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What Is Return on Investment (ROI)?

By:
Money Staff
10 min read

Return on Investment

Definition

Return on investment is a metric that measures the amount of profitability earned on a particular investment by comparing its costs to its returns.

Also known as:ROI, return on costs
First Seen:1914

Return on investment is a metric that measures the amount of profitability earned on a particular investment by comparing its costs to its returns.

The uses of return on investment

The purpose of any business is to earn a profit, also known as a return. You can calculate any business expense in terms of ROI, but investors and businesses use it differently. Investors use the ROI of various investments to gain insight into ventures and influence future decisions. For instance, if you invested in two ventures, the one with the higher ROI would likely encourage you to invest more.

Investors calculate ROI before they commit capital to help them determine a particular venture's value and how much money they can expect to make. A consistently positive ROI indicates a profitable venture and is a green flag.

Businesses use ROI to measure the success of a particular project. While some projects may not have a direct financial ROI, they contribute to an overarching investment. For example, buying an office microwave may encourage more employees to bring food from home, reducing the time they spend in the cafeteria.

While this may not directly affect sales, it can make employees happier and more satisfied. When a business owner invests money in a particular project like advertising, they will analyze the sales generated compared to the money spent to determine whether it's worthwhile.
Companies also use ROI to determine their business status. If they have a consistently positive ROI, their profits have exceeded the costs incurred, indicating a healthy business. A negative ROI indicates the company is experiencing losses and may need to reevaluate its strategy.

What constitutes a good ROI?

There is no universal standard for a business's success. A double-digit ROI, such as 10%, is a good marker, though this may vary among industries. In 2021, tech and other industries generated annual returns above 10%, while others, such as utility companies, generated smaller returns, even losses in some cases.

Qualifying an ROI as “good” depends on factors such as risk tolerance and the time the business takes to yield returns. Investments that take longer to pay off will require a higher ROI to be attractive to investors.

To assess an ROI, it’s essential to consider the following:

How to calculate ROI

The ROI formula is simple and easy to use. It only requires two figures: the benefits and costs. You calculate ROI by dividing the amount you earned from the investment (also known as net profit) by the cost of the investment and multiplying the result by 100. You can get the net profit by subtracting the cost of the investment from the present value:

ROI (%) = (present value – cost of investment) / cost of investment x 100
For example, if you invested $5,000 in a company and then sold the same shares for $6,000, you could calculate your ROI as follows:

ROI = ($6,000 – $5,000) / $5,000 x 100

This company’s ROI would be a net gain of 20%, or a ratio of $2 gain for every $10 spent.

Sometimes, however, an investment can yield a negative ROI, which indicates that the initial investment cost is higher than the profit earned. This is common in volatile markets or when a disaster happens after investing. Poor business management and performance can also lead to a negative ROI. When this happens, you should reevaluate your actions and find out where you’re losing money to avoid further losses. Strategies to improve might be more effective management or more research on investing decisions.

Using ROI in business

Since ROI can be used in most aspects of running a business, it’s worth looking at the importance of assessing ROI from a business perspective and the times when it can be used.

The importance of ROI

Determining ROI can help businesses see the benefits of investments, or the lack thereof. In short, ROI acts as a benchmark to shape future strategies. For example, it lets businesses know which marketing strategies are working, and which should be improved or abandoned altogether.
If a business doesn’t see returns from a particular endeavor, it would be unwise to continue throwing money at it. Spending money on a lost cause is the surest way to go bankrupt. The smart move would be to cancel that investment and invest in one with a higher ROI.

How to use ROI in decision-making

Since employees are critical to the success of a business, ROI is essential to consider during the hiring and firing process, where the decision may be based on the profit the employee brings into the business. When hiring an employee, businesses must first consider the benefits the employee will bring to the company. If the value the employee brings to the company is less than the cost of employing them, resulting in a negative ROI, you may consider terminating their employment or seek corrective action.

However, employees are only as capable as the tools they have available. Buying new equipment and software for a business can be a positive addition, but businesses must make wise purchase decisions. It’s essential to calculate the ROI of existing tools to get an idea of what equipment to add and the benefits those additional tools will bring to a business.
Improving organizational structure can also bring about efficiency. Adding a new department to a business requires leaders to determine how profitable that department will be. It’s best to determine the ROI of different departments, check their profitability and decide if there is room for expansion.

Additionally, ROI can help businesses compare asset utilization and the profitability of different departments with other companies in the market. Further, since ROI depends on a company’s financial accounting, there’s no need for a separate accounting measurement to generate data for ROI. Financial statements already contain all the information required.

Limitations of ROI

Though an essential tool for investors and businesses, the ROI formula has some limitations that are important to consider.

Limitations for investors

Return on investment does not factor in time. Having a better ROI isn't always an indication that it’s a better venture. For instance, two investments can generate the same ROI of 50%, but one investment may achieve this in two years, while the other might need five years to yield the same gains. Investors might fall for the more extended option when the time aspect is blurred. For this reason, you should compare two ventures under the same period and the same circumstances.

Second, ROI doesn’t give an investor any information about potential risks. You might invest in a highly volatile venture to get a high ROI and lose all your money before making a profit. A good example is investing in cryptocurrency. The estimated ROI can be attractive at first, but since the market is highly volatile and influenced by factors such as supply and demand, media hype and government regulations, there is no guarantee you will get a positive return. You are just as likely to lose everything as you are to gain.

Limitations for businesses

For businesses, there are other variables to consider, such as financial health. Since ROI doesn’t directly reflect a company’s cash flow, it may fail to measure financial health with complete accuracy. An accurate ROI should factor in the costs of taxes, maintenance, transactions and other ancillary expenditures, not merely the initial cost of the investment.

Summary of Money's guide to ROI