Return on Investment: What It is and How to Calculate
In starting up your own business, you want to make sure that you get your every penny’s worth. From conceptualizing product ideas, coming up with distinct logo designs, and carrying out your marketing strategy, you would want to ensure that every effort you exert will be worth the price.
A key business principle that enables every business owner to understand profitability – especially for startup businesses.
Let’s face it. The primary reason why people start or invest in businesses is to make money.
Therefore it is vital that business owners can understand and identify whether their business venture is worthwhile.
Therefore, it is vital that businesses use the most accurate performance measure there is. The most brilliant business owners combine earnestness and a keen understanding of foresight and investment returns to guide their business decisions and investment choices.
One of the primary financial principles that every owner should understand is the Return on Investment, known by many as the ROI.
So, suppose you would want to know more about your company’s profit, the whatnots of Return on Investment, and how to calculate ROI. In that case, you are on the right article. Also, check out what is EBITDA.
Understanding Return on Investment (ROI)
What is Return on Investment (ROI)?
Business decisions are often anchored on how much profit a business can earn. Taking the business to a new level involves understanding how the financial return on investment works.
Return on Investment (ROI) is one of the most known Key Performance Indicators (KPIs) that help determine your business’s profitability and losses. Whether your business spends time, money, or marketing efforts, analyzing your ROI can help you determine whether your business had a gain, a loss, or a break even.
Your ROI can help you determine the impact of all your effort which leads you to understand not just your current value but your overall financial performance as well.
Therefore, your Return On Investment (ROI) is exceptionally useful in determining your company’s profit and success over time. Thus, its value is highly essential for any type of business in whatever industry.
If you know how to calculate ROI, you gain leverage in understanding how well your business is doing and which areas you can intensify your efforts to gain higher ROI.
How do you Calculate ROI?
Measuring ROI is relatively easy. However, there are a number of ways in which you can calculate your Return on Investment (ROI).
One of the most common ways of calculating ROI is the net income divided by the total costs of investment which can be expressed in the ROI formula given below;
ROI = Net Income / Cost of Investment x 100
Here is an example of the basic ROI calculation:
A person invests $80 into a retail business with a total cost of $20 on research and packaging. Therefore, the total cost of investment relative to the business is $100. So, let us say that the business garnered a total of $500 in revenue but still had $100 of operational cost, then the net profit would be a value of $400.
Using the given formula above, the ROI equation would be $400 divided by $100 for a quotient of 4. Since the answer in the ROI formula is often expressed as ROI percentage, the quotient is always multiplied by 100. Therefore, the value of ROI, which is 4 x 100, is 400 or 400%.
Despite a low value in dollars, the higher ROI indicates that investment can be considered a productive one.
Another way to calculate ROI is through investment gain divided by investment base, which is expressed with the given ROI formula below:
ROI = Investment Gain / Investment Base
Given that there are multiple ways to calculate ROI. Thus, when discussing ROI within your company, it is essential to take note of what kind of formula was used, as each equation may measure a particular set of investments.
Return on Investment (ROI) can also be used to look into the trends of net profits. There are also other alternatives to calculate ROI. Thus, you may use some of these as deemed fit for your need:
Annualized ROI formula
Annualized ROI = ((Final Value of Investment / Beginning Value of Investment) ^ (1 / # of years) – 1 x 100
This formula may be used when you consider the length of a time period of a stakeholder’s investment. In terms of your annualized ROI formula for performance, you may use the formula below:
Annualized ROI = ((Initial Investment + Gains or Losses) / Initial Investment) ^ (1/# of years) – 1
Social ROI (SROI) formula
SROI = Net Present Value of Benefits / Net Present Value of Investment
The social ROI formula is used for outcome-based results and considers the broader economic, environmental, and social value. These outcomes are often expressed in tangible dollar or monetary values.
Marketing Statistics ROI formula
Marketing ROI: (Sales Growth – Marketing Campaigns Cost) / Marketing Campaigns Cost
The marketing statistics ROI formula is used to determine the impact and success rate of a company’s marketing program and campaign.
Social Media Statistics ROI formula
Social Media ROI: (Value / Total Investment) x 100
This formula helps in determining the effectiveness and impact of the company’s social media campaigns, which may be based on the number of likes and shares generated. It measures time, money, and resources
Limitations to ROI calculations
Despite ROI being valuable to many businesses, it does not go without limitations. One of its most known limitations is that it takes the time period out of the equation. Let us say that upon a company’s first investment, it had an ROI of 20% over five years and an ROI of 15% over 2 years. Therefore, the use of annualized ROI can measure the annualized return on investment, which takes time into consideration.
That is why it is a must to consider what aspect of your business performance you would want to gauge for you to go beyond the limitations of ROI calculations.
Another limitation experienced by many business owners is their susceptibility to manipulation. Financial topics often include the importance of having valid findings in terms of reviewing the financial capability of every investment.
For example, a manager can make use of the property calculation without considering additional opportunity cost and other expenditures such as maintenance costs, property taxes, sales fees, legal costs, and others. Therefore it is a must that in coming up with a business’s true ROI, all investments are accounted for.
Interpreting ROI Calculations
The ROI metric is exceptionally essential in measuring different business metrics, which all lead to understanding the profitability of your business.
So what makes a good ROI?
In order for ROI calculations to be accurate, it is imperative that you are also able to measure the total investment returns and total costs.
Thus, when the ROI calculations result in a positive percentage, therefore it can be considered a positive ROI – which means that the business is profitable. On the other hand, if the company has a negative ROI percentage, then it means that the cash flows within the business are much more going out than going in. In short, the company must have more debts than its earnings which generates more losses than profit.
It is important to take note that the basic ROI calculation can be used in different investments and facets of a company. In calculating ROI, even more, interpreting its results requires a deeper understanding of other factors that may be less apparent such as time, hidden costs, initial cost, and even emotional stress. All these things significantly impact your ROI.
For example, when your current investment is computer software, your expenses should go beyond the software itself. In calculating ROI, you may also consider the other cost of investment, such as training time, research, property taxes, maintenance costs, associated costs, and other hidden transaction fees, to calculate an accurate ROI figure. Check out the detailed guide about annual contract value.
Applications of ROI figure
Now that we have established that ROI measures your company’s growth and success. It is also a reliable investment metric that can help in determining your cash flow and the current value of a particular investment. Thus, it is safe to say that ROI calculation gives your business leverage in many advantages.
In fact, it is a no-brainer that your ROI calculation can not only set your investment cost to stone, but your average ROI can also determine whether your business is doing well in the industry. The different types of ROI can help businesses make strategic decisions resulting in greater ROI and a better investment.
Here are some of the different applications of Return on Investment:
New Product Investments
Purchasing new products and equipment for your business can mean a level up to your business, especially when done strategically. Calculating Return on Investment towards a new product purchase can help you properly gauge how much profit you can gain and how valuable this new purchase would be for your business.
Hiring Employees
Tracking your Return on Investment within your employees can help you better understand whether it is time to let go of some people or hire new ones. Explore how to do employee engagement.
Department Expansion
Just like hiring new employees, a business may have an increase in net profits once it adds a new team or a new department if needed. However, before deciding to move further to a particular investment, you have to calculate Return on Investment to ensure the profitability of your plan to expand.
Sales and Marketing Program
One of the most crucial investments that companies usually have is their sales and marketing programs. You would want to know when a particular sales strategy is effective and when they are not. This way, you can quickly adapt to the demands of the market and find new ways of putting your product or services out to the market.
Diversifying Products and Services
Before your business goes to further expansion, it is crucial to have your Return On Investment calculated. Diversifying your products makes ROI important as it can determine whether venturing out on other investments can bring your business extra financial value.
There are many ways to apply ROI calculations to your business. In many cases, any positive ROI can have both financial and non-financial benefits. So if you want your business to experience exponential growth, then you have to aim not just for higher profit but for higher ROI as well.
How does ROI improve Business Net Profit?
As mentioned over and over again, ROI is the central metric measured to track your business success in general.
With your ROI, you can ensure that venturing out on new investments is a smart move for your business and can help you compare it with your other investments and projected goals. Meeting your monthly target ROI can not just define your profit but also gauge your positive gains through time.
In fact, ROI has served its purpose in different business industries. For example, as published by Forbes, legal services have been shown to top the charts as per return on equity, a variety of ROI with 83.4 percent.
Another is that in 2020, a lot of tech companies have generated more than 10% of the average ROI threshold, while other businesses in the industry, such as energy companies, have incurred more losses than gains.
Therefore, it is crucial to understand that dealing with ROI and its results can change over time due to a number of factors such. as market competition, increase in technological support, and consumer purchasing behaviors.
Ways to Improve your Business ROI
As a business owner, you have to remember that your net profit may not be a full definition of your growth. Therefore, it is your Return on Investment that you have to focus on! As you have your ROI formula calculation going, you can now work on how to improve your ROI results further.
Here are some of the ways that you can increase your business’s ROI.
1. Do not be afraid to use analytics
Yes, there is a variety of analytics in the market which you can use to analyze your investment’s ROI. Therefore, when considering investing in software that your business can use, consider top-notch software with built-in and accurate reporting capabilities.
Many analytics today report website traffic, lead generation, email marketing performance, and customer engagement features, which are all highly useful depending on the industry your business is in.
2. Identify and understand your target market
As clichè as it may sound, knowing and understanding the needs of your target market can effectively boost your ROI. Investments that can deepen your knowledge of your target market or research topics that can help increase brand awareness will more likely result in higher ROI. Strategies such as market research and target campaign ads are just some of the investments that can lead to greater ROI calculations.
3. Be willing to try out and experiment
Of course, the road to achieving a great ROI involves a lot of twists and turns. So, do not be afraid of trying out new ways of working out a new investment that you believe is profitable for your business. You may also look into ways to measure your ROI in shorter terms to longer terms and test whether investment returns are worth it. Find the guide about the compound annual growth rate.
Benefits and Importance of ROI in businesses
ROI measures have been proven to be an excellent benchmark for shaping business strategies and decision-making. Let us look closer at the different benefits and importance of ROI in businesses.
Universality
Since many businesses use ROI as a metric to gauge financial performance, rest assured that it will be easily understood by everybody within the team, making it easier to grasp company performance.
Straightforward and easy to calculate
Calculating ROI is much easier than other metrics around. Investments can easily be tracked in a way that makes all the factors such as net profit quicker to pinpoint.
Budget efficiency
With understanding your ROI, all your investments can be guided. You can gain insights into different facets of your expenditures, most especially for small businesses. It helps you gain traction whether or not your initial investment and the rest of your investments make a significant impact on your business. This will help you reallocate your funds as needed.
Goal Planning
Once you start with understanding your ROI, you can immediately set realistic goals for your business. You can look at your business’s short-term and long-term goals while keeping your finances intact and business productivity rate high.
