How To Calculate ROI (Return On Investment)

And most businesses are unlikely to produce exactly $100k every year to the investors. Some

businesses will grow the profits year after year. Others might see the profits decline as the business matures and heads out of business.

So the proper way to calculate a return is using the "cash flow method."

Here's how you do it.

1. Get a spreadsheet, excel will do, although increasingly I recommend Google docs spreadsheet because it's simpler to share with others.
2. Lay out along a single row a number of years. I would suggest ten years to start.
3. In the first year show the total investment required as a negative number (because the investors are sending their money to you).
4. In the first through tenth years, show the returns to the investors (after your share). This should be a positive number.
5. Then add those two rows together to get a "net cash flow" number.
6. Sum up the totals of all ten years to get total money in, total money back, and net profit.
7. Then calculate two numbers. The "multiple" is the total money back divided by the total money in. And then using the "IRR" function, calculate an annual return number.

Here's a link to Google docs where I've posted this example. It is public so everyone can play around with it and see how the formulas work.

It's worth looking for a minute at the theoretical example. The investors put in $400k, get $100k back for four years in a row (which gets them their money back), but then the business declines and eventually goes out of business in its seventh year. The annual rate of return on the $400k turns out to be 14 percent and the total multiple is 1.3x.

That's not a bad outcome for a personal investment in a local business you want to support. It sure beats the returns you'll get on a money market fund. But it is not a 25 percent return and should not be marketed as such.

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