Here's everything you should know about return on investment and how to use it to ensure your business spending is increasing your earnings.
- ROI is better known as return on investment.
- For every investment, you need to determine the appropriate ROI.
- There are multiple ways to measure ROI.
- This article is for managers or business owners who are interested in understanding what ROI is and how to calculate it.
ROI, or return on investment, is a common business term used to identify past and potential financial returns. Managers and executives look to the ROI of a project or endeavor because this measure indicates how successful a venture will be. Often expressed as a percentage or a ratio, this value describes anything from a financial return to increased efficiencies.
What is ROI?
Any expense a company has can be calculated in terms of ROI. While some expenses or activities – such as buying staples or repairing an employee bathroom – may not have a direct or financial ROI, each expense contributes to an overarching investment. For example, hiring a graphic designer to create ads, paying a photographer to take pictures of the company, and overhauling the company's website can be considered a return on investment.
In many instances, ROI is used to calculate how much of a value an investment is. For example, an angel investor would want to know the potential ROI of an investment before committing any funds to a company. Calculating a company's potential or actual financial ROI typically involves dividing the company's annual income or profit by the amount of the original or current investment.
ROI is also used to describe "opportunity cost," or a return the investor gave up to invest in the company. If a business owner were to invest their money in the stock market, they could expect to receive an annual return of at least 5%. By investing that same money in a company, an owner would expect to see a similar, if not higher, ROI for their money.
Companies even use ROI to measure the success of a specific project. If a business owner were to invest money in an advertising campaign, they'd analyze the sales generated by the ad and use that information to determine the ROI. If the money generated exceeded the amount spent, then a business could consider it an acceptable ROI.
When calculating your annualized ROI, you're looking for the average yearly return on investment earned during the investment period. This shows you how profitable the venture is, which is helpful, because ROI doesn't include the holding period of an investment within its formula. Annualized ROI can help you analyze and compare the performance of your investment during specific time periods.
Key takeaway: ROI measures the growth or loss of funds invested in a business venture.
Why is ROI important in business?
Only smart businesses that spend wisely and monitor ROI closely survive in the long run.
If you aren't seeing an optimal ROI on a certain endeavor, stop throwing money at it; you're better off scrapping it. Continuing to spend on lost causes is a surefire way to run out of money and run your business into the ground.
Key takeaway: ROI allows you to see the fruits of your investment or the lack thereof, which is important to always have a handle on when running a business.
What is considered a 'good' ROI?
What's considered a good ROI depends on the investment. When a company is spending money on a piece of equipment, for example, the ROI is in productivity. Marketing spend, on the other hand, requires an ROI in sales. The ROI you expect from your search engine optimization efforts will be different from the ROI you look for from an investment in a new factory.
A healthy double-digit ROI is great for starters, and if you identify high-percentage ROIs, you should aim to figure out how to amplify and extend those effects.
Consider whether you get an ROI at all, and be realistic before signing contracts and spending money. Consider it carefully, and don't make any big purchases right away. Someone promising the moon is likely not going to deliver good returns. That leads to the next topic: problems in achieving an ROI.
Key takeaway: Being mindful of where you invest your money; consider whether it will increase the profitability of your venture and allow you to reach a healthy and higher ROI.
Challenges of ROI
Everybody thinks they can predict an ROI, but nobody can see the future. Averages can be found through big data, but for most us, only a well-thought-out investment will see positive returns. Blindly investing without doing your due diligence is never a good idea.
Before investing in partners or clients, meet with them in person. Tour the facility, and get to know the business. Ask to see as much documentation as you can to verify they are who they say they are. Anybody can register a business and rent a commercial space; that doesn't mean you'll see a positive ROI.
For example, if you invested in Bitcoin in 2010 and sold at the start of 2018, you made a bundle. If you bought at the start of 2018 and are still holding, you're probably not so happy. Two investors holding the same investment can have very different experiences and views of it, depending on the timing.
Dig into the business's financial history and all documentation. Without doing due diligence, you can expect many unpleasant surprises.
Key takeaway: Doing the proper research before pouring money into a business venture will give you a better chance of realizing a healthy ROI.
Limitations of ROI
You can gain a lot of financial foresight by calculating your ROI, but measuring your business's success based on an ROI has its limitations.
Here are three limitations to consider.
- Your company's cash flow is not directly reflected in your ROI, so your business's financial health may not always be measured completely or accurately using ROI alone. "For example, the ROI may be 5%, but it may be losing cash flow and be a very costly investment," said Robert Gauvreau, CPA and founder of accounting firm Gauvreau & Associates. "Whereas another investment that is generating 4% ROI may be generating a positive cash return to the investors."Depending solely on ROI to evaluate the financial health of a project only gives you a partial understanding of what's affecting your finances.
- To calculate an accurate ROI, you need a firm grasp of your future business expenses. If you don't yet have accurate numbers for future expenses, or if the numbers comprising your calculation are variable, such as interest rates that may change, the ROI may be inaccurate.
- ROI only measures the financial success of a project. For example, investing in new computers and tech for your employees may have a negative ROI, but it may make your employees happier and increase retention. The ROI of a project or venture doesn't account for the nonfinancial benefits of an investment.
Key takeaway: An ROI supplies specific information, which means that it doesn't always speak to the entire company. It's a helpful calculation, but it is limited in the data it provides.
Benefits of ROI
Understanding your profits, and the impact of an investment on your business, is important and extremely helpful when making decisions for your company.
Here are two more benefits that calculating your return on investment provides.
- Using an ROI allows business owners to track and analyze short- and long-term projects."You can set simple targets for both short-term and long-term goals, and ROI can measure if you are achieving those benchmarks quickly and easily," Gauvreau said.
- ROI helps you evaluate your business's financial performance. Knowing your ROI keeps your company on track by demonstrating whether your business is profiting above or below its average, said Leonard Ang, realtor and chief marketing officer of iProperty Management. It's a good reminder for companies to maintain a standard for their finances.
Key takeaway: ROI calculations can help you analyze your finances and make quality decisions about the future of your business.
One way to calculate ROI is to divide the net profit (return) by the amount that was invested:
ROI (%) = net profit / investment x 100
Another way to calculate ROI is to take the gains of an investment, subtract the cost of the investment and divide the result by the cost of the investment:
ROI = (gains – costs) / costs
For example, let's say you make a major purchase, like buying a home.
"You purchase your home for $1,000,000," Gauvreau said. "After living in your home for three years, you sell it for $1,120,000. The result, after three years, your home increased in value by $120,000."
If we follow the ROI = (gains – costs) / costs formula, we find that the return on investment is 12%.
($1,120,000 - $1,000,000) / $1,000,000 = 0.12
Another example of ROI would be investing in the stock market, Gauvreau said. If you invest $100,000 in Tesla stock, and then 12 months later it grows to $160,000, your ROI would be 60% because:
($160,000- $100,000) / $100,000) = 0.6
Key takeaway: An ROI formula is a simple equation used to help business owners calculate the success of their investments.
Learning from the past
ROI calculations are not intended to be precise methods of measurement, but rather ways to approximate. More accurate projections always help, but some error is generally expected with ROI. Understanding the ROI of any project or marketing campaign helps in identifying successful business practices.
Many companies use ROI to identify methods of marketing and advertising that yield the highest return based on previous successes. This way, ROI becomes not only a measure of past success but also an estimate for the coming months.
Key takeaway: ROI calculations are useful, because they help you analyze the progress of your business, and although they're estimations, they can impact and improve the decisions you make for your company.