Pros & Cons of Return on Investment
For a small business, the return on investment (ROI) can be calculated in one of two ways: simple or discounted. The ROI is a measure of profitability. Simple ROI looks at the total cost of the investment compared to the gains and is most often used for short-term investments. The discounted ROI, used for longer-term analysis, is considered the present value of the investment compared to the present value of costs. Both methods have pros and cons.
The simple ROI calculation method has the benefit that it is easy to understand. It takes a basic number, the amount invested, and divides it by the value of the gain. This gives a percentage of gain. For example, if $10,000 was used to start a business two years ago and the present bank account less any immediate debts is $25,000, the small business owner can state a 250 percent return on investment within a 24-month period (Simple ROI = $25,000 / $10,000).
The discount method uses the same basic principle but must first calculate the present value and discount it, making for a more complex computation. So the same $10,000 investment might be discounted by a 6 percent discount rate one year later, resulting in a $9,434 [Present Value = Future Value / (1 + rate)^n] initial investment value benefit in present value terms. (The variable component "^n" refers to using the number of years as the factor.) The discounted ROI at the end of year two is then calculated. The present value cost is subtracted from present value benefits, and the difference is divided by the cost: Discount PV = ($25,000 - $9,434) / $9,434, equaling 165 percent ROI. This is a considerably lower ROI than that derived with the simple method but more accurate in real terms.
The simple ROI method is designed so anyone can understand it, not just economists or financial analysts. Generally, as with any simple calculation method, accuracy drops with use of the simple calculation method versus the discounted method. One of the reasons the simple method is less accurate is it doesn't factor in the change in the value of the dollar, namely inflationary costs.
When looking at simple ROI versus discount ROI, the investor's perspective may play a role in determining which calculation to use. If a business owner is using an ROI calculation to determine how fast he can pay an investor back, it is beneficial to use the discount method of ROI. This method shows lower ROI values in the early years and allows the business enough time to develop revenues to safely repay investors. The simple method would have investors paid back much sooner, but may put the business at risk of undercapitalization in key years.
With more than 15 years of professional writing experience, Kimberlee finds it fun to take technical mumbo-jumbo and make it fun! Her first career was in financial services and insurance.