How to calculate ROI and get the most out of your investments
Nearly every decision you make has financial implications, from purchasing real estate to running a marketing campaign to hiring a new employee. Your return on investment (ROI) is how much money you can expect to get back from any given expenditure. As you can imagine, knowing how to calculate ROI is essential for making the smartest business decisions possible. Let's take a look at what ROI is, how to calculate it, and why it matters.
What is ROI?
ROI is the financial gain you receive from any investment you make. Different investments have different types of ROI.
The concept of ROI can be applied to anything from shareholder and ownership agreements to stock market investments. But ROI goes beyond measuring straightforward investments. It also applies to hiring, marketing efforts, and even social media ads. If you spend money on something, you can likely measure ROI.
ROI is also known as return on assets (ROA) when discussing any kind of asset, such as a hire or equipment purchase. The same concept as ROI applies: your ROA reflects how much money that asset generated versus how much it cost you.
ROI is not only a metric for determining the amount of money you'll get back, but it’s also a useful performance measurement. ROI calculations can compare the investment cost of two or more things versus their annualized ROI or return.
You always want a higher ROI, as this means you're netting more profit from your investment. Conversely, a negative ROI signifies money lost. In other words, the investment left you with less than if you had done nothing at all.
How to calculate ROI
There are a few ways to calculate ROI. Each method will help you determine your ROI, but the inputs can vary slightly and require more or less work in the process. It’s also worth noting that ROI is usually expressed as a percentage or ratio.
ROI formula #1
The first ROI formula is slightly more in-depth than others, but it reduces the chance of human error. You can calculate this formula manually or punch it into a spreadsheet program like Excel or Google Sheets.
ROI = (investment gains - investment cost) x 100 ÷ investment cost
Use this formula to determine your ROI for any decision that requires an initial investment or ongoing investment. For example, let's say you hired a marketer last year. Your marketing director uses attribution and determines the marketing hire brought in gross profits of $500,000 this year through their campaigns. Over the same period, you paid the marketer $80,000 in salary and benefits. You could then determine their ROI by using the above formula like so:
(500,000 - 80,000) x 100 ÷ 80,000 = 525
This calculation shows that your marketer is providing an internal rate of return of more than five times their salary.
ROI formula #2
The second ROI formula is as streamlined as it gets.This one requires you do a little work ahead as the formula is a distilled version of the first equation.
ROI = net income ÷ cost of investment
To illustrate the above formula, let's say you bought a sign printer. The total cost of the printer was $5,000. You then turned around and sold custom signs using this printer. The net income generated from this venture was $10,500. You would then plug this information into the formula like so:
10,500 ÷ 5,000 = 2.1
Using the above formula, we see the printer provided an ROI of 2.1, or 210% of the investment value. For something like a printer, where the purchase price is the only cost (assuming you didn't need to do any maintenance), an ROI of 2.1 is great. This ROI could fluctuate year over year, depending on any maintenance costs and how well the signs sell.
Return on investment calculator
If you don’t want to deal with formulas, there are numerous ROI calculators online that will do most of the heavy lifting for you. If you prefer to go this route, gather your financial statements to ensure you have accurate information, and find a calculator that fits your needs.
Keep in mind that some ROI calculators are limited in their use. For example, certain ROI calculators only work with time-based investments. Meanwhile, others let you factor in additional elements to more accurately determine ROI on equipment purchases, hires, and so on.
When calculating your ROI, be mindful of industry differences. There’s no single great ROI. The higher the better, but what’s “high” for one industry might be mediocre for another. Research your industry and see what kinds of ROIs are common, then compare your numbers against that.
Why understanding ROI matters
The importance of ROI goes well beyond general investing. While ROI is useful for understanding the monetary value of an investment, it can also help you operate with clarity in a number of areas.
ROI is a great performance indicator
ROI can be a useful performance indicator, especially when used before making any financial investment. Think of it as a form of financial projecting.
For instance, you could use ROI calculations to compare two different sales campaigns. Say you did some phone canvassing sales, which yielded an ROI of 150% after factoring in employee costs. You then compare this with your all-digital sales campaign and find it had an ROI of 330%. Using these two numbers, you can quickly tell which sales approach performed better. This information can inform the types of sales campaigns you run in the future.
ROI helps with hiring
Just as you can use ROI to measure performance, you can also use it to gauge which kind of employee to hire next.
For example, if you only have enough funding to hire one employee at the moment, you could use ROI to determine which type of role would give you the best rate of return. An ROI calculation can quickly tell you if the marketing hire or sales hire will yield more net income over time, allowing you to make the most financially sound employee investment.
If you’re unsure about what kind of ROI a role needs to bring in, talk to the relevant department head. This person should have, or be able to acquire, the right financial information to determine a role’s potential ROI. If this data isn’t available, check industry averages for various roles and see what kinds of profits or ROI each person drives.
ROI provides marketing clarity
Much like the sales example above, after running several different marketing campaigns, you can use ROI to determine which performed better over time. You could also continue refining the same campaign and update your ROI calculations to see if it's performing better or worse over time.
Marketing can be a huge money sink, so knowing you're getting the best ROI out of your marketing dollars is key to staying in the green.
ROI knowledge helps with cash flow
Every business needs healthy cash flow to function. Because ROI calculations help you make educated business decisions, they can improve your cash flow.
Estimating the ROI of any significant decision before you make it provides you with a clear understanding of how it may or may not pay out. Always look at past data and any available industry data to inform your ROI formula. Not every decision will have a massive return on investment. But you can still use ROI calculations to avoid making investments that will likely result in financial loss.
Know how to calculate ROI to make better decisions
To understand ROI is to understand how an investment can impact your business. It might not feel like it, but nearly every dollar you spend has a potential ROI. Choose a formula, write it down, and keep it handy.
ROI not only helps you know where you stand on investments, but it can also inform your hiring decisions, provide clarity on your marketing strategies, and ensure a healthy cash flow. Ultimately, knowing how to calculate ROI provides actionable information that can impact your current and future business decisions to help you in the long run.