How to calculate and understand return on investment (ROI)
Return on investment (ROI) is a performance measurement ratio (usually expressed as a percentage) that is used to evaluate the performance of a business. How do you calculate ROI?
Net income / Total equity
The return on investment metric calculates how efficiently a business is using the money invested by shareholders to generate profits. If a shareholder makes an interest-free loan to the company, this amount should be included in the total equity even though it is a liability. This ensures that the ROI is calculated on the total investment (at risk amount) of the shareholders.
Return on investment is a very popular metric because of its flexibility, comparability and simplicity. It allows shareholders to compare performance against other companies or investments (especially companies of different sizes or profitability levels). The question then becomes, is the ROI adequate, how can you raise the return, or should the shareholders liquidate the company and invest the money elsewhere to get a better ROI?
Variations on the return on investment (ROI) calculation
Multiple variations exist on the calculation of return on investment. These variations are similar to the original, but can produce very different results and significantly different meanings.
- Adjusted net income: Adjusting net income can result in a more meaningful calculation of ROI for the owners. One usual adjustment to net income is to remove the shareholder’s salary (if any) and include a fair value of salaries that would otherwise be required if the shareholder was not involved in management. This normalizes expenses since the shareholder may be compensated in multiple ways for tax planning purposes and their salary may be very different from the cost of hiring an external manager to provide those services. Adjusting the compensation provides a more accurate representation of the fair value return the company is generating. Other usual adjustments include the removal of one-time expenses (startup expenses) or non-recurring revenues (such as a gain on the sale of equipment). These items can make net income fluctuate greatly from year to year but do not present normalized returns for the company. By removing them, the calculation provides a more accurate measurement of the ROI from the ongoing operations and allows for greater comparability between years.
- Return on assets: Some calculations divide net income by total assets instead of equity. This variation can also be very useful to shareholders and creditors. However, it is important to note that the result of the calculation indicates the efficiency of assets to generate a return, not how much shareholders are making on their investment. This can be very different depending on how much leverage (debt financing) is used by the company. This calculation is frequently used when evaluating whether or not an investment in additional assets (such as a new piece of equipment) would increase or decrease the return of the company.
- Total equity plus fixed liabilities: This variation divides net income by total equity plus fixed liabilities. Again this calculation can be very useful to shareholders and creditors but the meaning is slightly different than return on investment. It shows the rate of return on total capital invested and the efficiency of the company to generate income based on total capital invested, not just the return on the shareholders’ investment. This is a useful measurement if owners are specifically using leverage to increase their returns.
Limitations to comparability between calculations
As these variations show, the ROI calculation can be varied significantly to measure different types of returns and can be manipulated by the adjustments. When using this calculation, you should be aware of what you are trying to measure. When using it for comparison purposes, you must ensure that all measurements are calculated on the same basis.
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