Return on Investment Explained for Small Business Owners

This FindLaw article helps entrepreneurs understand why return on investment (ROI) matters in a business investment. It will also show how to calculate the rate of return.

Return on Investment Basics

To attract capital, startups need to understand what an ROI is and why it matters to investors, lenders, and new business members. Below are important aspects of ROI:

• ROI is a ratio that measures the profitability of a potential investment

• ROI is a useful tool often used to compare the profitability of different investments

• The higher an ROI score is, the more likely it is to indicate a significant gain

• There are several ways of calculating ROI, but the most common method is a percentage calculated based on the investment’s net value divided by the initial investment

• ROI does not account for the period of time a small business keeps the investment before repayment or return, nor does it consider the time value of money when comparing long-term vs. short-term investments

The money you spend on your business should bring you a profit. If it does not, reexamine your business decisions and analyze operating expenses compared to your product or service prices.

Documents Needed To Understand Return on Investment

ROI is a popular metric for assessing an investment’s ability to generate income or its rate of return. The information needed to calculate includes:

• Advertising costs

• Annual returns (tax returns)

• Balance sheets

• Business start-up costs

• Cash flow

• Expenditures

• The initial investment amount, also known as the cost of the investment

• Interest rates, if any, for the investment

• Marketing campaign costs, including targeted or paid advertising on social media

• Net income

• Net profit

• Profit and loss statement

ROI is a ratio often expressed as a percentage. Investors commonly compare different investment alternatives to gauge the net worth of their investment. The ROI helps them to understand whether a current investment is an efficient use of their resources.

Investors use ROI because the calculation is simple and it’s often a good indicator of a business’s viability.

ROI Formula

The most common ROI formula is net return divided by cost of investment. The net return is the current value minus the cost of investment. This is expressed in the following equation:

(Current Value – Cost of Investment)/Cost of Investment x 100

This formula divides the increase in the investment’s value by its initial cost. The ratio is then expressed as a percentage.

For example, if an investment in a stock valued at $300 was initially purchased for $200, the ROI would be 0.5 or 50%.

That ROI calculation would look like this:

Current value = $300

Cost of investment = $200

($300-$200)/$200 x100 = 50%

This is an example of a good ROI.

A negative ROI is when an investor loses money on their investment. A negative ROI would look like this:

Current value = $300

Cost of investment = $400

($300-$400)/$400 x 100 = -25%

It goes without saying that a good ROI is preferable to a bad ROI.

ROI Limitations

Most critics of using ROI as a performance measure note that it fails to consider the time value of money (TVM). TVM is the concept that the money you hold today is worth more than that same amount at a future date. The reasoning is that you could earn additional funds by investing in the meantime.

An example of how ROI fails to take TVM into account would be comparing a one-year investment with a five-year investment that both had a 25% ROI. While you would earn the same profit from either investment, the one-year investment allows you to roll the 25% ROI over into additional investments. That’s not possible with the five-year investment, which ties the funds up for a much longer time.

The annualized ROI formula factors time into its calculation.

(Ending Value/Beginning Value) ^ (1 ÷ Number of Years Of Investment) – 1

Additionally, ROI fails to consider an investment’s degree of risk. A safe investment with a low ROI is preferable to a risky investment with a higher ROI. However, depending on your risk tolerance, it might be worth the risk if the potential ROI is high enough.

What Is an Average ROI?

A good ROI or average ROI depends on the type of industry you invest in. For example, the average ROI in real estate investing is 4.8%, but the stock market is 12.8%. The higher the ROI is, the happier an investor will be.

Need Help Calculating ROI for Your Small Business?

Both a certified public accountant (CPA) and a business lawyer can help you figure out the ROI of a startup or existing business before you invest too much time or energy into it.