This article contains general information and is not intended to provide information that is specific to American Express, or its products and services. Similar products and services offered by different companies will have different features and you should always read about product details before acquiring any financial product.
Return on investment (ROI) is a common financial metric that may be used to evaluate the efficiency and profitability of business decisions. Calculating ROI could help businesses plan for and invest in growth and make more informed spending decisions.
For example, a business owner may want to purchase new equipment, expand their team, or step up marketing efforts to reach a broader audience. Knowing how to calculate ROI might help with prioritizing those goals.
Key takeaways:
- ROI measures the profitability of an investment, relative to its cost.
- Businesses may use ROI calculations to help prioritize spending and manage available cash.
- ROI is different from cash flow, revenue growth, and profit.
- While ROI could be useful, it may have some limitations that business owners may want to be aware of.
What Is Return on Investment (ROI) and Why Is It Important?
What is ROI? In basic terms, it's a performance metric that measures the return an investment generates, relative to its cost. ROI may be expressed as a percentage and may help answer this question: "Is this investment worth it?"
Why is ROI important? ROI matters because it can provide a standardized way to compare different investments so a business may prioritize its time, capital, and labor resources. Calculating ROI, whether it's for short or long-term investments, may help business owners make informed decisions about how to pursue strategic growth.
How Businesses Use ROI in Decision-Making
Businesses may use ROI to evaluate and compare investment opportunities. Example use-cases for ROI calculations may include:
- Equipment purchases
- Increasing marketing spend
- Opening a new location
- Product development
- Hiring
ROI may help business owners rank opportunities based on higher projected returns so they may allocate capital more efficiently.
As an example of how to use ROI, assume a business has $10,000 to invest. They could spend it on a marketing campaign that's estimated to deliver a 200% ROI over the next six months, or use it to buy equipment that is projected to deliver a 50% return year-over-year. Here, the business may decide what's more valuable: a higher ROI in the near-term or a consistent ROI over time.
ROI vs. Other Financial Metrics
ROI is just one metric businesses use to measure financial health. Profit, revenue growth, and cash flow also may factor into business decision-making.
- Profit is the revenue left after deducting operating expenses.
- Revenue growth measures how revenue increases over time.
- Cash flow describes the movement of money in and out of a business.
In terms of how to compare ROI vs. profit, ROI measures the efficiency of an investment while profit indicates how much financial gain the investment generates. For example, a $10,000 investment that generates $50,000 in profit has a 500% ROI. Both may be useful for evaluating where and how to invest capital.
How to Calculate Return on Investment
You can find ROI by applying a basic calculation. Here's the basic ROI formula:
ROI = (Total Return - Investment Cost) / Investment Cost x 100
In this formula, total return is the total amount received from the investment. Investment cost is the amount of money invested.
Here's an example of how to calculate return on investment for a marketing campaign that costs $5,000 and leads to $15,000 in sales, assuming no additional costs.
$15,000 - $5,000 = $10,000 / $5,000 x 100 = 200% ROI
In this example, the investment returned the initial $5,000 spent, plus an additional $10,000 for a 200% return.
Variations of ROI Calculations
There are multiple ROI formulas businesses may use, depending on what they're comparing.
Formula |
What It Could Tell You |
|---|---|
Standard/basic ROI formula |
How efficient or profitable an investment is or is likely to be |
Annualized ROI formula |
The annualized return of an investment |
Marketing ROI formula |
How profitable a marketing campaign is or is likely to be |
While there is some overlap between them, the assumptions and inputs used for each formula may vary. Using multiple ROI formulas may offer a more comprehensive view of an investment's projected worth.
What Is a Good ROI?
No universal "good" ROI exists. What one business considers good may vary from another, depending on the industry the business operates in, the investment's risk level, and the time frame required to see results.
Instead of asking, "What is a good ROI?" it may be more useful to reframe the question as "What is the desired ROI for this investment?" Businesses may compare projected ROI with their cost of capital when evaluating an investment.
ROI Benchmarks and Expectations
ROI expectations may vary from industry to industry and project to project. For example, investing in technology or marketing may generate a higher short-term ROI, while infrastructure or equipment investments may yield a lower ROI but one that's more stable over time.
Researching ROI expectations for businesses that are similar in size and scope could help with developing relevant benchmarks. Reviewing investment trends within an industry, for example, may shed light on what other companies are spending to grow and how that's paying off, in terms of ROI.
Positive vs. Negative ROI
ROI may be positive or negative and it could be important for businesses to understand the difference:
- Positive ROI means an investment generates more financial return than it costs.
- Negative ROI indicates the investment resulted in a loss.
Understanding this distinction could help businesses assess the performance of investment and decide their next course of action. That may mean continuing the investment as-is, making adjustments, or abandoning it.
Positive and negative ROI may reveal whether the time and money spent on an investment were worthwhile. That may be useful in determining how to allocate capital for future projects and developing ROI benchmarks for measuring their success.
What ROI Doesn't Show
While ROI is useful, there could be limitations to consider. For instance, basic ROI does not directly account for the time period of an investment, nor does it reflect the risk profile of an investment. ROI does not directly measure other indicators of success either, such as customer satisfaction or employee satisfaction.
An investment may look good on paper based on its projected ROI in dollars, but that doesn't measure how it may be received by customers. A well-intentioned but poorly executed marketing campaign, for instance, could fall short of ROI expectations. In a worst-case scenario, it may result in damage to the business's brand reputation, which could hinder growth in the long-term.
The Takeaway
Return on investment could be a straightforward, but useful, calculation that businesses use when deciding how to deploy capital. It may also be helpful when weighing the merits of using financing to grow.
ROI FAQs
What is ROI in simple terms?
ROI is the gain or loss an investment generates, relative to its cost. It may be one way to measure the profitability of an investment, though not the only metric small businesses may use.
How do you calculate ROI?
To calculate ROI, subtract investment costs from the total return first. Then, divide that number by the total investment cost and multiply by 100.
What is considered a good ROI?
There is no universal good ROI — what constitutes a good ROI may vary from industry to industry and investment to investment.
Is ROI enough to evaluate an investment?
ROI by itself may not be enough to evaluate investment. Business owners might also want to consider the time frame involved, the risk level, and the cash-flow requirements before investing.
Can ROI be negative?
Yes, ROI could be negative if an investment produces a loss rather than a gain. Negative ROI means the investment costs exceeded its returns.
Photo: Getty Images
The material made available for you on this website is for informational purposes only and is not intended to provide legal, tax or financial advice. If you have questions, please consult your own professional legal, tax and financial advisors.
