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.
TL;DR (Too Long; Didn't Read)
Return on investment, better known as ROI, is a key performance indicator (KPI) that's often used by businesses to determine profitability of a business venture.
What's the Purpose of Return on Investment?
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:
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.
How to Project ROI
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. 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.
Importance of ROI in Business 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.
The best purpose of return on investment, though, is to see how your business performs relative to industry norms. According to a recent Forbes article, legal services tops the charts in terms of return on equity, a variation of ROI, with an average ROE of 83.4 percent. Numerous medical industries round out the top 15 industries with a high average ROE, alongside accounting at 73.1 percent, real estate agents and brokers at 62.3 percent, automotive repair at 58.5 percent, restaurants at 55 percent, as well as other industry sectors.
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.
For example, you can look at the ROI of individual marketing campaigns in order to improve the overall marketing ROI. Which campaigns have the best ROI? Which struggle to produce results? If social media campaigns out-perform direct mail campaigns in terms of ROI but most of your budget goes to direct mail, then you should consider refocusing your efforts on social media. This seemingly small change can improve your overall ROI. After all, the purpose of return on investment measurements is to keep your budget and business growing efficiently.
Neil Kokemuller has been an active business, finance and education writer and content media website developer since 2007. He has been a college marketing professor since 2004. Kokemuller has additional professional experience in marketing, retail and small business. He holds a Master of Business Administration from Iowa State University.