Return on Investment is a popular metric often used by CFOs and financial managers to evaluate the profitability of how well an investment performed. It can also be used to compare the efficiency of multiple investments.
This profitability metric helps financial managers assess the performance of their investments. While this popular metric does not take into account holidays or the passage of time, it is a simple calculation that finance leaders can use for a number of different applications.
Typically a positive ROI indicates that the cost of investment is worthwhile. On the contrary, a negative ROI means that the additional costs imply a net loss. Investors can use the ROI metric to see which investment choices will lead to the greatest return. While there are several types of investments business owners can prioritize, some include the campaign success of social media activities, the financial gain from property investment, or an expansion in business ventures.
Calculating the ROI for a business is essential as this metric can help show leaders the capital gain expected for each project, which in turn can help them make more strategic business decisions to support organizational goals.
What are the drawbacks to ROI?
One of the most noticeable drawbacks with ROI is that it does not allow you to calculate the potential return for a specific time period. If you wanted to see the returns of an initial investment in a marketing campaign, for example, you would have to use the basic ROI formula and then factor in the specific time period you are calculating for.
However, one way to combat this is by using the ROI calculation in conjunction with the rate of return (RoR). The rate of return factors in a project’s given time period. Another alternative is to use net present value (NPV), which factors in the changes in the value of money over time. When NPV is calculated using the RoR, this is referred to as the real rate of return.
How to calculate the return on investment
The first step when calculating ROI is to determine what type of investment you want to make. This includes whether you are looking at a single project or a series of projects. For instance, if you were considering investing in a new website design, you could calculate the ROI based on the total amount spent on the project. However, if you were looking at a larger-scale project such expanding your office space or investing in a new product offering, you may need to consider the ROI based on each individual element.
Once you know what type of investment you are making, you can start calculating the ROI. To calculate ROI, divide the benefit (or return) of an investment by the investment cost. The investment returns can either be expressed as a percentage or ratio.
