The primary reason people invest in a business is to make money. Return on investment is a measurement of efficiency in converting your business investment into profit. Therefore, it is vital to projecting whether a business venture is worthwhile and what adjustments to make once a company is active.
While there are a few alternatives to calculating ROI for businesses, a common approach is dividing profit in a given period by either total assets or invested capital. Total assets are normally recognized on a company's balance sheet. They include buildings, equipment, appliances, tools, inventory and supplies. If a business generates after-tax profit of $500,000 in a particular year, and total assets equal $1 million, the ROI is $500,000 divided by $1 million. Thus, ROI is 0.5, or 50 percent.
Small businesses have limited resources. One of the best ways to project the wisdom in a potential business expansion or product development is to assess the projected ROI, according to Inc. magazine. In some cases, a new investment takes a while to gain momentum, and a negative ROI is possible during the first year. One thing to figure out when projecting ROI is whether the estimated return is satisfactory. You may not find a 5 percent return worth the risk of failure, for instance. Also, comparing the estimated ROI for two projects is helpful in selecting the right opportunity.
Evaluating ROI Performance
Your ROI performance also takes center stage as you progress with your business. In general, you monitor ROI to compare it against projections and goals, to monitor profitability trends and to compare your results with those of competitors. Meeting or exceeding your ROI objectives and seeing steady gains over time are positive signals. One of the best ways to use ROI, though, is to see how your business performs relative to industry norms. According to a December 2013 Forbes article, the average return on equity, a variation of ROI, was 39.10 percent among private companies in the previous 12 months. Industry variance was significant, though, with legal services at 80.5 percent, employment services at 66.1 percent and personal care services at 63.8 percent.
The importance of ROI rests largely in your reaction to it. In some cases, business leaders make the tough decision to scrap a poor-producing business venture or unit. Retail chains, for instance, close negative ROI or low-performing stores to focus investments on high-profit stores. Alternatively, you can make adjustments when ROI is positive but not where you want it. Identifying new revenue streams, adding new products and cutting costs are strategic options for improving profit performance, and therefore, ROI.