Return on investment (ROI) is a financial ratio that compares the amount of income derived from an investment with the cost of the investment. ROI is known as a profitability ratio, because it provides information about management's performance in using the resources of the small business to generate income. ROI and other financial ratios can provide small business owners and managers with a valuable tool to measure their progress against predetermined internal goals, a certain competitor, or the overall industry. ROI is also used by bankers, investors, and business analysts to assess a company's use of resources and financial strength.
As James O. Gill noted in his book Financial Basics of Small Business Success, most entrepreneurs decide to start their own businesses in order to earn a better return on their money than would be available through a bank or other low-risk investments. If the ROI and other profitability ratios demonstrate that this is not occurring—particularly once a small business has moved beyond the start-up phase—then the entrepreneur should consider selling the business and reinvesting his or her money elsewhere. However, it is important to note that many factors can influence ROI, including changes in price, volume, or expenses, as well as the purchase of assets or the borrowing of money. In addition, ROI is limited by the fact that it focuses on one period of time and thus should be considered a short-term performance measure. Ignoring the long-term effects of investments can cause poor decision-making, so it is advisable to combine ROI with other measures of profitability and performance.
USES OF ROI
The general formula for computing ROI is income / invested capital. ROI can be computed on a company-wide basis by dividing net income by owners' equity. This measure indicates how well the overall company is utilizing its equity investment. Calculated in this way, ROI provides a good indicator of profitability that can be compared against competitors or an industry average. Experts suggest that companies usually need at least 10-14 percent ROI in order to fund future growth. If this ratio is too low, it can indicate poor management performance or a highly conservative business approach. On the other hand, a high ROI can either mean that management is doing a good job, or that the firm is undercapitalized.
ROI can also be computed for various divisions, product lines, or profit centers within a small business. In this way, it gives management a basis for comparing the performance of different areas. One large division may generate much higher profits than another, smaller division, for example, which might encourage management to consider investing further in that division. But an ROI analysis might reveal that a great deal more capital investment was required by the large division than by the smaller one. The smaller division may have generated a lower dollar amount of profit, but a greater percentage of profit on every dollar of investment. As Ronald W. Hilton wrote in his book Managerial Accounting, "The important question is not how much profit each division earned, but rather how effectively each division used its invested capital to earn a profit."
ROI can also be used to evaluate a proposed investment in new equipment by dividing the increase in profit attributable to the new equipment by the increase in invested capital needed to acquire it. For example, a small business may be able to save $5,000 in operating expenses (and thus raise profit by the same amount) by spending $25,000 on a piece of new equipment. This yields an ROI of $5,000 / $25,000 or 20 percent. If this figure is higher than the company's cost of capital (the interest paid on debt and the dividends paid to investors) prior to the investment, and no better investment opportunities exist for those funds, it may make sense to purchase the equipment.
In addition to the various uses ROI holds for a small business managers, it can also be a useful measure for investors. For example, a stockholder might calculate the return of investing in a company by the following formula: dividends stock price change / stock price paid. This calculation of ROI measures the gain (or loss) achieved by placing an investment over a period of time.