Return on Investment – Welcome to Fintekinfo. Where we do not lock but unlock the knowledge of finance. Whenever you do investment or think about investing money in a project or a business then it is very important that you calculate its return on investment.
which we call ROI in short. It is not a difficult task to calculate ROI. You can do it very easily. In this post, I will show you how this calculation is done. Now, ROI calculation is not a big deal, the main problem is that we sometimes don’t calculate ROI at all. Whether any business or investment will give us positive returns or not?
In fact, we become emotional, and passionate and maybe stop thinking rationally when we become this passionate. So, I’ve often seen people making these mistakes. In fact, why talk only about people, I myself have sometimes committed these mistakes. And in this post, we will see which types of mistakes we commit while comparing projects, businesses, and investments many times we don’t understand where exactly we should invest our money?
So, do this post from start to the end so that you don’t commit these mistakes. Let’s go straight to the blackboard. Now, see when we talk about return on investment then here I am not talking about any accounting convention. We will think clearly that how much money have we put into a business or an investment and how many returns do we get?
According to that, we will think about calculating our returns on investment. So, let’s take an example here You want to invest in a project by project, I mean any business, any franchise be it any kind of business investment it can be an investment like stocks, mutual funds, FD, etc., etc.
So, what we see when we put money into a project or an investment So on one side, we invest money and on the other side, we want the returns. From here, our cash is entered and from another side, it is out. So, this cash out is our return. and this cash-in is our investment. So, we want to see how good returns we get? and we want to compare the investments and products on the basis of ROI.
These returns, which we got are actually per year returns whenever we are talking about ROI. So, in this, If I talk about the formula so if we write ROI’s formula, then we will write the cash you get, I am writing in plain English cash you get per year divided by cash you put in.
This means the amount of money you withdraw within 1 year is divided by the money you deposited. This is your ROI. So, If I write this in another language then basically, your profit per year means the amount of money/profit you earned after excluding all the expenses.
In this project or suppose you invested in any business in that all the expenses like rent, maintenance, salaries after taking out all the expenses, the profit you earned in a year you divided it by your investment. that how much money you invested in that. This formula is applied to every type of investment.
If we talk about FD. Let’s suppose you invested the money in an FD so when you talk about returns Let’s suppose you say I am getting a profit of 7% so here you are talking about 7% returns of an FD. So here, ROI is 7%. Now suppose you invested in mutual funds, then what we talk about in mutual funds that how many percentages of returns can we get in a year? we can get 12-15% returns. We can get 12-15% ROI.
If you invest in PF, provident fund How many returns can you get here? you get an 8.5% return on investment. Now see, this is a very simplified calculation where you clearly know how much annual returns you are going to get. or how much is the annual interest being promised? But when we invest in a business or when we invest our money in any investment where we need to do some calculation where we need to do some brain work, then sometimes we make some mistakes.
Let me give you an example for the same this is very easy to understand but still, we do very basic mistakes that many times, we couldn’t compare two projects we invest our money where we should not and because of that only we continue bearing losses that too every year. Let me explain to you with the help of an example Let’s suppose you want to compare a project.
Let’s say you invested in a gym. Then let’s say, our investment in this will come out to be of let me write investment as ‘i’ here Let’s say you have to put around 1 crore here And how many returns it can give you? Means how much your profit per year can be? Let’s say it can give you a profit of around 15 lakh per year. So here, what is our ROI, return on investment?
15 lakh divided by 1 crore, let me write 1 crore as 100 lakhs here So here, your ROI comes to 15% which is not that bad. Now, let’s try to compare it with other investments Let’s say you want to open an institute for vocational training, and let’s say your investment comes out to be 1 crore here also. And let’s say you want to compare whether you invest 1 crore in the gym or in vocational training
And let’s say your profit per year comes to around 10 lakh rupees. 10 lakh per year Now, here if you calculate ROI then here if you divide 10 lakhs by 100 lakhs then here you get 10% Now here, any wise fellow would say, 15% returns are better then why do I invest in vocational training? 15% returns are always better Yes, absolutely right. If you are investing the whole money from your pocket, then there’s no problem.
Now here, the game changes a bit many times when you take a loan. Now, a loan means, one cost of capital has come. Because you won’t be getting a loan for free. If you take a loan, then basically you’ve to pay the interest This interest is the cost of capital There’s a cost of a loan and the cost is known as interest. Now, let’s take an example. Let’s say this investment of a complete 1 crore is done on loan.
This 1 crore of investment has come 100% from the loan. Let’s say it’s interest rate… at an interest rate of Let’s say you have to take this loan at 18% Now, let’s see how the equation changes Your interest per year will be if you pay interest per year, then if you calculate 18 % of 1 crore then you have to pay 18 lakhs per year as interest. Your profit was 15 lakhs per year. So here the equation has completely changed. Here, your ROI was less than the cost of capital.
See here, your ROI is 15% Here this ROI of 15% is less than the cost of capital of 18% So definitely, it’s going to be your loss only. See here, every year you are earning 15 lakhs and paying the interest of 18 lakhs. So every year you are doing a loss of 3 lakhs per year. Let’s see how the equation changes for the second project. Let’s assume for vocational training instinct, the government gives a loan of 100%. Let’s say here you get the loan on 7%. For example, it is a subsidized loan. So here, when you will do your interest calculation how much your interest per year will be?
On 1 crore, according to 7%, it will be 7 lakhs per year. How much you are earning? 10 lakhs per year. So here, is your ROI, Return On Investment. Return on investment means this 10% is more than 7%. So the return on investment is more than the cost of capital. That means here overall you are getting a profit. So how much is your overall profit here? You are getting a profit of 3 lakhs per year. Now, this is basically, profit after interest. When we will the overall calculation, it will be profit after interest.
And when we are calculating overall profit after interest then you are going in loss overall. Whenever you are selecting a project, you should only select it when your return on investment is greater than the cost of capital. Now, oftentimes we call a return on investment a return on capital. So your return on capital should be greater than the cost of capital then only invest in that project. Now let me give you one more example of this. People do many mistakes here. For example, people invest in real estate.
See if you want to live in that house then it is a different thing together then after staying you are calculating its value in a different way. But if you treat real estate as an investment then many times you suffer loss as well. I am not saying real estate is a bad investment. No. it is not like that. But if your timing is wrong, then the real estate can be a very bad investment. Let’s understand this too with an example.
Let’s propose this house is also of 1 crore. And let’s say you do the downpayment of 20 lakhs, you pay directly from your pocket. And take a loan of 80 lakhs. Let’s say you get a loan on 10% interest rates. Now, for this, you get rent See, where you’ll get the profit from? If you yourself are living, then obviously there will be no rent. Here, we are talking about investment. So let’s assume you give it on rent. First, you will be profited by rent and second will be your capital appreciation. Because rates also increase in real estate. That’s where you get the profit from. So what should be your rent plus appreciation?
as we have talked about in ROI. These two parts are of ROI, right. What should be your ROI? It should be greater than the cost of capital. This means it should be more than 10%. Rent’s portion, if I talk about let’s say residential, is around 3% That means your capital appreciation should be 7% every year. If your capital appreciation is less than 7%, then it is a very bad investment.
Now, let’s assume there’s no capital appreciation in 4-5 years in real estate. It becomes your dead investment and you are paying money from your own pocket every year. So because of that, oftentimes, people do not handle it well. So whenever you invest money anywhere, what do you have to do first? Have to calculate its return on investment.
If you are taking a loan, then you should subtract the interest on that and then calculate the profit. Then calculate your return on investment. Or if you are talking about before interest then your return on capital should always be greater than the cost of capital. Keep this thing in your mind. Suppose your interest is 10%, then the return should be greater than 10%, then only you will profit. So basically, I’ve given you a preliminary return on investment. Now, we will go into more detail about return on assets, return on equity, and return on capital employed How to calculate all these? I’ll be discussing these in the coming post.