Return on investment (ROI) compares the costs of an investment to the revenue generated from that investment. Often, small business owners will forecast their expected ROI before making a business decision, such as a technology or equipment purchase. Marketers also use ROI to determine if a technique or campaign earns more revenue than it costs.
Although the ROI formula is simple, some expenses are harder to define, and you may need to measure additional metrics to get a complete picture. However, ROI is an invaluable metric for understanding investment profitability. Learn how to use the ROI calculation to improve your financial decisions.
What is ROI in business terms?
ROI, or return on investment, is a profitability metric that calculates how much profit or loss an investment generates compared to its costs. Small business owners use the ROI formula to measure investment profitability of different strategies, from social media marketing campaigns to equipment or software purchases. For example, if you spend $500 on advertising and generate $2,000 in sales, your investment return is 300%, meaning you earn $3 for every dollar spent on ads.
Standard ROI formula for small business owners
The ROI formula requires two initial calculations: net profit from investment and investment cost. The investment's net profit is the revenue or earnings gained from the investment, like new sales from email marketing or increased revenue from an equipment purchase. Investment cost includes any money spent on the project.
The standard ROI formula is:
ROI = (net profit - investment cost) / investment cost × 100.
[Read more: 8 AI Tools to Improve Financial Planning for Your Business]
Use ROI to see if upgrading equipment can increase your capacity, profit margins, or competitiveness or if your latest social media campaign generates enough leads to cover your marketing expenses.
Alternative ROI formulas and small business use cases
An alternative ROI calculation could provide better insights depending on your measure and how detailed you need to be. Consider using different ROI formulas to compare investments or add maintenance and labor expenses to your total costs.
Net return-based ROI formula
Unlike the standard ROI calculation that evaluates raw profit versus investment cost, this performance measure considers operating expenses, including labor, materials, and maintenance.
- ROI formula: ROI = net return on investment / cost of investment × 100.
- Best for: Small business owners who need a detailed profitability metric that accounts for all expenses.
Final vs. initial investment value calculation
The basic ROI formula measures immediate profit, whereas this version evaluates an asset's value change over time. Small businesses can calculate their return when buying commercial properties or vehicles and selling them later.
- ROI formula: ROI = (final value of investment - initial value of investment) / cost of investment × 100.
- Best for: Companies making long-term real estate, stock, or business acquisition investments.
Net income ROI formula
This profitability metric focuses on net income instead of net profit. It answers the question: Did this course or business coach increase long-term earnings?
- ROI formula: ROI = net income / cost of investment × 100.
- Best for: Service-based businesses and freelancers that invest in business coaching or courses to improve their earning potential.
Investment gain vs. investment base equation
For a quick performance comparison between different investments, use this ROI calculation. It doesn't break down costs and profits, making it faster to compute than other versions.
- ROI formula: ROI = investment gain / investment base.
- Best for: Small businesses wanting quick insights when comparing marketing or advertising channels.
Simplified ROI calculation (gains vs. costs)
The gains vs. costs calculation works when you need a rough estimate or don't have detailed financial information handy.
- ROI formula: ROI = (gains - costs) / costs × 100.
- Best for: Small business owners who need a fast, rough estimate of ROI.
[Read more: How to Calculate Cost of Equity for a Small Business]
How to determine a 'good ROI' for small businesses
The bottom line is that anything above 100% means you're doubling your money. However, you should look at several aspects to ensure profitability.
Consider these factors when evaluating your ROI:
- Industry benchmarks: Research ROI expectations in specific sectors, or compare your ROI to similarly sized companies or past investments.
- Short-term vs. long-term: Decide whether you need to boost cash flow with a high ROI with fast returns or a slower but scalable long-term ROI.
- Business costs and profit margins: A good ROI should be higher than your costs and profit margins when factoring in all hidden expenses, like labor and maintenance.
- Risk vs. reward: Risk-tolerance levels can define what a good ROI means to you. If you're strapped for cash, a lower ROI but steady returns could be better than risking huge losses.
- Other financial metrics: Use multiple performance metrics to get a complete picture. For example, track customer lifetime value if you rely on recurring revenue or use an annualized ROI formula for investments that take years to pay off.
When to use the ROI metric
The ROI metric can quickly estimate many business decisions and help sell your idea to stakeholders or leaders. For example, suppose you want to add generative artificial intelligence to your tech stack. In that case, Gartner suggests using ROI to "rank and prioritize GenAI quick wins by potential impact, cost, and complexity."
You can compute the return for your business or focus on specific activities or departments. Use ROI to see if upgrading equipment can increase your capacity, profit margins, or competitiveness or if your latest social media campaign generates enough leads to cover your marketing expenses. You can even estimate how much money installing energy-efficient windows in your office saves you.
How to use ROI effectively for business decisions
Small businesses can use ROI as a decision-making tool before spending, after investing, and for financial planning.
Here's how you can use ROI for business decisions:
- Focus on profitable investments. Increase cash flow by prioritizing higher-ROI strategies first and adding long-term growth projects later.
- Set ROI benchmarks. Measure progress and adjust your approach if your return is lower than expected.
- Track ROI over time. Regular tracking can reveal financial health trends and long-term value. Analyze ROI to see if your investment pays off and to estimate future returns.
- Measure growth strategies. Use ROI calculations to compare expansion options and decide if you should add e-commerce or open a new location.
Constraints of using ROI for analysis
Although ROI benefits businesses, it doesn't give a complete picture, nor is it as precise as other metrics. First, ROI doesn't specify a time frame. Therefore, your ROI for 30 days can be significantly different from an annualized figure.
Secondly, your pre-investment ROI will be less accurate if you don't fully understand your future business expenses. Newer companies with more variables may have trouble calculating their ROI.
And most importantly, ROI estimates your project's financial success but doesn't account for other factors, such as employee satisfaction rates. There are certainly cases where your ROI may be low or nonexistent, but the venture still has value. Completing a cost-benefit analysis allows you to factor intangible benefits and costs into your investment decision.
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