Know Your ROI
by Abigail Tracy, Inc. Magazine
Every business owner hopes his or her company is a success — but what defines success? The concept is subjective, but there are a handful of metrics you can use. Return on investment, aka ROI, is one of the key measurements most frequently used.
What Exactly Is ROI?
ROI is a financial ratio used to measure the benefit or “return” from an investment. Or to put it another way — what you get from what you put in. ROI is typically used in determining the profitability of a company, though it is by no means the only way to do this
Inc. breaks down the calculation: “The general rule to keep in mind is that ROI is the ratio produced when all gains from a transaction, less the costs associated with that transaction, are divided by the initial investment.”
Though the concept behind ROI is fairly straightforward, there are several different ways to calculate a company’s ROI. Generally, you can calculate the ROI of a business by dividing the company’s net income for a defined period of time by its invested capital.
However, this is where problems can arise, as the definition of “invested capital” is not set in stone. According to Inc., “it is sometimes defined as net worth or owners' equity. Other definitions include the company's long-term debt on the principle that, for operational purposes, money derived from debt is equivalent to paid-in capital.”
But regardless of what version of the formula you choose to calculate ROI, the key is consistency over time. Once you pick a method, stick with it.
So What Does an ROI Calculation Look Like?
Let’s assume a cash purchase of a residence for $100,000. The house is held for 10 years and is then sold for $150,000; during its 10 years of ownership, maintenance costs have been $1,000 per year, so that the net sales value is $140,000. This sum, less the purchase price, nets out to $40,000. That $40,000 divided by the purchase price produces 0.4 or 40 percent. The ROI of this transaction is therefore 40 percent.
When presenting your ROI or discussing ROI with someone else, it is important that you clarify what method you are using in your calculations and that you are using other metrics to define a project or investment’s success beyond ROI. Jack and Patti Philips, founders and owners of the ROI Institute, elaborate the importance of recognizing this in an Inc. column:
“A huge misunderstanding is that ROI is everything for a program or project. In reality, it is only one measure. The original developers of ROI to measure the payoff of capital expenditures (professors and economists) stated that ROI was an imprecise measure, suggesting it be used in conjunction with other measures (never alone) to make decisions about the investment.”
Abigail Tracy is a staff reporter for Inc. Magazine and Inc.com. Follow her on Twitter @abigailtracy.