What is it?
Return on investment or ROI is the most commonly used financial term in many conversations about spending large sums of money. Simply put, it measures the profits or benefits arising out of money invested to achieve those benefits.
It should not be confused with ROCE – return on capital employed, which measures how well a business uses its assets to earn returns – see my previous blog on ROCE and when to use it http://bit.ly/1vvgmCD
How do you calculate it?
ROI in a business would be its net profits after tax divided by its share capital – this measures the rewards earned by investing in the business, i.e. the cash return as a percentage of the cost outlay.
Of course, ROI is used to measure every type of investment, from individuals investing into shares and property to companies investing into new equipment, marketing campaigns, social media to setting up a new division. The net cash return divided by total costs gives ROI. The higher the ROI, the happier everyone is.
When to use it?
For individuals, ROI on any item they want to spend their money on comprises looking at perceived risk and projected benefits. If you’re buying a house, you would consider the location and the likelihood of that location increasing the value of the house as well as what the risks are of further development in the area suppressing prices as well as the risks involved in the actual building itself. You would want to get the best house in the best location at the best price – within what you can afford to spend.
For investors’, its important to compare projected ROI on different investments to help make their choice. Of course ROI is not the only measure savvy investors’ use and their analysts would use IRR to other measures including the perceived risk of the potential business. For an entrepreneur, its important to get ROI as high as possible in their business since that’s what attracts new investors.
For companies investing into new ventures or investing into a social media campaign or starting a new product or introducing a cost savings programme, calculating ROI is important since a high ROI will increase the value of the company.
An important aspect of ROI is to ensure the benefits are measured as scientifically as possible. The most common mistake I have seen in ROI calculations is people using ill-advised measurements of benefits to bump up ROI to try to justify their projects.
Key points to consider
- Measure the projected benefits scientifically and don’t include any intangibles – if you can’t convert it into a figure forget it!
- Take into account all the costs including the costs of money
- Take into account the time value of money
- Use ROI to compare your business to the competition
- Don’t forget to consider the risks – higher ROI will invariably have higher risks