Return on investment (ROI) compares the costs of an investment to the revenue generated from that investment. Often, small business owners will forecast their expected ROI before making a business decision, such as a technology or equipment purchase. Marketers also use ROI to determine if a technique or campaign earns more revenue than it costs.
Although the ROI formula is simple, some expenses are harder to define, and you may need to measure additional metrics to get a complete picture. However, ROI is an invaluable metric for understanding investment profitability. Learn how to use the ROI calculation to improve your financial decisions.
What is ROI in business terms?
ROI, or return on investment, is a profitability metric that calculates how much profit or loss an investment generates compared to its costs. Small business owners use the ROI formula to measure investment profitability of different strategies, from funding an invention to equipment or software purchases. For example, if you spend $500 on advertising and generate $2,000 in sales, your investment return is 300%, meaning you earn $3 for every dollar spent on ads.
Standard ROI formula for small business owners
The ROI formula requires two initial calculations: net profit from investment and investment cost. The investment's net profit is the revenue or earnings gained from the investment, like new sales from email marketing or increased revenue from an equipment purchase. Investment cost includes any money spent on the project.
The standard ROI formula is:
ROI = (net profit - investment cost) / investment cost × 100.
[Read more: 8 AI Tools to Improve Financial Planning for Your Business]
ROI in practice: worked examples for common small business investments
Small business owners make decisions everyday, and using ROI can help owners compare solutions or see if a purchase is worth the money. And when you have limited funds, calculating ROI can show which investments deliver the most benefits.
For example, marketing campaigns, equipment purchases, or new hires may produce returns, but the type of return differs. They may increase revenue, save time, or reduce costs. Check out the following examples to see how ROI informs different decisions.
Marketing campaign ROI
Consider a local service business that spends $2,000 on a targeted email and social media campaign. If the campaign attracts 12 new customers, and each client spends an average of $400, then the campaign generated $4,800 in revenue.
The ROI calculation looks like this: ($4,800 - $2,000) / $2,000 x 100 = 140% ROI. For every $1 invested, the business earned $1.40. However, this does not take other costs into account, such as labor or software.
Equipment purchase ROI
ROI can measure equipment returns like cost savings and productivity. It also provides a comparison point when evaluating funding options, such as business loan costs.
To see if equipment pays off in the first year, look at ROI. Consider a small landscaping company that buys a $6,000 mower. If employees can do the same amount of weekly mowing in eight fewer hours, then the owner saves on labor. Let’s say this adds up to $8,000 annually.
The ROI calculation is ($8,000 - $6,000) / $6,000 x 100 = 33.3% ROI in year one. For a more accurate figure, include the costs of maintenance, training time, and financing costs.
The ROI of hiring an employee or contractor
Hiring ROI is harder to measure because returns are not always immediate and benefits may not be as obvious. For example, hiring a part-time administrative assistant may free up your time to take on more billable work. Additional revenue is a direct return. But a good hire may also contribute indirectly to less owner stress, faster follow-ups to customer concerns, or fewer missed sales opportunities.
Alternative ROI formulas and small business use cases
An alternative ROI calculation could provide better insights depending on your measure and how detailed you need to be. Consider using different ROI formulas to compare investments or add maintenance and labor expenses to your total costs.
Net return-based ROI formula
Unlike the standard ROI calculation that evaluates raw profit versus investment cost, this performance measure considers operating expenses, including labor, materials, and maintenance.
- ROI formula: ROI = net return on investment / cost of investment × 100.
- Best for: Small business owners who need a detailed profitability metric that accounts for all expenses.
Final vs. initial investment value calculation
The basic ROI formula measures immediate profit, whereas this version evaluates an asset's value change over time. Small businesses can calculate their return when buying commercial properties or vehicles and selling them later.
- ROI formula: ROI = (final value of investment - initial value of investment) / cost of investment × 100.
- Best for: Companies making long-term real estate, stock, or business acquisition investments.
Companies use ROI alternatives to assess investments that need more specific measurements. Three common metrics are return on advertising spend (ROAS), payback period, and internal rate of return (IRR).
Net income ROI formula
This profitability metric focuses on net income instead of net profit. It answers the question: Did this course or business coach increase long-term earnings?
- ROI formula: ROI = net income / cost of investment × 100.
- Best for: Service-based businesses and freelancers that invest in business coaching or courses to improve their earning potential.
Investment gain vs. investment base equation
For a quick performance comparison between different investments, use this ROI calculation. It doesn't break down costs and profits, making it faster to compute than other versions.
- ROI formula: ROI = investment gain / investment base.
- Best for: Small businesses wanting quick insights when comparing marketing or advertising channels.
Simplified ROI calculation (gains vs. costs)
The gains vs. costs calculation works when you need a rough estimate or don't have detailed financial information handy.
- ROI formula: ROI = (gains - costs) / costs × 100.
- Best for: Small business owners who need a fast, rough estimate of ROI.
[Read more: How to Calculate Cost of Equity for a Small Business]
How to determine a 'good ROI' for your industry
The bottom line is that anything above 100% means you're doubling your money. However, you should look at several aspects to ensure profitability.
Consider these factors when evaluating your ROI:
- Industry benchmarks: Research ROI expectations in specific sectors, or compare your ROI to similarly sized companies or past investments.
- Short-term vs. long-term: Decide whether you need to boost cash flow with a high ROI with fast returns or a slower but scalable long-term ROI.
- Business costs and profit margins: A good ROI should be higher than your costs and profit margins when factoring in all hidden expenses, like labor and maintenance.
- Risk vs. reward: Risk-tolerance levels can define what a good ROI means to you. If you're strapped for cash, a lower ROI but steady returns could be better than risking huge losses.
- Other financial metrics: Use multiple performance metrics to get a complete picture. For example, track customer lifetime value if you rely on recurring revenue or use an annualized ROI formula for investments that take years to pay off.
When to use the ROI metric
The ROI metric can quickly estimate many business decisions and help sell your idea to stakeholders or leaders. For example, you can see if borrowing money via SBA loans to expand your company earns enough of a return to justify repayment. On the other hand, if you’re strapped for cash, use ROI to assess short-term financing options.
You can even calculate ROI to estimate how much money installing energy-efficient windows in your office saves you.
How to use ROI effectively for business decisions
Small businesses can use ROI as a decision-making tool before spending, after investing, and for financial planning.
Here's how you can use ROI for business decisions:
- Focus on profitable investments. Increase cash flow by prioritizing higher-ROI strategies first and adding long-term growth projects later.
- Set ROI benchmarks. Measure progress and adjust your approach if your return is lower than expected.
- Track ROI over time. Regular tracking can reveal financial health trends and long-term value. Analyze ROI to see if your investment pays off and to estimate future returns.
- Measure growth strategies. Use ROI calculations to compare expansion options and decide if you should add e-commerce or open a new location.
Constraints of using ROI for analysis
Although ROI benefits businesses, it doesn't give a complete picture, nor is it as precise as other metrics. First, ROI doesn't specify a time frame. Therefore, your ROI for 30 days can be significantly different from an annualized figure.
Secondly, your pre-investment ROI will be less accurate if you don't fully understand your future business expenses. Newer companies with more variables may have trouble calculating their ROI.
And most importantly, ROI estimates your project's financial success but doesn't account for other factors, such as employee satisfaction rates. There are certainly cases where your ROI may be low or nonexistent, but the venture still has value.
For example, small nonprofits or mission-driven organizations may compare financing options based on grants or donations, not just affordability. Likewise, businesses recovering from a declared disaster may look at many factors unrelated to profits when considering an SBA disaster loan. Completing a cost-benefit analysis allows you to factor intangible benefits and costs into your investment decision.
When to use ROAS, payback period, or IRR instead of ROI
Companies use ROI alternatives to assess investments that need more specific measurements. Three common metrics are return on advertising spend (ROAS), payback period, and internal rate of return (IRR).
Use ROAS for advertising and marketing campaigns
ROAS looks at advertising performance. It compares the revenue generated by a campaign with the amount spent on ads. The limit of ROAS is that it does not show profit unless you take additional factors into account.
Use payback period to assess cash flow risks
Small businesses with limited cash reserves may use this method to learn how fast they can get their money back. For example, if a $10,000 equipment purchase saves $2,500 a month, then the payback period is four months. You can evaluate other factors to understand how shorter or longer periods affect risk.
Use IRR for larger or longer-term investments
IRR is more complex than ROI but helps you compare projects with different costs or timelines. Owners often use this method to analyze major decisions, such as opening a second location or buying property.
In addition, IRR may be more useful for startups and fast-growing businesses that expect returns over several years. For example, founders preparing for investment rounds need to show more than a simple, one-year ROI. Investors want to know how funds will impact valuation and future returns.
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