This is an ultimate guide on how to calculate Return on Investment Ratio (ROI) with detailed interpretation, analysis, and example. You will learn how to use this ratio formula to evaluate a business profitability.
Definition - What is Return on Investment Ratio?
The return on Investment (ROI) is a metric that measures the efficiency and return of an investment.
It’s a simple ratio between the money earned on an investment and the initial cost of the investment.
Investors can use the ratio to compare various potential investments, and decide which is the most profitable.
The equation for ROI ratio is as follows:
Return on Investment = (Investment Revenue - Cost of Investment) / Cost of Investment
To calculate this ratio, you simply subtract the initial cost of the investment from total value of the investment at the end of the investment period, and divide that number by the initial cost of the investment.
An easier formula to remember is the following:
Return on Investment = Gain from Investment ÷ Initial Investment
In this formula, you merely take the monetary gain from the investment, and divide it by the initial investment.
To make this idea clearer, here is an example: Suppose you have two prospective investment projects called Project HHH and Project JJJ.
Project HHH requires a $50 million investment, and expects a $35 million and $60 million return in year 1 and year 2, respectively.
Project JJJ requires a $100 million investment, with returns of $75 million and $50 million in year 1 and year 2, respectively.
Return on Investment
Plugging in the numbers in the equation above, we can calculate that the ROI for Project HHH is 90%, and the ROI for Project JJJ is 25%.
Interpretation & Analysis
The above example shows why this ratio can be a powerful metric.
At quick glance, Project JJJ seems like a better investment because you obtain a $125 million return, as opposed to $95 return from Project HHH.
But the rate of return on investment measures the percentage return.
It takes the initial investment into account to show investors what percentage of the money originally invested will be returned over the life of the investment.
So, in the above example, the ROIs of the two projects shows that Project HHH will return 90% of your original investment, while Project HHH will only return 25%.
This ratio allows you to look past the monetary returns, and analyze the percentage returns of investments.
Cautions & Further Explanation
While the ROI ratio is a valuable tool that aids investors in their quest for higher profits, it has its limitations.
For example, this ratio does not take time into account.
Two projects that have the same initial investment and same monetary gain will have identical ROIs regardless of how long the investment horizons are for the projects.
If one project returned $1 million a year for 100 years, and one project returned $100 million in one year, they would both have the same ROI.
But it doesn’t take a math whiz to know that an investment that returns your money quickly is more attractive than one that repays you over a long period of time.
So this ratio is looked at as more of a “quick-and-dirty” method of calculating return, while CAGR and IRR are considered to be more the more comprehensive metrics that analyze investment returns.