Understanding ROI for small businesses

What is Return on Investment (ROI)?

ROI is a financial ratio measuring the income generated by an investment. It’s a common business calculation that helps you decide things like:

• whether to open a new location or buy new assets
• the success of a marketing campaign or project
• whether ordering from a different vendor is cost effective
• whether to hire new staff

ROI measures the profitability of an investment relative to its cost, expressed as a percentage. ROI differs from rate of return (ROR) – ROR is calculated over a specific period, while an ROI calculation considers only the investment and the amount earned.

How to calculate ROI

To calculate ROI, you need to know the initial investment amount and the amount the investment generated. ROI equals the income generated divided by the initial cost.

The formula is simple: (Net Profit/Cost of investment) * 100%

In the formula, net profit is the total return from the investment minus the cost of the investment (the total amount spent on the investment).

Here’s an ROI calculation example:

A small kombucha company wants to know the ROI of a recent marketing strategy that involved an advertising campaign. To calculate ROI, the company first determines the value of kombucha sales generated from the campaign, then subtracts the costs to get the net profit, then divides that total by the campaign's overall spend.

Suppose the company spent R4,000 in one month on the advertisements and attributed R6,500 in extra sales that month to new customers who clicked on ads. The net profit is 6,500 – 4,000 = R2,500. The company divides the 2,500 by 4,000, meaning the ROI is 62.5 per cent.

Accounting software can help you calculate your ROI.

What is a good ROI?

There is no universal benchmark that measures ROI. Whether an ROI is good or bad depends on circumstances like:

• Your risk tolerance
• Alignment of the investment with company goals
• The potential long-term financial and non-financial benefits of an investment

What are the benefits of using ROI measurement?

ROI has many benefits for small businesses:

• Investors use ROI to decide whether to invest in a business.
• It’s easy to calculate and the results are easy to interpret. A positive ROI means the project or business segment was profitable; a negative ROI means you lost money.
• ROI can be used in various situations or investments, such as determining which tools work best and which products or services perform the best.

You can also use ROI analysis before making a particular investment to determine its viability.

What are the limitations of ROI?

While ROI is an important metric, it’s not the only one and doesn’t answer all questions.

• Many factors affect profitability – such as the cost of depreciation, investment timing, and finance costs – but the ROI formula fails to provide information on these factors.
• ROI doesn't account for the amount of time the money has been invested.
• Some types of investments have qualitative as well as quantitative returns, such as social media campaigns that improve a brand's reputation. These qualitative returns are critical to a business's long-term success, but ROI won't reflect them.

So take a balanced approach to ROI and consider it along with other factors such as risk, strategic alignment with your goals, and potential long-term returns (financial and non-financial).

ROI metrics for specific business activities

Marketing ROI

You can use ROI analysis to determine the effectiveness of marketing campaigns, channels, and tactics in improving ecommerce revenue. For example, you can use ROI analysis to determine the customer acquisition cost (CAC), return on ad spend, or conversion rate.

Sales ROI

ROI tracking can also help you increase sales by assessing sales strategies, promotions, and customer segments. You can use ROI to examine metrics such as sales growth rate, average order value (AOV), and customer lifetime value (CLTV). Our guide has tips for increasing sales.

Project ROI

Measuring ROI helps evaluate the financial viability of new projects. It uses metrics such as net present value (NPV) and internal rate of return (IRR).

Employee ROI

ROI also can help small businesses understand the effectiveness of hiring, training, and employee development initiatives. It works with metrics such as revenue per employee, employee turnover rate, and employee engagement.

Additional considerations for small businesses

Small businesses should consider several factors into consideration when considering investment returns.

Time frame

Suppose you compare two investments:

• A marketing campaign that took place over a year, and with a 25 per cent ROI
• An investment in new equipment that took place over two years, also with a 25 per cent ROI

An investment that earns 25 per cent in one year is very different from one that earns 25 per cent in two years. When deciding the appropriate time frame for measuring ROI, consider your business goals and think about calculating ROI over different time periods, such as monthly, quarterly, annually, and bi-annually.

Intangible benefits

ROI measures only the financial aspects of an investment – other business measures (like increased brand awareness, customer loyalty, and employee morale) are also important. Consider these along with ROI when evaluating the success of a project or strategy.

Risk vs reward

You might expect some investments to yield a high ROI, but they may also require more risk. Assess your company’s risk tolerance when considering whether to undertake investments to maximise ROI.

Common ways to improve your ROI

• Set clear goals and objectives for your business activities and investments.
• Track and measure your results regularly.
• Use accounting software, which will help provide the information you need to measure the effectiveness of your strategies.
• Use ROI to inform your decisions.
• Be willing to experiment and try new approaches.

FAQs on ROI

1. What's a good ROI for a small business?

There's no single answer – it depends on your industry, goals, and tolerance for risk. In general, aim for an ROI that exceeds your cost of capital, but be sure to benchmark against your industry averages. To find benchmarks for your industry, use websites like Statista or ask your financial advisor.

2. How long does it take to see a return on investment?

It depends on the investment type. For example, some marketing campaigns might show investment returns within weeks, while investments in new equipment or employee training might take months or even years to generate a positive ROI.

3. What if my ROI is negative?

A negative ROI means your investment cost more than it generated. Analysing

the reasons behind your negative ROI is essential. For example, was the investment poorly planned, were there external factors at play, or was it simply a bad decision? Use the information to improve your future investments.

Harness ROI for your business

Understanding ROI helps you evaluate the effects of decisions on your business’s profitability and make better decisions in the future. But you should also use other financial performance metrics to evaluate the business. ROI analysis, profitability analysis, and cash flow management are all critical for small business success.