Do you want to invest, but you don’t know if it can be profitable or not? Do you need to understand if your past projects have positively impacted your company? Do you intend to buy software or a new machine but don’t know whether to take the risk? To understand the validity of an investment, it may be helpful to know the Return of Investment an essential metric for entrepreneurs, because it allows you to know the profits related to acquisitions, already made or potential.
ROI, or return on investment, has a very precise function: it makes you understand if an investment is valid or not. This universal metric is obtained by relating the costs to the investment and shows whether your investment is profitable or not.
The result is expressed in absolute terms or as a percentage so that you have a more generic parameter to evaluate your company’s performance and, above all, your strategies.
It is an extremely versatile metric and lends itself to various uses: it measures the impact of a marketing campaign, evaluates the profits generated by introducing a new machine, shows the performance of your choices over time, and makes you understand what they are revenue from sales. In short, knowing what ROI is and learning how to use it can radically change the fate of your business.
If you need to analyze your company’s situation immediately, click the button below and find out more about how I can help you. Otherwise, continue reading and evaluating the benefits of this budget indicator.
What is ROI?
ROI stands for Return On Investment and measures the profit obtained from an investment, net of costs. At the business level, knowing the return on investment helps you decide where to go and which investments can actually be profitable.
It is a significant indicator of marketing because it allows you to plan campaigns, optimize them and calculate their efficiency. Applied to marketing strategies, it also takes the name of Return on Marketing Investment (indicated with the acronym ROMI )
To understand what ROI means, we must start with the factors we use to calculate it: total capital invested and operating income (expected or to be realized). By making the relationship between these two data, we obtain the profits obtained by the company, or predicted, for a given investment.
ROI can refer to either a small investment in machinery, Information Technology, or marketing campaigns or to long-term investment, such as improving infrastructure, increasing staff, or starting a new business. . Therefore, it can be applied to individual company departments as a real KPI, or to the entire company strategy. In the first case, it is sufficient to have the data on the pre-purchase situation and evaluate the trend in subsequent times.
The ROI calculation can be helpful both to calculate the actual profits generated by investment and to obtain future projections on different perspectives to be examined.
All profitability indicators
ROI is one of the most used and known financial ratios, but it is certainly not the only one.
A good entrepreneur must also know the other profitability indicators to better evaluate investments in the previous phase and understand their performance better.
Here are the other profitability indicators, in addition to ROI:
- ROS: Return On Sales is used to calculate sales profitability or the earnings generated in relation to sales. It is calculated by dividing the result generated by sales by the sales revenue.
- ROE: considered one of the leading corporate balance sheet indicators, the Return On Equity is used to indicate the profitability of the invested capital. In this way, investors can evaluate the potential returns of an investment.
- ROD: The Return On Debt still concerns the return on capital but only calculates that refers to the capital lent.
- ROA: Return On Assets measures the company’s profitability considering the resources employed in an activity.
- ROGC: the Operating Income of the Typical Management represents the company’s profitability according to its management methods.
- EBITDA: The Gross Operating Margin or EBITDA is the ability of the capital to generate value, that is, to produce profits.
- EBIT: is defined as capital’s ability to produce wealth after taxes and interest; EBIT measures cash flows.
How ROI is calculated
Given the importance of the return on investment, you must know the ROI formula, that is: ROI = Operating result / Net invested capital.
So the ROI is nothing more than the relationship between the results obtained, the profits generated and the company capital invested in a specific project.
Although it may seem a very simple operation at first glance, in calculating the ROI, you have to pay close attention to the data used.
When I speak of invested capital, I mean the entire capital, which includes equity and borrowed money. However, in this calculation, it is necessary to evaluate which components should be considered and which should be excluded: I refer to out-of-pocket expenses, commissions, and taxes. In some cases, in fact, these data significantly alter the results.
To obtain data to compare, the ROI can be obtained as a percentage according to this formula:
This makes it easier to generalize the data and have a broad view of the company’s performance.
If the ROI offers a general overview of the return on investment, the ROMI allows you to evaluate the profits generated by a marketing campaign. The ROMI formula can be expressed in two ways: ROMI = (gross sale – the cost of the product) / advertising cost or, alternatively, net gain/advertising cost.
How it is useful in business
But what is the function of ROI? Why is it important in business?
ROI is a calculation that can be applied in different situations; its versatility allows one to obtain essential data on various departments, individual investments, and company performance.
Despite having limits, therefore, it is a useful indicator for analyzing past and present investments and making forecasts to set future sales targets. The results of the calculation also show any losses and provide useful data to adjust the investment roll.
Return on investment is an intuitive and universally accepted metric that does not allow for misunderstandings.
To give you a better overview, here are some ROI benefits:
- allows you to evaluate the progress of each department;
- allows you to have an analysis of the profits obtained from each investment;
- it gives the possibility to make forecasts on the profitability of future investments;
- shows the trend of investments made in the past;
- it allows comparing the performances of the past years with the current ones.
You can use ROI profitably depending on the industry you operate in and the type of business you run. If you are in online sales, for example, the ROI calculation could help you evaluate the return on investment in campaigns. In a production company, on the other hand, the ROI will allow you to evaluate the economic benefits related to the purchase of a new machine.
How good an ROI must be
Usually, there are no generic parameters to evaluate the quality of the ROI. Each sector and each company have its own points of reference, and a good yardstick is a comparison with the data relating to past performance and those of the competition.
By convention, it is said that a good ROI ranges from 5 to 9%, while an optimal ROI is between 9 and 12%, but from experience, I always tell you to take into account the peculiarities of your company, your prerogatives of yours: sector, the inflation rate and the ROI of other players.
By making these considerations, you can evaluate what a positive ROI would be for you, that is, the one that does not affect your capital and does not make you lose money.
The assessment to be made also concerns the capital to be invested: is it still money? Do you have any alternatives to this type of investment? Is it a sum you could lose without suffering major repercussions?
In short, the quality of the ROI is extremely subjective in the sense that it cannot refer only to generic parameters but must be weighed in a personalized way. As a consultant, one of my axioms is to never refer to extended and universal parameters, but to evaluate every single company’s reality in the context in which it operates.
Tips on how to read your ROI
I have already pointed out that ROI may seem like a simple parameter and that the data obtained looks pretty intuitive to read. Despite the appearance, however, to read the ROI correctly, you need to have a broader vision of both the indicator and the company’s reality.
Using the percentage data, it is easier to make comparisons and to compare ROI obtained in different sectors or in different periods. The percentage data can consist of either a positive figure that gives a negative value . When the ROI is positive, the profit generated exceeds the costs incurred. Conversely, a negative figure indicates that the investment has exceeded the profit.
It is important to focus on the data to obtain a reliable result. If you want the return on investment to be accurate, you must enter the figures relating to the total investment and the total profit in the calculation.
One of the limitations of ROI is that it does not consider the time factor. However, with a little attention, you can adjust the formula and get more accurate data on the annualized ROI.
But on a practical level, how do you calculate the investment made? Only the costs incurred in the initial phase are often included in the calculation of the invested capital. Doing so, however, falsifies the calculations since out-of-pocket expenses are not considered, i.e., the costs incurred for maintenance and investment management.
The benefits of calculating your return on investment
ROI is a clear and universally used metric that gives you an overview of assets, facts, and possible ones. The ROI expressed as a percentage will enable you to compare different types of investments based on the profit obtained and the expected one.
Although the calculation of the ROI returns interesting data, it is also necessary to know how to consider this metric’s limits and apply the right corrective measures to have valid and realistic parameters. The secret of the return on investment lies not in the ROI formula but its optimal use.
You can’t use random numbers to make important decisions for a company, and investments fall into this category. This would only give a very rough estimate of profitability.
ROI is a fundamental tool for companies and investors, but it must be used with a lot of competence.