ROI (Return on Investment) is a performance metric in business that reflects the benefit derived from a particular investment over a period of time. A high ROI demonstrates the financial efficiency of an investment. ROI helps inform an investor whether the investment was worth the cost.
The use of ROI has become quite popular given the ease of calculation and versatility of applications. The traditional formula for calculating ROI is to divide the benefit of the investment (or net benefit) by the cost of the investment:
Return on Investment = (Benefit from Investment – Cost of Investment) / Cost of Investment
For example, imagine that John bought a small condo for $100,000 and sold it the next year for $125,000. John could calculate the return on the purchase of his condo by taking the benefit of the investment ($125,000 – $100,000 = $25,000) and dividing it by the cost ($100,000). Here, John’s ROI on the condo would be 25%.
ROI helps a business owner understand the full picture. Looking at only the benefit of the investment without the cost would paint an inaccurate picture. Adding on to the scenario above, imagine that Jane only made $20,000 on her sale of her small condo after one year. In isolation, it might seem that John made the better investment because he made $25,000, but what if you found out that Jane bought her condo for $50,000 instead of $100,000 like John? Jane’s ROI would be 40%, while John’s ROI would only be 25%.
ROI has many applications in the business context. The difference between good and bad reasons to look for external capital comes down to ROI — regardless if a borrowing from family and friends, seeking equity investments or applying for a term loan. Aside from evaluating a particular item of investment such as real estate or stock, business owners can look at their entire company and use ROI to assess their business’s profitability. Business owners would divide their net profit (which is essentially the net benefit) by total assets:
Return on Investment = Net Profit / Cost of Investment
Michael’s barbershop made $90,000 in net profit, but the cost of starting his own barbershop, including the purchasing of all equipment, was $200,000 (total assets). Here, Michael’s ROI would be 45%. Knowing this Michael can look at other competitors and their financial information to assess how his business is performing. If Michael’s barbershop has a lower ROI than other companies, this could indicate that his competitors are operating more efficiently. In addition, Michael can use this ROI information to compare how he has performed through the years. If ROI has decreased over the years, Michael should evaluate how his barbershop is operating.
What is noticeably missing from the calculation of ROI is a factor for time. If Michael made $90,000 in profit, but it took him 5 years to make that, his investors would not be very happy. As such, it is important to calculate ROI periodically (perhaps quarterly or annually) to get a better picture of how a business is truly performing.
To increase ROI for your business, you will have to do at least one of two things: generate more revenue and/or reduce costs. A business can generate more revenue by increasing sales and marketing efforts. Building a strong brand could lead to consistent revenue growth. A business can minimize costs by creating a detailed financial map of the company to see what costs can be cut. Transitioning and upgrading your business to digital products can offer hundreds, if not thousands, of dollars in savings. With the advent of cloud services for small businesses, owners can streamline their operations and reduce costs.
