The Return on Investment Ratio (ROI) measures the profitability of an investment by comparing the Net Profit (or Loss) to the investment cost, expressed as a percentage, helping decision-makers make informed decisions about resource allocation.
Primary Implication
The only way your money works harder for you than you do for it is to generate returns on your use of cash. Every dollar you spend in your business ahead of earning a sale is an investment in the business.
Generate more sales than you spend, and you earn a profit. The higher your profits, the higher your returns from the money you spent. This is what calculating your Return on Investment Ratio does for you. It helps you know if the returns on your investment are making you money or not.
Overview
The Return on Investment Ratio (ROI) is a Profitability Ratio that reflects how much money is made based on invested money. ROI is an easy-to-calculate ratio dividing the Net Profit (or Loss) from an investment by the cost of the investment. Since it is expressed as a percentage, you can compare the profitability of different investment choices regardless of their investment size by their potential to return more profit than is spent.
ROI is frequently used to determine the ending profitability of an expenditure. To perform the ROI calculation, you need to know two total values. The first is the ending Amount Gained or projected to be gained from an investment. The second involves the cost of the investment reflecting the total costs incurred or to be incurred to generate the gain representing the Amount Spent. For example, if $20,000 is planned to be spent on advertising that is expected to generate additional sales of $30,000 your sales ROI is 0.5 ((30,000 – 20,000) / 20,000 = 0.5 or 50%).
The formula for Sales Return on Investment is as follows:
((Amount Gained – Amount Spent) / Amount Spent) x 100
If you calculated the profit ROI on the $20,000 spent to generate $30,000 in sales, you would convert the sales into profits. Assuming a Net Income target of 10% the profit generated would be $3,000 (30,000 x 0.10 = 3,000) divided by the investment cost of $20,000 represents a 15% ROI (3,000 / 20,000 = .15 or 15%)
The formula for Return on Investment is as follows:
Net Income from the Investment / Total Investment Cost
Knowing a Sales ROI is nice, yet it isn’t as important as knowing the Profit ROI. It does you no good if you generate higher sales for less money. Put another way, it is never good to trade one dollar for four quarters or less. Calculating Profit ROI helps a business owner make better business decisions. The number one reason it helps is that it forces the owner to determine how much they expect to earn and what it will cost them to generate that return.
A ratio of 1 means that every invested dollar generated one dollar of sales. A 1.8 ROI means that every invested dollar earned $1.80 or 180% return to owners on their investment.
Higher is Better: indicates that the company is making wise investment decisions.
Lower is Worse: this means that the company isn’t generating sufficient returns on its investment.
An alternative method for determining the risk of an investment for a small business is to convert the cost of the investment into sales required to earn the investment back. Say an investment costs $100,000, and you want a 25% return on that investment. I.e., you have a goal of earning 25% in Net Income in your business. The sales value of that investment is $400,000 (100,000 / .25 = 400,000). This means you will need to generate $400,000 in sales to return your $100,000 investment. The core question is, how long will it take to generate the $400,000 in sales?
BusinessCPR™ Step 3 is about confirming the quality of your profits. Every investment you make in the business either generates more than it costs, or it doesn’t. Earning a return on every investment is the goal. The hard reality is that this is hard to do because most planned investments cost more than planned and almost always return less than expected. This is why it is advisable to calculate your projected ROI before undertaking a major investment. Then, calculate your actual ROI to see how well your reality matches what you expected. The best way to ensure your money is working harder for you than you do for it.
