How to Calculate Return on Investment

Return on investment answers a narrow question: for every pound put in, how much came back? It is the most portable measure in business finance, which is also why it gets abused. ROI can be made to look impressive by choosing a flattering time frame, ignoring the costs of producing the return, or comparing investments of very different risk.

This guide covers the formula, what belongs in the gain and the cost, a worked example, and the limits that matter when the answer is used to make a decision.

The formula

ROI = (net gain / cost of investment) × 100.

Net gain is what you got back, minus what you put in, minus any costs of making the investment happen.

Cost of investment is everything committed to it: the purchase price, installation, training, fees, and the working capital tied up while it is underway.

The result is a percentage. A 25 per cent ROI means that for every 100 invested, 25 came back on top of the original 100.

What counts as the gain

The gain is not just the money that arrives. It is the money that arrives because of the investment.

If a 4,000 piece of equipment generates 5,200 of extra revenue over its life, the gain is not 5,200 — it is 5,200 minus the additional costs of running that equipment: power, maintenance, consumables, insurance and any operator time.

It is also worth being strict about attribution. Revenue that would have arrived anyway, or that a competitor's move would have prevented, is not a return on this investment. Where attribution is uncertain, state the assumption next to the number.

Worked example: 4,000 in, 5,200 out, 200 of costs

A business invests 4,000 in equipment.

Over its useful life it produces 5,200 of additional revenue. Running and maintenance costs over the same period are 200.

Net gain = 5,200 - 4,000 - 200 = 1,000.

ROI = (1,000 / 4,000) × 100 = 25 per cent.

The business recovers its 4,000 and ends 1,000 ahead. If the equipment has a resale value at the end, that should be added to the gain, net of any disposal costs. If it carries a maintenance contract that continues beyond the period, that belongs in the costs.

Annualising so periods compare

Raw ROI ignores time. A 25 per cent return over five years is a very different proposition from 25 per cent over one, and comparing the two without adjustment is the most common error in investment appraisal.

To annualise a single-period return: annualised ROI = ((1 + ROI)^(1 / years) - 1) × 100.

For a 25 per cent return over three years: (1.25)^(1/3) - 1 = 0.0772, or about 7.7 per cent a year. Over five years it is about 4.6 per cent. Both are well below the headline 25 per cent, and either may be below the cost of borrowing.

This is an approximation, not a substitute for a full discounted cash-flow analysis, but it is enough to stop a five-year project being compared directly with a one-year one.

What ROI leaves out

ROI is a ratio, and a ratio discards information.

• Risk. A 30 per cent return on a speculative project and a 12 per cent return on a contracted one are not comparable without a view on the probability of each.
• Cash flow timing. An investment that returns everything in year five is worse for a small business than one that returns the same total steadily, even where the ROI is identical.
• Opportunity cost. The relevant comparison is not zero; it is the best alternative use of the same money, including leaving it in the business.
• Scale. A 100 per cent ROI on 500 is 500 of profit. A 20 per cent ROI on 50,000 is 10,000. The percentage alone does not tell you which matters.

Use ROI to compare options of similar size and duration. Use cash-flow modelling when they differ.

Common mistakes

• Leaving out the costs of the return. Revenue gained is not net gain.
• Using revenue as the gain and forgetting the capital. The original investment must be deducted.
• Comparing periods without annualising. Five-year and one-year figures are not the same unit.
• Ignoring the cost of finance. If the money was borrowed, the interest belongs in the calculation; what you owe and when depends on the agreement, so read it rather than assume.
• Treating ROI as a forecast. A projected 25 per cent is an assumption until the revenue arrives.
• Using one ROI for a portfolio. An average return hides the projects that failed.

Using ROI well

Run the numbers through the ROI calculator to see the percentage and the net gain side by side, then test the result at a lower revenue figure to establish how much of the return depends on optimism. If the investment needs borrowing, the loan calculator will show the repayments that the return has to cover. An ROI below the cost of the finance is a signal, not a rounding error.