Before taking the leap into a new business investment, you want to know how likely you are to see returns. Will you get back what you give? Return on investment, or ROI, gives a quantifiable figure showing you the likely benefit of an investment. Here’s how it works.
What is return on investment (ROI)?
Return on investment (ROI) measures how effective your investment will be at generating returns. It’s important for any investor to set out with a goal or baseline figure of expected returns. One way to assess this measure is with the ROI. The ROI meaning applies to any type of investment, whether it’s hiring a new assistant or purchasing manufacturing equipment. By calculating ROI, you can determine whether the money you’ve spent on these resources has paid off.
Calculating the ROI of different investments also offers a way to determine which business decisions are working, and which are a waste of time and money.
How to calculate ROI
Learning how to calculate ROI is simple, as this measurement takes an investment’s return and divides it by the investment’s cost. The result can be expressed as a ratio or percentage.
Here is the ROI formula:
ROI = Return / Cost
As an example of calculating ROI, imagine that you spent $200 on a new investment which has earned a profit of $400. You can plug these figures into the ROI formula:
400 / 200 = 2
Expressed as a ratio, the ROI is 2:1 or 2. As a percentage, the ROI could be expressed as 200%.
How does ROI work?
Now that you understand the ROI meaning and how it’s calculated, we’ll take a look at when to use this metric. Return on investment is popular in business due to its simplicity. It’s also easy to apply to a number of different situations, be they stock investments or hiring personnel for your business. The metric simply boils down to whether your ROI is positive or negative. The higher the percentage or ratio, the more worthwhile the investment is likely to be for your business.
You can also use ROI as a comparison tool. If you’re weighing more than one investment and there’s an option with a significantly higher ROI than the others, it’s worth a second look. In addition to money, remember that investments also require time. You should factor these into the equation to really analyze the best options.
What is a good ROI?
There’s no single answer for what constitutes a good ROI. Generally, businesses want to break even with investments at a minimum, and anything above this is a positive gain. You can set your own goals regarding returns. With investment, higher risk tends to generate higher returns, so your goal will depend on how risk-averse you are as well as how much time you have on your hands.
Limitations of ROI
What’s important to keep in mind is that these calculations are often overly simplistic. While they provide a snapshot of profits earned, ROI doesn’t factor in variables like the time value of money. Some investments take longer to generate profit, while others will see quick returns.
Another limitation to consider is the fact that returns are often due to a variety of factors, rather than simply the initial cost of the investment. There may be multiple investments involved with the launch of a new product, for example. You’d not only need to think about the money you spent on raw materials, but also on machinery, advertising, and sales. All of these would contribute to earnings.
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