Return on investment (ROI) is a financial concept that measures the profitability of an investment. There are several methods to determine ROI, but the most common is to divide net profit by total assets. For instance, if your net profit is $50,000, and your total assets are $200,000, your ROI would be 25 percent. A common definition of ROI is “a profitability measure that evaluates the performance of a business by dividing net profit by net worth.”
In a small business, the uses of ROI could be to measure the performance of pricing policies, an investment in capital equipment, or an inventory investment. When purchasing assets in a business, such as inventory or equipment, you expect to get a financial benefit from the purchase. Return on investment is a tool to help decide between purchase alternatives that will either generate revenue or result in cost savings that benefit the net income of the business. Investors will also look at return on investment when choosing whether to fund a business venture.
Return on investment may also be measured unconventionally, such as in terms of social responsibility or environmental and societal benefits. This is more difficult to measure—in determining the social return on investment, the payback would need to be quantified to calculate the cost versus the benefit. A network of practitioners was formed in 2006 to facilitate the evolution of calculating social return on investment.
While return on investment is a useful tool to look at profitability, calculations are complicated by other factors such as time, maintenance costs, financing costs, other investment considerations, and the overall goals of the company. For instance, with the purchase of capital equipment, it is expected that equipment will provide a benefit to the company for several years. As such, the net income will need to be estimated for future time periods to determine the overall ROI. Additionally, maintenance costs over the life of the equipment will reduce the overall ROI. An accountant can assist with the formulas to determine more complex ROI calculations.
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[ Down to Business is a weekly small business advice column featured in The World Newspaper, originally published online by the Oregon Small Business Development Center Network, and republished here with permission. ]
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