If you invest in the stock market or have a retirement account, you want your holdings to produce good returns. For example, if you buy a stock for $20 a share and it increases to $40 a share, you double your investment. The same logic applies to investing in your small business – you want a positive return on the amount of money you invest in marketing, equipment, expansion, and new products or services, to name just a few. Of course, not all projects and initiatives will generate a positive return on investment (ROI), but it is essential to stay on top of how everything is performing.
Doing so allows you to measure the success of your current expenditures; it can also help you make better business decisions in the future. This Balboa Capital blog article is your return on investment guide. We explain what ROI is, how to calculate it, and how you can use it to determine the profitability of your investments.
What is ROI?
You have probably seen or heard the phrase “return on investment” or the business acronym “ROI” many times. Both terms are commonly used by investment managers and regular investors when discussing the performance of stocks, bonds, mutual funds, and exchange-traded funds (ETFs). In addition, marketing professionals and advertising agency executives use the phrase when evaluating the effectiveness of advertising campaigns. Large companies and small businesses have long used the ROI metric, too.
ROI is the gold standard for evaluating and understanding how profitable investments are for small businesses. As its name indicates, it measures the return on investment. The higher the return, the more significant the financial gain.
How to calculate ROI.
The ROI calculation is simple. Let us say you own a winery that produces several different red wines, and you expand your product offering to include white wines. To do this, you plant 2,000 chardonnay vines and 2,000 sauvignon blanc vines on five acres of land that you own. The total cost of buying the vines and planting them is $20,000. Four years later, you have your first harvest, and the yield is five tons of fruit per acre. Each ton of grapes produces 300 bottles, resulting in 1,500 bottles that you sell for $25 each ($37,500).
To calculate return on investment, divide your net return ($37,500) by the amount you initially invested ($20,000) and multiply it by 100:
$37,500 ÷ $20,000 = 1.875 x 100 = 87.5% ROI
So, your investment in chardonnay and sauvignon blanc vines turned out to be a smart one with an investment gain of $17,500 and an 87.5% return.
Putting ROI to use.
You can evaluate the ROI for just about every type of small business expenditure. Some expenditures will be easier than others, such as advertising or new equipment or machinery, whereas others will be more difficult. For example, an employee onboarding program or advanced training program for employees can benefit a business, but there is a lack of reliable methods for calculating their return.
After you calculate the ROI for your expenditures, you will be able to compare the results and get a birds-eye view of what worked and what didn’t. One important thing to remember is that your results will only be accurate if you have correct accounting records. So, make sure your list of expenses and sales results are updated regularly so that nothing falls through the cracks.
What is a good ROI for your expenditures?
This is a difficult question to answer because every small business is unique, and various factors will impact the ROI of their expenditures. These include the town or city in which the business is located and things like the economy, product or service demand, seasonality, and competitive environment. So, a good ROI is positive and helps your small business make money. Simply put, if the return is between 3% and 5%, that is good news. Anything higher is excellent news. It is not uncommon for some investment initiatives to have double-digit, triple-digit, or quadruple-digit returns.
Small business owners should focus on initiatives that generate more significant returns. For example, let us say that a marketing budget of $10,000 for one quarter helps generate $250,000 in sales, a 2,500% return. In that case, the business owner might maintain the same marketing budget or even increase it in the next quarter.
The timing of your reporting is vital.
If you boost your marketing budget, finance a piece of business equipment, launch a new product or service, or buy new software, the time frame for which you calculate your ROI is essential. For example, you might see a higher return in the first few months, which may decrease down the road. Because of this, it is a good idea to monitor the financial returns of your investments on a weekly, monthly, and quarterly basis throughout the year.
Next, timing will play an essential role in your reporting if you have an investment that will take several months or years to complete. The ROI will not be accurate until the investment is finalized and deployed in these instances.
ROI is an excellent means of calculating the financial success of any business investment you make. Just remember that ROI reveals your net financial gains and does not include intangible benefits such as brand-building and gaining an advantage over the competition. Additionally, it does not account for the risk and uncertainty associated with business investments.