What is ROI and how is it calculated

Everyone talks about it, it’s one of the most important metrics of your business. We’re obviously talking about ROI (Return on Investment). The return on investment is surely one of the most significant KPI’s that a businessman must keep in mind when deciding which business activities to pursue and which to set aside.

However, the simple definition “return on investment” is not enough to explain what ROI really is and why it’s so important.

So let’s try to understand how the ROI is calculated and how you can use our tools to obtain the measure of your performance results much more quickly!

How is ROI calculated

In simple terms, ROI is the ratio between net income and investment. Defined as such, the return on investment is an essential parameter for indicating the profitability of the capital invested in a company, or in a production line, measuring the return obtained per each euro invested therein, whether it be equity capital or debt capital.

As for net income, it’s simply the difference between the revenues and the typical costs of a business project, without considering – therefore – other elements that are unrelated to the typical margin like financial expenses and taxes. The investment, instead, is the sum of the equity capital and third-party capital.

Let’s make an example!

Example of ROI calculation

Let’s imagine to have closed 2019 with a net income of 100.000 euros, and that the investment was equal to 600.000 euros for the same period. Using the formula for calculating the ROI illustrated before, we find that:

ROI = (100.000 / 600.000) * 100 = 16,67%

But what information can we obtain from this result?

Given that the ROI allows you to get an idea about the profitability of the investment you are making, and that, all other factors being equal, the higher the ROI the higher the efficiency of the investment, the first thing to do in order to assess whether the ROI is satisfactory or not is to compare the interest rates.

If the ROI is higher than the interest rates you would pay on a debt, it would make sense to contract debts in order to make business investments, since the returns would pay you back the costs needed to support them.

You can also evaluate the ROI of a production unit with respect to those of other units in case you should need to decide which products to keep and which ones to “thin down”, favoring those projects that can guarantee more satisfying returns.

ROI: what does it mean… and what not!

Unfortunately though, things aren’t as easy as they seem.

Firstly, it’s not always easy to keep a close eye on the income generated by an investment in a business or in a production line, because:

  • it’s often not simple to attribute the “merit” of a return to a specific channel / investment;
  • the purchases made by one’s customers are often the result of a long decision-making process, therefore not denoted┬áby an immediate response to a particular investment;
  • many products and services are bought recurrently by customers, hence, there are multiple returns for the same initial investment.

It’s also for this reason that the investment (that is, the denominator in the above-mentioned formula) is often calculated as the average of the last 2-3 business years, rather than as an exact value.

Anyways, notwithstanding these operational difficulties, the calculation of the ROI still remains one of the most important operations for measuring performance, that we recommend all entrepreneurs to strongly keep in mind.

How do we help you?

Our advice is to assess the evolution of the ROI together with the other KPI’s that are fundamental to your business and to your investments, like revenues, profits and margin. We will be dealing with a few of these topics in our next insight articles, so keep an eye on our blog to not miss out on them!

In the meantime, please keep in mind that on ZonWizard we have prepared daily updates of these indicators on the Dashboard that you can find in the Profit section. By the way, have you already taken a look at our live demo to see how it works?

Leave a Reply