Understanding return on investment

A solid understanding of ROI is integral to determining the profitability of your investments and making sound decisions that generate positive returns. To maximize your financial success, it’s important to understand the following key components:

• The basics: what is return on investment?
• How to calculate return on investment properly
• What to avoid when calculating return on investment
• The inherent flaw in ROI

What is return on investment (ROI)?

ROI is the simple measure of what you have gained from an investment in relation to what the investment has cost you. In addition to being used to evaluate the profitability of an investment, ROI is often used as a comparative tool between different investments to determine optimal strategy going forward.

How is return on investment calculated?

Here’s how to calculate return on investment quickly through the use of a formula:

ROI = [(Gain – Cost) / Cost] x 100

For more context, consider this scenario:

Let’s say you invested $2,000. Two years go by and you decide to sell your shares for what they’re now worth: $3,200. To determine your ROI, follow these four steps:

1. Take the total gain from your investment: $3,200
2. Subtract all costs associated with your investment (your initial investment amount): $3,200 – $2,000 = $1,200
3. Divide that number (your net gain) by the total cost of your investment: $1,200 / $2,000 = 6
4. Multiply that number by 100 to make it a percentage: 6 x 100= 60%

Your investment yielded an ROI of 60%. Good work!

How to utilize the four main types of ROI

Perhaps the most appealing aspect of ROI is its versatility. The above example outlined a simple investment to familiarize you with the concept. When utilized more comprehensively in a business context, there are four main types of ROI:

Operational – This figure helps you gain an overall understanding of your business’s performance, allowing you to see where your profits are being made as well as the areas that aren’t as effective. Follow the basic formula tailored to the area in question to calculate operational ROI:

ROI = [(Gain – Cost) / Cost] x 100

Technical – This figure helps you understand how the costs of any new equipment or technologies employed by your business compare to the benefits or savings they deliver, allowing you to determine if those costs make financial sense to maintain. Follow this formula to calculate technical ROI:

TROI = [(Total Savings – Technical Costs) / Technical Costs] x 100

Marketing – What is ROI in marketing? It’s a measure to help you better understand how your business’s marketing is going, allowing you to make informed decisions on how much capital you should devote to marketing going forward. Follow this formula to calculate marketing ROI:

MROI = [(Growth in Sales – Marketing Costs) / Marketing Costs] x 100

Competitive – If you want to know if your competitor is doing something you should be doing, you can use competitive ROI. Compare your ROI figures to those of your competition as a strategic measure to help discover if there’s something missing in your business.

Mistakes to avoid when calculating ROI

When calculating ROI, it’s crucial that the right numbers are used. ROI will reveal different outcomes using different types of data. To experience any degree of accuracy, you have to consider where your business wants to see growth and utilize all relevant numbers from that area. Although it’s tempting to celebrate a positive ROI by any means, you have to be both realistic and strategic if you want to make the best decisions for your business.

Consider all associated costs

For example, in marketing, if you’re considering the usefulness of your company’s latest campaign, the growth of sales metric is certainly relevant. However, without also factoring in all aspects of the marketing costs associated with that campaign, you aren’t accurately representing the investment or its return.

Similarly, consider the investment example we used where we invested $2,000 and after two years, the investment grew to $3,200. Say it was actually an investment in a bicycle shop and during the shop’s first few months in business, you spent your weekends helping out for free. To produce an accurate picture of your ROI, you would have to quantify that time and include it into the costs associated with your investment, yielding a lower, but more realistic ROI than previously calculated.

Compare like terms

One of the most common mistakes companies make when using ROI calculations is comparing unlike figures.

Your investment is always defined in terms of cash. However, the measurable returns on your income statement are often expressed as profit or revenue—figures not necessarily indicative of actual cash flow.

One way to avoid this mistake is using your company’s cash flow statement. Since the cash flow statement reflects the actual amount of cash entering and leaving the company, it will provide a more realistic view of your ROI in a given area.

Keep in mind that the most important thing to consider when calculating ROI is your unique set of business goals. From that starting point, you can most effectively evaluate your progress using the relevant data.

The flaw in ROI

As we’ve discussed previously, while ROI is ubiquitous with understanding business value, the flaw in calculating return is that we are not taking into consideration business risk and the potential cost of not moving forward with investments. As Ed Kless states, “there are situations where not investing in something will have a significant deleterious effect on the business.”

Running a business is hard work, and learning the jargon can make it easier for you to get through your daily operations. The Sage Advice glossary can help with some “must-know” business terms.