Every investment you make in your small business is aimed at moving your company forward and increasing income. This includes expenditures on equipment, technology, vehicles, marketing, and employee training. It is essential to assess the performance of these investments by calculating their return on investment (ROI).
ROI is a financial metric commonly used by small businesses and large corporations to measure how effectively they utilize their investments to generate profits. This article from Huddle Business Capital offers a detailed overview of ROI, including how to calculate it and how to use it in decision-making to drive growth.
As we mentioned above, ROI is a widely used financial metric that helps evaluate the profitability of a business investment relative to its cost. Specifically, ROI provides insights into whether the capital used is generating a positive or negative return.
By evaluating the ROI of your investments, you can prioritize those that deliver value and pay less attention to those with low or negative returns. This helps take the guesswork out of ongoing and future investments and helps you allocate resources more effectively.
ROI outcomes can vary depending on the specific type of investment and the duration over which it is evaluated. For example, an equipment or machinery upgrade might take six months or longer before seeing results from the investment. In contrast, a paid marketing campaign typically offers a much quicker turnaround, perhaps in only one or two weeks. This emphasizes the need to align investments with their type and expected ROI timeline.
A good rule of thumb is to track ROI on an ongoing basis rather than waiting for a set date. This allows ROI to be measured over different time frames. For example, if you invest in a new customer relationship management (CRM) system for your business, you could calculate the ROI after one month, again at six months, and once more after one year to get a full understanding of your investment's performance.
The formula for calculating return on investment (ROI) is straightforward, provided you have the necessary information: the cost of the investment and the net income it generated for your business. It is important to include all costs associated with your investment to obtain an accurate ROI. For instance, if you purchased a new commercial vehicle for your business, you should factor in the purchase price, any interest (if the vehicle was financed), and related expenses such as maintenance, repairs, and fuel costs.
To calculate ROI, net income is divided by the total cost of the investment, then multiplied by 100. Here is the formula:
ROI = Net Income ÷ Total Cost × 100
So, if your business spends $2,000 per month on paid advertising and generates a net income of $500 per month, the ROI is 25%. The following is the breakdown:
$500 ÷ $2,000 = 0.25 × 100 = 25%
There isn't a universal ROI threshold, as it can vary by industry and investment type. Some investments yield strong returns, while others provide more moderate results. That said, most financial experts agree that an ROI between 10% and 25% is considered good, and anything higher is deemed excellent.
If your business is generating strong profits, you may want to invest capital into initiatives that are already successful. For example, if your marketing efforts are effectively attracting leads and driving sales, consider increasing your marketing budget while maintaining the same message. Additionally, if you and your employees rely on equipment daily to meet tasks and production goals, it may be worth investing in newer, more advanced equipment that can save time and directly boost your profits.
Other investment ideas to consider include accounting software, which streamlines bookkeeping, and inventory management software, which reduces manual labor. Additionally, consider tasks where you can save money while generating a higher return on investment (ROI). This might include outsourcing website design and content writing for search engine optimization (SEO), purchasing automated software for same-day invoicing, and sending marketing emails to customers who have opted in to receive email communications from your business.
If you take out a business loan or obtain funding to finance or lease equipment, you can calculate the return on investment (ROI) of your funding. To do this, you will first need to get the total cost of your business funding: the loan or lease amount, total interest paid over the term, and origination fees and closing costs (if applicable). Then, look at how much revenue was generated with your business funding.
To calculate the ROI, subtract the total loan cost from the net profit, divide the result by the total loan cost, and multiply by 100. Here is the formula:
Net Profit from Loan - Total Loan Cost ÷ Total Loan Cost × 100
For example, if you take out a $100,000 equipment loan that has $18,000 in total interest and fees, the total cost of your loan is $118,000. If the equipment generates $150,000 in new revenue over the three years you finance the equipment, your ROI is 27%. Here is the breakdown:
$150,000 - $118,000 = $32,000 ÷ $118,000 = 0.271 × 100 = (27%)
This Huddle Business Capital blog article is purely educational and contains general information and opinions; it is not intended to provide advice or recommendations of any kind. Huddle Business Capital is not affiliated with nor endorses the companies mentioned in this article.