Return on investment is a ratio measured against expenses and revenues to determine an overall economic benefit derived from an investment. A high ROI indicates that the total profits relative to the initial cost of the investment, usually a large sum of money. As such, ROI is frequently used as a performance indicator, often to compare the efficacies of various investments, or to evaluate the profitability of an ongoing operation. In other instances, a low ROI may indicate poor investment decisions.
There are many ways in which to calculate the value of an investment. One common method is to determine the gross profit or net profit, less any paid-in capital. The net profit after expenses, including stock-based and property-based fees, less any realized gain, is then divided by the invested amount to calculate the ROI. While this is a straightforward approach, it may fail to take into consideration some important variables. Some, but not all, investments will produce a negative net profit; others will produce only a net profit, which may be positive or negative.
Another way to calculate return on investment is through the use of a financial metrics formula. The most commonly used formula for this purpose is the numerator denominator or revenue-profit divide, which involves first determining the growth or level of the firm over time, and then dividing that number by the firm’s current gross revenue. While the formulas are widely available, they can not be used all the time, since most businesses change their bottom line more frequently than their revenue or profit.
Return on investment can also be calculated using spreadsheet software. By using investment-time management techniques, spreadsheet software can effectively track and then calculate the ROI of business decisions. One such technique for doing so is by dividing the total investment into two categories: the initial investment and the operating costs. The initial investment represents the cost of creating the product or service, while operating costs pertain to those required to run the business on a daily basis, such as salaries, electricity, and so forth.
There are several ways to divide a firm’s capital expenses between its operational and creative areas. In a nutshell, the more a firm spends on one area, the larger its profit is expected to be. Many firms divide the cost of production between advertising, selling, and production by using the law of large numbers to calculate a ratio called the 10,000 cost rule. This rule states that if a firm produces ten thousand units of any product and spends an equal number of dollars on each of those units, the firm will earn a certain percentage of revenue over the course of a year. Using this method, firms can quickly calculate the expected growth in their profit margin by dividing the ten thousand cost ratio by the expected annual profit.
Many people are surprised to learn that a simple formula for determining the Return on Investment can be found in any text book on entrepreneurship or management. The formula is simply expressed as the net present value of an investment over time. The goal of the investor is to invest money that does not have to be paid back to the date, thus multiplying the amount of potential profits. Another way of looking at the equation is to calculate the amount of money that can be generated from a project today to the sum of all future generations in a population. Return on Investment can be measured in a variety of ways, but one of the most popular is the net present value of an investment over a period of time.