How to calculate return on investment

The formula in words: net profit from the investment divided by the cost of the investment. business.gov.au's glossary describes ROI this way, with the result converted to a percentage, and says it shows how efficiently a business turns its owners' and shareholders' original equity into profit.

The division gives a decimal, which the tables below show as it is. The cost must be above zero, and both figures should cover the same thing over the same period, usually a year.

1. Define the investment and the period you are measuring it over.
2. Total everything it cost to make it happen, including travel, materials and outside help.
3. Work out the extra gross profit it brought in: the extra sales less the direct cost of those sales.
4. Take away the investment's own cost to find the net profit it produced.
5. Divide that net profit by the cost.

A positive result means the expo paid for itself and left a profit. A negative result would mean the extra gross profit didn't cover what the stall cost.

The arithmetic is easy. The judgement is in the top line: which profit would not have happened without the investment? A few questions help:

• Would some of these customers have ordered anyway, through the website or a phone call?
• Will the expo lead to repeat orders after the period ends, and should a later review count them?
• Did staff time spent at the expo cost the business work elsewhere?
• Are you comparing the same length of period for every option you are weighing up?

Write down how you measured the profit, and check the figure again once the profit and loss statement for the period is finalised.

Marketing ROI uses the same formula; the hard part is knowing which sales the campaign brought in. business.gov.au's cash flow guidance lists marketing campaigns, sales promotions and social media among the ways to reach new customers. Before a campaign starts, decide how you'll tell its customers apart: an offer code that appears only in the campaign, a question for every new customer about how they found you, or a booking page used nowhere else.

Then set the gross profit from those customers, not their sales, against everything the campaign cost, including design, printing, distribution and advertising.

Over the 3 months the campaign returned 0.50. Over a year, with repeat bookings from the same customers, it returned 1.11. Neither figure is wrong, but campaigns can only be compared over the same length of time, and a business whose customers come back regularly may want the longer view.

Tracking has gaps. Some customers who saw the campaign won't use the code, and some who used it would have booked anyway. The two gaps pull in opposite directions, so write down how you counted, and use the same method for every campaign you compare.

Equipment earns its return over several years, so measure it over the working life you expect from it. business.gov.au's glossary calls a substantial one-off purchase of items such as plant or equipment a capital cost. The return can come from extra sales, from costs the business stops paying, or both. Count every cost of owning it: the purchase price, delivery and installation, servicing and running costs, and the interest if you borrow to buy it. Then take off anything you expect to get back by selling it at the end.

The printer's return comes from outside printing the business no longer pays for, less the ink, servicing and power it now uses. Over 5 years it brings back its cost and 22,500.00 more, an ROI of 0.70 over its life. Dividing by five gives a simple average of 0.14 a year, which treats every year alike and says nothing about when the money came back. The payback period below covers that.

Two more things can change the answer. Staff time spent running the printer is a cost if it takes people away from other paid work, so put a value on it. And business.gov.au's funding guide suggests weighing up whether buying or leasing suits you better for vehicles, equipment and tools, while its cash flow guidance notes that leasing or hiring spreads the cost, especially for something needed only for a short time. Work out each option over the same 5 years, with its own costs, before comparing them.

Payback period is the time an investment takes to bring back what it cost. When the net cash it brings in is about the same each year, divide the cost by that yearly amount: for the printer, 32,000.00 divided by 10,500.00 is about 3.05 years. When the amount changes from year to year, keep a running total and note where it passes the cost.

Machine A is the printer from the example above. Both machines bring in 54,500.00 against a cost of 32,000.00, so both show an ROI of 0.70 over 5 years. Machine A has its money back about 7 months sooner, which leaves less cash tied up and less riding on the later years turning out as forecast.

Payback has a blind spot of its own: it ignores everything after the cost is recovered, so a quick payback isn't the same as a large return. ROI ignores how long the money took. Used together, each covers the other's gap. Neither allows for a dollar that arrives sooner being more useful to a business than the same dollar arriving later.

business.gov.au's business valuation guide describes an ROI method based on the business's net profit for the past year. It works in both directions:

• To test a selling price you have in mind, divide the net annual profit by that price.
• To find a price from a return you want, divide the net annual profit by that return. Both the profit and the return must be above zero for the answer to mean anything.

business.gov.au notes that there is no single set way to value a business, and that methods can be combined. It suggests professional help from your accountant, a business adviser or a business broker if you can afford it.

Yes to both. A negative ROI means the investment brought in less than it cost, so part of the cost was never recovered. A result of exactly zero means it just paid for itself, and a result of (1.00) means none of the cost came back at all.

An ROI above 1.00 means the net profit was bigger than the cost: the investment returned its cost and more than the same amount again. The marketing campaign above passes 1.00 once its repeat bookings are counted. A result well above 1.00 is still worth checking for a missing cost, such as staff time or a bill that was recorded in a different period.

• How long the return took. The same result over a month and over several years are very different outcomes.
• How risky it was. A steady return and a lucky one look the same in hindsight.
• How big it was. A small spend can show a high ROI and still add little to the business.
• When the cash moved. Money may go out long before the profit comes in.
• The owner's time, unless you put a cost on it and include it.

Treat ROI as one input alongside the budget and a cash flow forecast, not the whole decision.

This guide doesn't give a target ROI, because the return worth accepting depends on the business, the risk and what else the money could do. The figure means more when you set it against:

• the other options for the same money, measured over the same period and with every cost counted the same way
• doing nothing, including what happens to sales or costs if the old equipment isn't replaced or the campaign doesn't run
• the cost of borrowing, if a loan would pay for it. business.gov.au's funding guide lists repayments with interest among the drawbacks of debt finance, so the interest belongs in the cost
• the forecast you made before spending, so each new forecast learns from the last.

Work it out twice: once before the decision, as a forecast, and again when the results are in. Keep the forecast, the invoices that make up the cost and a note of how you tracked the profit together, so the second calculation uses the same definitions as the first.

Give each cost and each gain its own row, with a column for each year of the period you're measuring. Total the costs and the gains, take one from the other for the net profit, and divide by the total cost in a cell that stays blank while the cost is zero. A running total that starts with the cost as a negative figure and adds each year's net cash shows the payback year at a glance: it's the first year in which the total turns positive.

Set the forecast and the actual result in neighbouring columns, using the same rows. Any difference then shows up line by line, so it's clear whether a weaker return came from higher costs, smaller gains, or gains that took longer to arrive.