Why ROI is a Such a Crucial Metric for Your Business?
For many small to medium businesses, turning a profit can be a challenging endeavor. Often, it takes considerable time to build a customer base and establish a reputation before actual profits start rolling in. The pivotal moment when a business covers its fixed and variable costs and begins making a profit is known as the break-even point. Calculating this point provides crucial insights, such as the necessary investment to launch the business, components to include in the monthly operating budget, and appropriate pricing for goods and services. This article defines the break-even point, delves into its calculation intricacies, and highlights the valuable advantages of conducting a break-even point analysis.
Return on Investment (ROI) explained
The principle of return on investment, or ROI, is defined as a financial ratio that shows how much benefit is returned to an investor in relation to the initial investment that they made. This ratio is measured by dividing the net income generated by the venture by the cost of the investment in the venture. The higher the result of this calculation, then the greater the ROI. A lower figure represents a poor investment that has not generated enough revenue to make its initial costs worthwhile.
Every expense incurred by a business and all the expenditures made by a business can be evaluated by their ROI. From smaller expenses such as office supplies to larger expenditures like hiring a marketing consultant or purchasing a piece of machinery can all be measured by the return on investment a business makes.
It must be said that not all expenses have a direct financial ROI, but they do all contribute in some way to the overall investments that have been made in a business.
How to calculate ROI
ROI can be calculated for a specific project over a designated time period, such as measuring the success of a marketing campaign. ROI can also be used to track of the overall investments made in a business over the course of a financial year or accounting cycle. This is known as an annualized ROI calculation.
In theory, the basic formula for calculating ROI is simple. All you have to do is calculate all the gains your investment has made and the divide that number by the original cost of the investment into the venture. This figure is then multiplied by 100. This will give you the ROI percentage.
As an equation, this method of ROI calculation looks like the one below:
Net income generated by investment / Initial cost of the investment = X
X x 100 = ROI%
Let’s look at an example. An investor purchases a house for £100,000. After five years, the investor sells the home for £112,000. £12,000 /£100,000 = 0.12. 0.12 multiplied by 100 is 12. We arrive at a figure of 12 % ROI. Not too bad.
Another example would be if the same investor bought a factory for £200,000. After five years, the investor sells the factory for £150,000. So, there are no gains, but instead a loss of £50,000. £50,000 divided by £200,000 equals -0.25. Multiplied by 100, we arrive at -25. The ROI ratio for this investment therefore shows that it lost 25 % of the initial investment.
Predicting future ROI
Future ROI can be calculated by using the expected income returns on an investment. Say you are thinking about purchasing 1000 books for £2 per book. You intend to sell the books for £3. As well as the cost of buying the books, you have to factor in transport costs of £100. Is this venture going to be profitable for you?
First, you need to calculate your total expenses and the total predicted net income.
- Predicted net income = 1,000 x £3 = £3,000
- Total expected expenses = (1,000 x £2) + £100 = £2,100
Then you need to subtract your expected expenses from the predicted net income:
- £3,000 - £2,100 = £900
We can now use the ROI formula to calculate of this will be a good investment or not:
- £900/£2,100 = 0.429. 0.429 x 100 = ROI 42.9%
From this figure we can see the venture is expected to generate an ROI of 42 %, a good risk for an investor., but only if, however, the figures all remain at the predicted values.
What is the optimum ROI for a venture or investment?
Because every individual investor or business has their own particular set of expectations, it is difficult to ascertain what the optimum rate of ROI is. However, as a general rule an ROI that is between 10 and 50 % can be looked at as favourable. Some investors may go as low as a 7 % ROI on an investment.
To find out if the ROI is going to be a good risk for you, consider the following questions:
- How much risk are you comfortable with?
- Can you afford to lose the money if you invest in the venture?
- How much profit do you expect from the investment?
- Are there other, more productive ways you could spend your money?
What are the benefits of ROI?
ROI calculations have a wide range of benefits for investors and business owners alike. An investor can use the ROI calculation to determine if they think a venture is worth the risk. A business owner can use ROI to determine if their business idea is profitable.
A manager can use ROI to see if an investment has paid off for their company. ROI calculations also assist with setting targets for long and short-term projects and calculating the working capital they may require.
The ROI equation is relatively simple to use and is universally understood so it is also a popular metric in determining the overall value of a company. An accountant may make an annualized ROI calculation when performing an audit of a business and use this data alongside an analysis of the financial statements. ROI percentages are often used in conjunction with profit and loss statements, bad debt statements and an anlaysis of the company’s break-even point.
Understanding the challenges and limitations of ROI
ROI calculations are generally considered to be approximations of value rather than statements of fact. Errors in ROI calculations are always expected as are contributing factors or unexpected developments.
There are a range of factors that can occur that impact the true ROI of an investment, such as unforeseen costs and even the stress or extra workloads that the venture may have caused. Other issues with ROI include:
- The actual cash flow of your business will not be shown in its ROI. So, while a business may show a reasonable ROI, it may still be losing cash flow
- Without a good understanding of expenses, an ROI is not accurate
An ROI will only provide insights into the financial aspects of a venture. They do not count the social impact that a venture may have. While some projects may have a negative ROI, they may deliver other nonfinancial rewards. A case in point could be where a company decides to invest in new office furniture. This may have a negative financial ROI but may vastly improve staff morale and increase productivity.
Other projects may have a good financial ROI but may negatively impact a business in other ways. For example, a project with good ROI may significantly damage a company’s reputation, impacting its ability to remain viable in the long-term.
Another difficulty with ROI calculations is that they often do not take into account the time period of the investment. While an ROI calculation may show an investment return of 25 %, it will not stipulate the amount of time it took for this return to be generated. This issue, however, can be dealt with by using a more complicated ROI formula used to determine annualized ROI:
[(Ending Value / Beginning Value) ^ (1 / # of Years)] – 1 = ROI%
We can easily see that the annualized ROI requires a much more advanced knowledge of mathematics than the typical ROI equation. When dealing with such difficult calculations, many business owners choose to use an accountant, an online ROI calculator, or a specialised software package.
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