Definition:
For small businesses, Return on Investment (ROI) is a profitability ratio that evaluates the performance or return of a business project. The ROI equation considers the benefit received from the investment divided by the original cost of the investment at first glance.
How does the Return on Investment (ROI) work?
The Return on Investment (ROI) functions as a return ratio that is typically expressed as a percentage, allowing the business owner to calculate how efficiently the company utilizes its total asset base to generate sales. Total assets include all current assets such as cash, inventory, and accounts receivable, as well as fixed assets like factory buildings and equipment.
If the investment yields a good return, or if the investor or business owner has other available opportunities with higher returns, calculating the ROI on different opportunities can guide them regarding which investment to choose for the best return.
Many analysts and investors prefer to use the ROI metric due to its flexibility and simplicity. Essentially, it acts as a quick indicator of investment profitability, and it is very easy to calculate and interpret for a wide range of investment types.
Examples of Return on Investment (ROI)
Let’s assume Joe invested $1,000 in his startup “Joe’s Super Computer Repairs.” He has a buyer for the company valued at $1,200. The ROI in this case is Joe’s profit of $200 divided by his initial investment of $1,000, which equals 20%.
Joe also invested $1,000 in Sam’s new computer sales, and the buyer is looking to pay $1,800. The ROI in this case is the profit of $800 divided by the investment of $1,000, which equals 40%. From this comparison, it seems that selling new computers for Sam is the better option because the ROI is double what he will get from Joe’s Super Computer Repairs.
Instead of buying a company, let’s say you bought shares of a company: 100 shares at a price of $1 per share. Your initial investment was $100. Shortly after buying the shares, the CEO of the company is arrested for fraud. The stock price drops to $0.50 per share, and you sell all your shares. Your ROI is -50%: (50-100) / 100.
Interpreting Return on Investment (ROI) Results
To interpret the percentage of return on investment (ROI), appropriate comparative data such as trends (time series) or industry data on ROI should be gathered. A business owner can look at the company’s ROI over time and also at industry data to see where the company’s ROI stands.
Note: The higher the ROI percentage, the more efficient the company is at using its asset base to generate sales.
Return on Investment (ROI) and Time Factor
What the ROI equation does not tell you, and one of the weaknesses of the ROI ratio, is the time taken. This measure can be used alongside the return on assets or project return rate, which takes the time period into account.
You can also incorporate Net Present Value (NPV), which considers the differences in the value of money over time due to inflation, for more accurate ROI calculations. The application of NPV when calculating the rate of return is known as the real rate of return.
Frequently Asked Questions (FAQs) about Return on Investment (ROI)
How to calculate ROI?
The process of calculating ROI involves several details, but generally, you can get the ROI by dividing the amount of money you receive from the investment by the amount of money or assets you invested in it. Small businesses can use ROI to decide whether it is worth investing in a new software platform, for example.
What
What is Return on Investment (ROI) and why is it important?
Return on Investment (ROI) is a measure of the return you can get from an investment. Your investment can be in a business project or a security like a stock or a fund. It is an important metric because it can help you decide whether it is worth putting your money into a specific project that you wish to do for your business.
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Sources:
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts in our articles. Read our editorial process to learn more about how we verify facts and maintain the accuracy, reliability, and quality of our content.
University of Georgia. “Return on Investment (ROI)”, pages 1-2.
Crestmont Capital. “What is Return on Investment?”
Source: https://www.thebalancemoney.com/return-on-investment-ratio-393206
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