The return on investment ratio lets you know how much return you receive for the money you invest. If you are starting a business or looking to grow your existing company, lenders want to know how much money they will receive in return for lending you money. The same logic applies to investing in your small business – you want a positive return on the amount of money you invest in marketing, equipment, expansion, and new products or services, to name just a few. Of course, not all projects and initiatives will generate a positive return on investment (ROI), but it is essential to stay on top of how everything is performing. This Union Commercial Capital blog post is your return on investment guide.
What is ROI?
Return on investment (ROI) is a metric used to understand profitability of an investment. When you put your money into an investment or business endeavor, ROI helps you understand how much profit or loss your investment has earned. ROI is the gold standard for evaluating and understanding how profitable investments are for small businesses.
Putting ROI to Use
You can evaluate the ROI for just about every type of small business expenditure. Some will be easier than others, such as advertising or new equipment, while others will be more difficult. For example, an employee onboarding program can benefit a business, but there is a lack of reliable methods for calculating their return.
After you calculate the ROI for your investments, you will be able to compare the results and get a great view of what worked and what didn’t. One important thing to remember is that your results will only be accurate if you have correct accounting records. So, make sure your list of expenses and sales results are updated regularly so that nothing slips through the cracks.
How to Calculate Return on Investment
To Calculate return on investment, divide the amount you earned from an investment by the cost of the investment and multiply that by 100. The result should be represented as a percentage. Here are 2 ways to represent this formula:
ROI = (Net Profit / Cost of Investment) x 100 ROI = (Present Value - Cost of Investment / Cost of Investment) x 100
For example, Tony owns a pizzeria on the southside of Chicago. He notices business is slow and starts to brainstorm ways he can improve his business. Assuming that the quality of his pizza may not be meeting customer expectations, Tony decides to swap out his outdated pizza oven for a new replacement.
The new pizza oven costs $500. By the end of the year, his pizzeria ends up earning $2,000 more than it had the year before. Given that the new pizza oven was the only investment made by Tony during the year, the return on investment for that year can be calculated as:
ROI = ($2,000 / $500) x 100 = 400%
This means that each dollar Tony spent on the new pizza oven generated $4 in net profit. Because Tony's new oven will continue to generate increased sales over time, his ROI will grow as time passes.
Timing
If you boost your marketing budget, finance a piece of business equipment, launch a new product or service, or buy new software, the time frame for which you calculate your ROI is very important. For example, you might see a higher return in the first few months, which may decrease down the road. Because of this, it is a good idea to monitor the financial returns of your investments on a weekly, monthly, and quarterly basis throughout the year.
Next, timing will play an essential role in your reporting if you have an investment that will take several months or years to complete. The ROI will not be accurate until the investment is finalized and deployed in these instances.
The Bottom Line
ROI is an excellent means of calculating the financial success of any business investment you make. Just remember that ROI reveals your net financial gains and does not include intangible benefits such as brand-building and gaining an advantage over the competition. Additionally, it does not account for the risk and uncertainty associated with business investments.
The more practice you have with thinking about your ROI, the more refined your decision making will become. ROI is only a single performance metric, but it's one of the most essential tools for business owners looking to get the most out of their investments.
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