What is ROI? Why It’s Important, and How to Calculate It

Aug 20, 2019 • 5 min read
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      Do you want to take your small business to the next level? If so, you need to make every financial investment into your business count. 

      Successful business owners combine due diligence, a deep understanding of business processes, and keen foresight to turn a small business into a profitable one. One key financial principle that business owners must understand is ROI. 

      What is ROI? 

      ROI stands for return on investment. With any investment, whether it is time or money, there is going to be a financial gain, loss, or break-even point. ROI is the analysis of this financial performance in the business world.

      Here’s an example: you purchase $500 in stocks today. If you were to sell those stocks tomorrow for $1,500, you would have a gain—a positive return on your investment. If you were to sell those stocks tomorrow for $100, you would have a loss.

      Why Does ROI Matter? 

      Having the foresight to determine if an investment will result in a positive return allows you to make financial decisions that will ultimately help you successfully grow your business. 

      ROI is especially important when it comes to business financing. If you’re borrowing money, you want to make sure the growth opportunity will generate enough revenue to justify the cost of the loan. Otherwise, you could find yourself drowning in debt. 

      Calculating ROI can also come in handy if you’re trying to determine which investment makes the most sense for your bottom line. Here are some examples of how you might put an injection of capital to use: 

      • Replacing outdated equipment or machinery
      • Redesigning your website to take your brick-and-mortar shop online 
      • Hiring a marketing manager to kickstart new marketing and advertising initiatives
      • Opening a second location on the opposite side of town
      • Diversifying your product line and services to sell more to existing customers and attract new customers 
      • Franchising your small business to expand it nationally—or even globally
      • Consolidating several forms of high-interest business debt under a new loan 

      The investment path you choose depends on many factors. It depends on where your business stands now and what it has to offer. It depends on the market and future trends. It depends on how far you want your business to grow. And it depends on you, your team, and your combined strengths and weaknesses.

      With all of these factors in mind, you will need to decide which of the above paths is most likely to create a positive ROI. 

      How to Calculate ROI 

      Calculating ROI can be a bit tricky if you start overthinking it. InvestingAnswers offers a simple ROI formula that small businesses can use to determine the return on investment for most ventures.

      ROI = (Net Profit ÷ Cost of Initial Investment) x 100

      Here are a couple of examples of this formula in action based on a few of the small business expansion ideas mentioned earlier. Please note that these are just examples of the ROI formula in use and not typical results of the specified investments.  

      Scenario #1

      Your business invests in a complete redesign of your website. The total cost of investment is $15,000, which includes a custom e-commerce website design and quality photos of your entire product line. 

      After the first month, your new e-commerce store generates a net profit of $3,000. This net profit is calculated after deducting monthly website hosting fees, product shipping and handling costs, and additional costs associated with your new e-commerce store.

      The ROI of your website redesign, for the first month alone, is ($3,000 ÷  $15,000) x 100 = 20%. 

      Scenario #2 

      Your business invests in a new marketing manager. The total cost of investment is $52,000 for the first year based on the new hire’s salary, benefits, and initial training. 

      After the first year, new marketing initiatives generate a net profit of $120,000. This net profit is calculated after deducting advertising fees, monthly marketing software fees, and additional marketing spend.

      The ROI of your marketing manager for the first year is ($120,000 ÷  $52,000) x 100 = 231%. 

      Scenario #3

      Your business invests in opening a second location. The total cost of investment is $225,000, which includes permits, POS equipment, inventory, payroll, and the retail space itself. 

      After the first year, the net profit for your new boutique is $85,000. This net profit is calculated after deducting standard operating costs and taxes. 

      The ROI of your second location for the first year is ($85,000 ÷ $225,000) x 100 = 38%. 

      What is a Good ROI?

      For most scenarios, any positive return is considered a good return on investment. If you want your business to have exponential growth, you will want to aim for the highest ROI possible. 

      You’ll want to increase your sales without increasing your spend. You can employ several tactics alongside major investments and business expansions to increase your overall revenue. 

      Focus on providing excellent customer service and remind all of your customers to review your business online. Your business rankings in search engines will steadily improve as it receives a larger quantity of positive rankings, leading to exposure among your ideal customers. Also, be sure to respond to your reviews, as that can help improve your local rankings, according to Google.  

      Train all of your employees to upsell. If you can increase the average dollar amount of each sale, you will increase your business’s overall revenue without having to increase marketing or advertising spend to attract new customers to your store. 

      For small businesses with online stores, look for ways to improve online conversions. Place opt-in forms on every page of your website for visitors to share their email address to receive future sales promotions. Utilize A/B testing tools, like the one provided by Google Analytics, to test your product sales pages and determine which changes result in the highest conversion rates. 

      Once you understand ROI, you’ll be able to make informed financial decisions for your small business that will lead to its success. After thorough research and some careful calculations, you may find that the path that seems riskiest may have the potential to generate the highest return on investment. And that will be the best scenario for taking your business to the next level. 

      About the author
      Samantha Novick

      Samantha Novick is a content marketing writer covering business and finance for Funding Circle.

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