Starting your own business can be a bit overwhelming at first, considering all the factors you have to take into account, such as coming up with a good product, finding the right market and, last but not least, finding the investors to help you kick it off. However, as long as you are confident in your vision and strengths, finding the path to success may prove to be difficult, but not impossible.
Since business it all about making it all worth it, an important step in creating your plan is understanding how to calculate your return on investment (ROI), because this is directly tied to your profit and, ultimately, to your success.
What is ROI and Why Should You Care?
The return on investment, or ROI, is often mistaken for the profit because both terms refer to a very similar thing. Their similarity is justified because the ROI is in fact a variation of the net profit, the only difference being the fact that the net profit is the sum of money generated by an investment, expressed as a figure, while the ROI is the sum of money generated by an investment, expressed as a percentage.
Out of all the business metrics, ROI is definitely one of the most important, as it is a very clear indicator whether an investment will be profitable or not. This metric is considered a vital factor by investors when it comes to making the final decision regarding an investment, so getting the ROI right can literally make or break your business.
To get a better idea on how ROI is different from profit, let’s compare two investment scenarios and have a look at the profit and ROI of each: an investment of $100,000 that led to a gross profit of $150,000 and an investment of $10,000,000 that led to a gross profit of $15,000,000. In the first scenario the net profit is $50,000, whereas in the second one the net profit is $5,000,000. Which investment would you say was most profitable? The answer is simple: they were equally profitable, despite the big difference in the amounts. Let’s see why.
ROI is calculated using a very simple formula:
ROI = [(gross profit – investment) / investment] x 100
Using the same two scenarios presented earlier, we can easily calculate the ROI for each, as follows:
[(150,000 – 100,000) / 100,000] x 100 and [(15,000,000 – 10,000,000) / 10,000,000] x 100
Surprisingly (or not), the result is 50 in both cases, meaning that both scenarios had a return of investment of 50%. Now, assuming you were to put the figures from both scenarios into accounting, wouldn’t it be way easier to work with a percentage rather than actual values, considering the significant differences between them?
Considerations When Calculating ROI
Perhaps one of the most interesting things about the ROI formula is that it does not contain a timeframe. Although this might seem like a minor detail, it is actually quite an important aspect that can instantly turn the balance all the way around. Imagine an investment opportunity that has a return on investment of 15% – not bad, right? Well, it may not be bad if that return on investment occurs in a decent timeframe, but what if it only happens in 50 years? Your investors might not be too happy about it…
To avoid running into such scenario, consider calculating the ROI at a monthly or yearly level and, to get an even better control over it, check out this course that goes deeper into topics like lean financial models, metrics and investors.
Another aspect to keep in mind is that the ROI can change along the way. The best example to illustrate this scenario is investing in real estate – you calculate your ROI based on the initial purchase price of the property and the price you hope to sell the property for, but various other profits and expenses may arise along the way. You may want to rent the property, in which case you will obtain some extra profit, but you may also end up having to renovate the property or pay some unforeseen taxes – all these things affect the ROI, so if you want to keep it accurate, you will have to recalculate it every time you deal with an expense or an income. Real estate can be an attractive field, but if you don’t play your cards right, you might come out on a negative balance. Prevent that by learning how to buy or invest in real estate.
Last but not least, ROI is a metric that is based on a hypothetical situation. It may sound harsh but you have no guarantee that, even if you are doing everything according to your plan, you will actually generate the expected gross profit. Some people suggest that you can base your ROI calculations on past performance of similar investments, but you only have to look as far as the stock market to understand that something that is worth a fortune one day can be worthless the next.
Take the Leap
By this point you should be aware of the risks involved with starting your own business. You should know that you need a good plan, a good idea and maybe even a dose of luck. You should also know how to calculate your ROI and determine whether you will be successful or not.
If there is any piece of information you still need, you’re most likely to find it in this course on how to start a business.