ROI, or return on investment, is one metric you can use to calculate profits generated by your small business. When you know how to find ROI, you can see whether you're investing funds wisely in projects that make money.
In this comprehensive guide, I’ll explain the formula and show you some examples of ROI to explain why it's important for your small business.
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What Is Return on Investment (ROI)?
ROI shows how much money you earned from a specific investment based on its initial cost and its total net profit. You can measure ROI to see if a project was successful and determine whether to continue. ROI can look at the profitability of just one part of your business or examine the overall revenue your company creates.
Why Is ROI Important in Business?
ROI can illustrate the profit created by each of your business expenses. You can find the ROI of various projects, departments and investments so you can more effectively manage resources.
These are just a few examples of how you can use this calculation to benefit your small business:
- Deciding how much inventory to purchase
- Determining whether to open a new location
- Calculating the potential return from an investment in new equipment
- Pricing your products and services appropriately
- Seeing if a marketing campaign was effective
- Determining whether it makes financial sense to hire staff
- Lowering your expenses by switching to more affordable vendors
If you plan to seek funding for your small business, you'll need to prove its positive ROI to potential investors.
How to Calculate ROI
To calculate ROI, simply divide the amount of profit from an investment or project by its original cost. Let's look at a basic example to see how it works.
Imagine you started a lemonade stand with $100 in supplies and ingredients. Through this investment, you sold 100 glasses of lemonade at $2 each for a revenue of $200 and a profit of $100. When you divide $100 (profit) by $100 (original cost), you get an ROI of 1.You can also express this number as 100%.
You can also find the ROI of your entire company. For this calculation, divide the net profit of your business by its total net worth. For example, if you've generated $100,000 in profit from $10,000 in assets, your company's ROI is 10, or 1,000%.
What Is Considered a Good ROI?
What is a good ROI? That’s a tricky question to answer. The target ROI number varies significantly depending on the industry, size of your business, type of project or investment, and other factors.
In general, investors want to see ROI of 5% or higher before investing in a small business. That means if your company earns $250,000 in profits, it should have less than $50,000 in expenses to attract attention.
If you find the benchmark ROI for parts of your business, you can track this metric over time and make adjustments as needed. You can also use these hints to get an idea of the target return for your business:
The Pros and Cons of Using ROI
Benefits of Business ROI
ROI provides easy-to-understand information about profitability with one quick calculation. You only need a few basic numbers to get an idea of whether your investment will make money.
It's also one of the most flexible metrics for small business owners. You can find the revenue generated by the entire enterprise as well as the profit derived by each of its components.
Potential Drawbacks of ROI
ROI earns points for simplicity, but it doesn't account for factors that could affect profitability. Examples include:
- Your business objectives
- Interest, fees and other financing costs
- Maintenance and repair costs
- The time expense associated with an investment
- The cost of depreciation
- The longevity of an investment
More complex methods of calculating ROI do consider these complications, however. They can also predict the future return on an investment expected to benefit the business over several years, like a vehicle or piece of heavy equipment.
As mentioned above, it can also be difficult to determine whether a given ROI is "good" in a particular situation. You'll need some experience with this number to see how it rises and falls for your business. ROI can be a particular challenge if you want to determine the value of investments with qualitative returns, such as social media or marketing campaigns.
The Bottom Line
ROI offers a smart starting point to evaluate the profitability of your small business, especially if you're new to running your company's finances. However, when you use this metric to assess your operations, it's important to understand its limitations. For best results, combine ROI with other measurements to get a more accurate picture of your business's financial health.
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