ENTREPRENEURSHIP / MAY. 25, 2014
version 2, draft 2

How to Calculate the Rate of Return

Cash flows. Capital. Net profit. Gross profit. Capital gains and losses. Debt financing. Equity financing. If you’ve ever felt like financial jargon is another language entirely, you’re not alone. It can be very intimidating and confusing. That said, as a business owner or entrepreneur, you should have at least a basic understanding. After all, it is YOUR business or idea, and you want to know about the dollars and cents involved, right? While it wouldn’t be a great idea to try and tackle it all alone (get yourself a good accountant and/or financial advisor), there are plenty of concepts that aren’t that difficult to grasp on some level.

Take the rate of return, for example. It refers to the gain or loss of a specific investment over a specific period of time (usually one year), expressed as a percentage of the initial amount. The rate of return is useful in two ways. First, as an entrepreneur looking for more investment, the rate of return is a crucial stat to present to possible investors. They are going to want to know how their money will likely perform with your company. Second, as an investor yourself (either as a profit-making endeavour or while budgeting for future investment and improvements in your company), you want to see the bang for your buck.

The Basic Rate of Return

The formula for finding your basic rate of return is rather simple:

1. Present Value - Initial Investment

So, for example, if you invested $15,000 in your startup, and it has a current value (including interest and dividends, if any) of $18,500, it would look like this: $18,500 - $15,000 = $3500. You have a positive return of $3500. To find the rate of return (expressed as a percentage), you need to perform two additional steps.

2. Change in Value / Initial Investment

In our example, that becomes $3500 / $15,000 = 0.23

Finally, multiply that decimal by 100 to give you the rate of return expressed as percentage.

3. Our simple example is therefore 0.23 x 100 = 23.

An initial investment of $15,000 that is now worth $18,500 has a rate of return of 23%.

If only it were always that simple. Sadly, it’s not. There are a great deal of other factors that could come into play that would affect and influence the overall rate of return, but the basic formula does give you a pretty good (albeit simplified) indicator of whether something is a decent investment. Obviously, the higher the rate, the better.

What If An Investment Has Lost Value?

The basic formula still holds. Let’s work with another simple example: An initial investment of $10,000 is now worth only $9000. Follow the steps outlined above.

  1. $9000 - $10,000 = -$1000. This represents a negative return of one thousand dollars.
  2. -$1000 / $10,000 = -0.1
  3. -0.1 x 100 = -10

In this example, the rate of return is -(minus)10%. Not a great investment at this point. And not an attractive stat to lure potential investors to your company.

Other Methods of Calculations

Calculating an accurate rate of return can get infinitely more complicated when you add in cash flows (either in or out of a portfolio), varying time periods, length of investment, and so forth. Each scenario has a corresponding formula for calculating the rate of return, with varying degrees of difficulty that are best left to professionals. Three of the most common include:

The Time-Weighted Return

This is useful for portfolios with frequent cash flows (either in or out of the portfolio) that are controlled by a client, rather than the portfolio manager. Time-weighted return examines the period between cash flows as a separate entity, working them out individually and then arriving at a final, overall average. This technique is a better assessment of a portfolio or money managers performance when they do not actually control the cash flows themselves.

The Money-Weighted Return

This technique is best for situations in which a money or portfolio manager does directly control the cash flows in and out of it. The money-weighted return looks at both the size and timing of cash flows when calculating the rate of return for a given investment.

The Modified Dietz Method

This weighted technique considers both timing of cash flows (both in and out of the portfolio), as well as the individual length of time each amount has been in or out of the final sum when calculating the rate of return. The modified Dietz method assumes a constant rate of return over a specific period of time.  

Finding a straightforward rate of return is a relatively simple, 3-step process. Unfortunately, finance at any level is rarely that easy, with amounts moving in and out of a total, for various periods of time. The most accurate calculation will likely involve much more complex formulas and calculations, so make sure you fully understand the system before attempting it. Good business means delegating to those better or more equipped than you to tackle certain things. A certified accountant or financial advisor is worth their weight in gold, and should be one of the first positions you fill for your growing business.

Photo Courtesy of Pixabay

 

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