible.
If you run marketing campaigns to promote your business, you might want to calculate the ROMI (Return On Marketing Investment) of different options. This will help you find the one which works best for your business type.
Here’s the formula you’ll need to use:
|ROMI = ((Profit from marketing channel used - Marketing expenses) / Marketing expenses) x 100|
Let’s see how it works in action, comparing different marketing campaign options.
A store decides to test campaigns on Facebook and AdWords in comparison to their usual method of advertising in their local newspaper. They track the purchases and compare which customers were recruited by which marketing campaign.
Customers who found the store through Facebook bought products worth $9,700 during the test period. Customers who came from AdWords spent $8,600 and those who heard about the store from the newspaper accounted for $5,000 of sales.
The store can then compare these sales against the costs of each different channel. In this case, let’s say that Facebook cost $2780, AdWords $2530, and the regular ad in the newspaper cost $4000. Here’s how the ROMI for each stacks up:
|Profit from the campaign||Money spent on the campaign||Money spent on the campaign||ROMI|
|Ad in a local newspaper||$5000||$4000||25%|
This ROMI calculation tells us that the Facebook campaign was the most profitable and efficient, while the regular route taken - advertising in a local newspaper - wasn’t such good value. Investing $1,000 in Facebook adverts in this case would provide a return of $2490, while the same spent on a newspaper ad would return only $250. You can also run similar calculations for different campaigns using the same channel, to see which angle serves your business best.
Real estate investment is a popular way to diversify an investment portfolio, and benefit from both ongoing rental income and potential capital growth. Using an ROI calculation can help you decide if an existing or potential real estate investment is right for you.
The way you calculate the ROI of a real estate purchase will depend to an extent on the way you’re financing it. If you own a property outright and have rental income from tenants, it’ll be slightly different compared to someone with a mortgage to pay, for example. While the basic approach is the same in all instances, it’s important to get the right figures for your investment, expenses and income to get an accurate ROI number.
Let’s look at an example. If you’re making a cash purchase of a property, you’ll need to first work out the total cost of the investment. This will cover the property cost, but also closing costs, and the price of any renovations or remodeling you choose to do. If you buy a $200,000 condo, and then have a further $10,000 in closing and repair costs, for example, your total investment is $210,000.
You then achieve a rental income of $1,000 a month, making your gross income $12,000 over the course of a year. However, during that time you’ll also incur costs for bills, taxes, insurance and maintenance - and these costs must be deducted from the rental income to get your net profit over the year. If you need to spend $1500 over the year, your net profit will be $10,500 - allowing you to calculate your ROI as follows:
|ROI = (12,000-1,500)/210,000 x 100 = 5%|
The calculation will look somewhat different if you take a mortgage on the same property. In this case, you’ll need to look at the amount you spend on the property initially, which will include a downpayment on the mortgage, as well as closing costs and remodeling fees as above.
To work out the income you make from the property over the course of the year, you’ll need to take the rental income, and deduct the amount you pay for bills, taxes and insurance as we did previously - but you’ll also need to deduct the costs of servicing the mortgage, including interest and capital repayments. Once you’ve captured all the different costs, you can then use the same ROI formula as we have used above.
The easiest way to calculate the ROI of your real estate investment is to use a handy real estate ROI calculator, available online for free. These tools walk you through the different pieces of information needed to come up with an accurate figure for your investment return.
It’s worth also noting that real estate investment inevitably comes with unexpected situations - and costs. These may include vacancies between tenants or necessary repairs - and can change your projected ROI significantly.
Another measure you may have heard of is IRR - internal rate of return. This is more difficult to calculate than ROI, and typically is used to evaluate shorter term investments.
There’s no real formula to calculate IRR. Instead, you look at the projected amount of income - from a project for example, and then work backwards to calculate the investment you should make. In this way IRR takes into account the value of money over time, providing a picture of the annual growth rate.
ROE - return on equity - is another calculation used in some situations, to assess whether a business is performing well. This measure looks at the returns made by the company divided by the equity of the shareholders, and gives a picture of how well the management of a business is using company assets to generate a profit.
So there you have it - your full guide to ROI to help you build your business and grow your profits. Use the helpful tools available to calculate and assess the ROI of different business options, to stay ahead of the game.
And don’t forget you can also save money - and give your profits a boost - with a specialized TransferWise business account for low cost, safe and fast international payments.
1.ROI Formula (Return on Investment)
2.A Guide to Calculating Return on Investment – ROI
3.How to Calculate the ROI on a Rental Property
4.Finding Your Return on Real Estate Investments (ROI)
5.IRR vs ROI
This publication is provided for general information purposes only and is not intended to cover every aspect of the topics with which it deals. It is not intended to amount to advice on which you should rely. You must obtain professional or specialist advice before taking, or refraining from, any action on the basis of the content in this publication. The information in this publication does not constitute legal, tax or other professional advice from TransferWise Limited or its affiliates. Prior results do not guarantee a similar outcome. We make no representations, warranties or guarantees, whether express or implied, that the content in the publication is accurate, complete or up to date.
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