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What is return on investment?

Return on investment is the concept of investing some sort of resource, be it time, money or equipment that will at some point, yield a benefit to the investor. In business terms, it is one way of considering profits in relation to capital invested.

What is capital?

1. Capital can be time
2. Capital can be equipment
3. Capital mostly commonly is funding

What is profit?

1. Profit is not sales revenue
2. Sales less expenses = profit/loss
3. Assuming income is more than expenses = profit
4. Assuming income is lower than expenses = loss
5. The profit or loss represents a positive / negative Return on Investment

Why is return on investment important?

You need a positive Return on Investment to get access to more capital

Why you need capital

1. Capital is used to fund business activities
2. Capital is used to fund expansions
3. Capital is used to fund marketing
4. Capital is used to fund slow periods
5. Capital is required to remain solvent

Why you need profit

1. A loss represents a negative return
2. A profit represents a positive return
3. An investor will not give you funds if they do not receive a Return on Investment
4. You would not pay to work for someone (negative Return on Investment on human capital)
5. You would not expect someone to pay you to take their goods (negative Return on Investment on equipment)

How to calculate Return on Investment

There are two methods to calculating return on investment Method One

• Net Profit / Investment x 100 = Return on Investment (%)
• $100,000 Net Profit
• Over an Investment of $500,000
• Times 100
• Equals a Return on Investment of 20%

Method Two

• (Gain from investment – Cost of investment) / Cost of investment
• $600,000 gain ($100,000 profit + Capital return)
• Less $500,000 cost
• Divide $500,000 cost
• Equals a Return on Investment of 20%

How to review Return on Investment?

Reviewing your Return on Investment regularly is very important Example One

1. You spend $100,000 on marketing activities which results in $500,000 of sales of which you make a 25% net profit
2. The Return on Investment is not $500,000.
3. The Return on Investment is $125,000 (25% of $500,000)
4. This represents a Return on Investment on your $100,000 of 25% (1-($125,000 / $100,000))
5. This is a positive Return on Investment and therefore this was a worthwhile exercise

Example Two

1. You spend $50,000 on a consultant. The lessons learnt increase your sales by $75,000 of which you make a 25% net profit
2. The Return on Investment is not $75,000
3. The Return on Investment is $18,750 (25% of $75,000)
4. This represents a Return on Investment on your $50,000 of minus 62.5% (1-($18,750 / $50,000)
5. This represents a negative Return on Investment and therefore this was not a worthwhile exercise

How to improve your Return on Investment

There are two simple ways to dramatically improve your return on investment Method One – Improve Sales

Method Two – Reduce Expenses

Now combine an increase in sales and a reduction in expenses

The smallest changes in the mechanics can make the biggest difference to Return on Investment.