Businesses must spend money to stay successful. Whether it’s to replenish inventory, replace outdated equipment, or just pay their employees, cash keeps the gears turning.
But businesses need to spend deliberately – just throwing money at a new venture is not guaranteed to produce results. Businesses must know how to calculate return on investment to help them decide how to spend their money wisely.
Because cash supply is finite, every business investment decision has an opportunity cost. In other words, once money is invested, those funds cannot be invested elsewhere. Therefore, choosing the investments with the highest potential returns can be the difference between a stagnant year and one with record success. Once an investment has been made, analyzing the results is a crucial step for a business trying to decipher what went wrong and what went right. Calculating the historical and expected returns on investments can give managers and decision makers important insight into where to invest next.
What Is Return on Investment (ROI) and Why Is It Important?
Return on investment is a ratio used to show profits generated from an initial investment, typically shown as a percentage. The higher the profit generated relative to the size of the investment, the higher the ROI.
Many businesses will calculate ROI at multiple points throughout the life of an investment. It's first calculated as a projection before the investment is made, so a business can set expectations and create benchmarks it hopes to reach throughout the project.
After the investment has yielded a return, businesses will once again calculate ROI. This helps a business answer 'hindsight' questions, like “What did we miss in our initial projections?” and “How can our next investment be more accurately forecast?”
For long-term investments, ROI may be calculated at certain milestones, such as annual calculations done over the life of manufacturing equipment.
All these calculations help paint a more detailed picture of the profits generated from investments. This data can be used as comparison points for results or to inform future returns. For example, if the last two warehouse equipment upgrades generated an ROI of 40%, a business can use that as a baseline to compare future upgrades or to forecast expected profits from future equipment investments.
How to Calculate Return on Investment
ROI uses a simple formula:
Return on investment = Net Profit Returned X 100
Cost of Investment
To demonstrate, let’s look at a sample calculation, based on a hypothetical equipment investment. If a business invests $30,000 in manufacturing equipment that generates $45,000 in returns, the net profit for the investment is $15,000 ($45,000-$30,0000).
The return on this investment is calculated like this:
ROI = Net Profit Returned X 100 = $15,000 x 100 = 50% ROI
Cost of Investment $30,000
A 50% ROI means that for every dollar invested, $.50 of profit is generated.
There are more factors involved in generating profit than just initial investments – such as changing market trends and customer preferences – but managers can use ROI as a baseline for forecasting future returns.
For example, if this same business planned to invest $40,000 in similarly performing equipment next year, it would expect another 50% ROI (a $20,000 net profit) from that investment.
What Is a Good ROI?
There is no universally accepted good ROI. ROI is only considered good when compared with other investment options, competitors’ results, or other comparable benchmarks. Many businesses use past projects’ ROI to compare investment options and determine which one has the highest profit potential to try to replicate.
For example, if a company has to choose between upgrading two pieces of equipment and one expects a 15% higher ROI than the other, it would likely choose to upgrade the equipment with the higher profit potential.
Return on investment is a simple, useful calculation for businesses analyzing the success of past and future investments.
The quality of an investment’s return can also be helpful when exploring external financing options and considering the cost of capital. A business wouldn't want to be stuck paying more for interest on an equipment loan than what the equipment is generating in profits. Similarly, if that equipment yields a small ROI, it may have been more profitable to have invested the cash somewhere else or left the money in a high-yield savings account instead.
For example, if a new warehouse is only generating an ROI of 4% and was purchased through a loan with 3.5% interest, the initial investment may have been able to generate more profit somewhere else. But if the warehouse is generating an ROI of 15%, it may be worth those financing costs.
By studying ROI, businesses can be more confident in their investments – or know when to try a new strategy.
Positive vs. Negative ROI
Theoretically, any positive ROI can be classified as “good,” as it means the investment is making more money than it is costing.
However, every company has a hurdle rate – its own minimum benchmark on what minimum ROIs are worth pursuing. If an asset is only generating $.01 for every dollar put into it, it is technically creating a profit and showing a positive ROI, but might not be the best use of that dollar.
If ROI drops turns negative, it means the investment is costing more than it's generating. When an investment incurs a loss, analysts can check for inefficiencies to turn the investment positive or reconsider the investment altogether. Some assets might be outdated or a poor fit for a business’s operation – and may turn a higher profit being sold off rather than remaining in operation.
What ROI Doesn’t Show
ROI does not include all the necessary detail required to fully understand an investment. Business leaders also should consider:
- Cost: It’s important to understand what goes into the cost of an investment. This may include costs needed for the investment to be profitable, like labor and raw materials. For example, if a business buys a piece of equipment in their warehouse for $40,000 and it generates $40,000 in profit, analysts may consider that an ROI of 100%. But that may ignore additional costs, like taxes, installation fees, and more.
- Time: The simple ROI formula does not include time, so an investment that takes several years to start showing returns may have a “bad” ROI during the beginning stages. For example, it may take time for a new product line to grow a customer base: it may show short-term negative ROI before later becoming a best seller. The simple ROI also does not show the time value of money. A short-term return may be more valuable than future earnings, as that short-term gain can be reinvested to start earning returning profits of its own.
- Other benefits: ROI only measures profit and ignores more qualitative benefits a business may value. For example, investing in better employee training measures may not show high returns in immediate dollar value, but it can create higher levels of employee retention – raising productivity and saving money in the long run.
Return on investment is a simple, useful calculation for businesses analyzing the success of past and future investments. Decision makers can use past performance data and metrics to estimate returns for future investments and make sure they’re making the wisest – and most profitable – investments possible. While there’s not one perfect ROI measure to shoot for, higher returns expand net profits and help businesses grow. But ROI doesn’t show everything an investment contributes to a business and is just one point – albeit a crucial one – when mapping out how your business will spend its money in the future.
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