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Grow Your Business Finances

What is ROI?

image for cat-scape / Getty Images
cat-scape / Getty Images
  • ROI is better known as return on investment.
  • For every investment you need to determine what you think is the appropriate ROI.
  • There are different ways to measure ROI. 

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.

Any expense a company has can be calculated into 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 prior to 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 were to invest money in an advertising campaign, they'd look at 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.

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. Put time into thinking on it, and don't make any big purchases right away. Someone promising the moon is likely not going to have good returns. That leads into the next topic: problems in achieving an ROI.

Everybody thinks they can predict an ROI, but nobody can see the future. Averages can be found through big data, but you're not entitled to reach them. 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 prove 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 good 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 financial history and all documentation. Without due diligence, your investment is doomed to be filled with not-so-fun surprises around every corner.

Only smart businesses that spend wisely and monitor ROI closely can survive in the long run.

If you aren't seeing an 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.

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

ROI calculations are not meant 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 return on investment of any project or marketing campaign helps in identifying successful business practices.

Many companies use ROI to identify methods of marketing and advertising that will 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.