ROI: What Should You Know?
You might have heard of ROI. It stands for return on investment, and business owners use it as a method for decision making in trying to turn a profit. It’s a simple concept, in theory – it essentially means that in order to increase your business’s profitability, you should always shoot for a positive ROI – don’t make business decisions that give you a negative one.
But Wait, There’s More
Put simply, ROI is the result of the investment, but it has complex terms behind it. It’s a performance measure, and anything that measures performance involves some sort of math. The ROI formula takes the benefit of investment and divides it by the cost of the investment. The result is a percentage, and that represents your ROI.
The benefit of an investment is calculated by subtracting the cost from the current value of the investment. So your ROI formula is represented like this:
The current value of an investment is the proceeds from the sale of the investment in question. The result is always going to be a decimal, but it’s easily convertible to a percentage. This expression as a percentage makes it comparable, so it’s easy to see which investments are best for your company.
Why is ROI Important?
ROI matters because it gives you insight into future business decisions. If you know, to some extent, what your return will be from making a purchase, it’ll help grow your business. Especially when it comes to getting a loan or financing business purchases, ROI is an important tool.
ROI for Financing?
If you’re trying to get a loan or finance anything within your business, it can be important to use your ROI to calculate if the loan will generate enough revenue to justify taking it out in the first place. Loans always end up costing more than the thing you’re getting a loan for – these are the unfortunate facts of finance. It’s always a matter of planning to make sure the investment in one is going to benefit you in the long run, even if it will end up costing more.
The point of an ROI is to compare it to other investments in order to see which one(s) make the most logical sense to pursue. So, if you’re trying to figure out if you should finance a kitchen or a new point-of-sale system, knowing your ROI is recommended. You can prioritize the investments with the highest ROI, and then slowly make your way through your portfolio of investments.
ROI Calculation Breakdown
So, for financing, ROI would take the cost of the total loan – say you’re taking out a total of $12,500 (with interest and fees) for a new photo booth – and subtract it from the total value of the purchase. How do you find that? Well, in the case of a photo booth, it’s likely you’re running a business that rents them out for events. If you expect to rent it out for four events a month at $500 each time, that’s a revenue of $2,000 per month. And If you’re financing the equipment over a two-year period, you’ll pay $522 toward the total loan per month, for 24 months.
You can figure out the ROI for the term of the loan. At $2,000 monthly over the two-year period, you can expect to bring in around $48,000. That’s your total value. Subtract your loan cost from this total value and you get $35,500. Finally, you divide that by the loan cost, as exemplified by the formula, and you get 2.84, or 284%
Obviously, this shows a very positive ROI and would represent a good investment. If you were running a party rental business, you could use this method to compare different pieces of equipment and figure out which would be best to recieve financing for.
As with any method of financial calculation, ROI isn’t fool-proof, and it does have its shortcomings. The Harvard Business Review (HBR) makes the case that the “single most important limitation in this category results from the fact that ROI oversimplifies a very complex decision-making process.” It claims that the measure can be simple and easy, but also unrealistic. Because the rate of return is objective, and there’s no real way to know what you’re going to gross in revenue, so it says that relying on ROI can be thin ice to tread.
HBR also states that ROI remains constant no matter the economic trade-offs. It’s the same no matter the assets, time or number of investments. This can be problematic because it can ignore economic factors that could inherently influence profit acquisition for your company.
In the End?
With all this being said, the best idea when using any predictive measure is to always predict for losses, and not rely too heavily on subjective calculations. ROI can be good, however, for understanding a general idea about your investments and if they’ll be profitable.
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