Ever heard of what ROI is? As a business owner, chances are you have already made an investment in your company. To determine whether your investment is worthwhile and efficient, you can calculate your return on investment or ROI. The more you understand ROI and how to calculate it, the better you will be able to make informed decisions about future investments.
In this article, we’ll define ROI, why it’s important, its limitations, and how to calculate it.
What is ROI?
Return on investment, or ROI, refers to the measurement of the financial benefits you get from investing. In other words, it is a way for businesses to determine investment efficiency.
Determining your company’s ROI is important when it comes to making important financial decisions. Depending on your ROI, you will be able to evaluate whether your investment is financially viable. If your company’s ROI is high or positive, it’s usually a worthy investment. If it’s low or negative, it’s usually a bad investment.
When calculating ROI, it is important to consider the limitations that arise. Not only does ROI not adjust for risk and potentially large losses, but you also have to consider the holding period of the investment.
For example, just because one investment has a high ROI and another has a low ROI, doesn’t mean one investment is better than another.
This is because ROI does not take into account the time period of each investment. It is possible that the timeframe for higher ROI is longer and the timeframe for lower ROI is much shorter. This can be misleading when calculating ROI.
Despite its limitations, ROI is relatively easy to understand and calculate. As a business owner, you want your calculations to yield a high ROI that reflects the maximum return based on the money you invest.
How to Calculate ROI?
There are several variations of the ROI formula, but they will all give the same result. Two of these formulas include the following:
ROI = investment profit / investment base
or
ROI = net income / investment costs
Using this formula, consider the following steps when calculating your ROI:
1. Determine the return on your investment
To begin your calculations, determine how much you earn on the investment you are measuring. For example, let’s say you own a $300,000 house. At the time of sale, it was $500,000. This means your return on investment is $200,000 because that’s how much the price of the house has gone up since you bought it.
2. Determine the investment cost
Next, you will need the amount of money you paid for an investment. Using the example above, since the house is worth $300,000, $300,000 is the investment cost.
3. Calculate ROI
Using the first ROI formula listed above, you can now calculate ROI. Do this by dividing the investment profit by the investment base.
In the house example, you would divide $200,000 by $300,000 to get an ROI of 0.667. Since ROI is usually expressed as a percentage, multiply this value by 100. This will give you a 66.7% ROI.
Keep in mind that good or bad ROI often depends on how it’s measured. Usually, you will want a high ROI which ensures that you make wise choices in investing your time, money and effort that will ultimately result in a profit for your business.
Example of ROI Calculation
Consider the following example when calculating ROI:
Example 1
Say you are working on a new advertising campaign for your department store. The advertising department spent 3,000,000 on various materials and generated 10,000,000 in revenue for the year.
To calculate ROI, you would divide your income (10,000,000) by the investment cost (3,000,000). This will result in an ROI of 3.33 or 33%.
Example 2
Let’s say you renovate your rented house and spend a total of 50,000,000 to update your kitchen and two bathrooms. Prior to your renovation, your rented house was worth 200,000,000. After the renovation, it’s worth 300,000,000.
Your investment gain in this example is 100,000,000. To calculate ROI, divide 100,000,000 (investment return) divided by 200,000,000 (investment base) to get an ROI of 0.5. To get a percentage, multiply this value by 100 to get a 50% ROI percentage.
ROI Type
In terms of ROI, there are three types of money you can make on your investment. They include the following:
- Interest: One way to earn on your investment is through interest. Savings accounts and bonds are two investments that will pay your company through interest.
- Capital gains: If you sell your investment for more than you paid for, this will result in a capital gain for your company.
- Dividends: Lastly, you can also get paid in the form of dividends. In this case, you will regularly receive a share of what the company produces.
Why is ROI Important?
ROI is important for several reasons. For starters, it can help you evaluate your investment and determine if it is worth the time, money and effort.
For example, if you are generating low ROI for a new marketing strategy that you have implemented, you may decide to discontinue it or approach the same strategy from a different angle to increase your ROI.
In the end, if this marketing strategy does not bring you additional income or profit, there is no point in continuing to apply it because you will continue to face financial losses. Overall, ROI helps you evaluate the efficiency of your investment.
