Every entrepreneur gets into some venture believing that they can make some money out of it. But no matter what you are doing in order to start seeing some gains, you will need to invest something first. That could be a lump sum of money. Or plenty of your time, skills and efforts.
No matter what you put in, at some point you’ll expect to see a return on your investment. And that’s the concept we’ll tackle in this post.
What is ROI?
Here’s a quick recap in case you have forgotten. Return on investment (ROI) is a performance measure indicating how much money you are getting back on any particular investment, relative to the investment’s cost. Usually, ROI is calculated as a percentage number. In a nutshell, it’s a parameter you can use to gauge the value you are getting from any activity.
The process of calculating the generated value can be really straightforward. For example, you have invested $100 in an Instagram marketing campaign. And it brought your business 3 new customers, who spent $500 with you. Your ROI is clearly positive (aka you’ve earned more than you’ve spent) and it will be 500%.
Here’s how you can calculate return on investment yourself.
Your ROI Formula
Generated Value of Investment/Initial Investment x 100% = ROI
So that’s the formula we used to calculate ROI of that marketing campaign. Here’s another relatively straightforward ROI calculation example.
You have found a good online business for sale. The seller asked $50,000 for their e-commerce shop and you’ve paid it up. After several years of hard work, you’ve scaled that small shop into a more profitable venture generating twice more sales. But you are tired of running the ship, and decide to sell it off to another entrepreneur.
You’ve managed to negotiate a good deal and the buyer offers you $150,000. You sign off the papers and get the money into your account. Great job! So the ROI of your initial investment is:
Gained Value: ($150,000)/ initial investment ($50,000) x 100% = 300%
Not so shabby, eh? But wait, we are not really done with calculating the return of investment just yet.
Why ROI Calculations Can Get Complex
Chances are that you did not just spend $50,000 on your business. After you have moved past the break-even point, you’ve decided to take part of the yearly profit (e.g. $20,000) and reinvest it in business growth. You’ve signed on with a bigger warehousing facility, hired a marketing consultant and perhaps did a website redesign.
So when you factor in various spendings, the actual ROI from your business will be less – just around 214%.
During the course of buying, running and selling that business you have probably incurred some additional expenses. Perhaps you have hired a lawyer to liaise the sale terms. Maybe you took a loan to afford to buy that business in the first place and had to pay some interest rates. In any case, all of such spendings should be factored in as part of the original investment.
And here’s another majorly overlooked factor – time. Let’s expand our ROI example even further and imagine that you’ve had two businesses.
- One that you’ve purchased for $50,000, ran for 5 years and sold for $150,000
- The second one that you’ve built as a side hustle for 3 years from the ground up. You’ve spent $10,000 on it and now planning to sell your biz for $50,000
Business one may initially seem like a stronger money-maker. But when you add time to the equation (5 years), it’s no longer the case. So let’s compare the annual return of investment for both of these companies:
- Business 1: 60% ROI per year
- Business 2: 133% ROI per year
So yes, you are selling the second company for less. But it actually allowed you to make more money in a shorter period of time.
How to Calculate ROI If You Have Been in Business for a Long Time
Here’s another problematic area with the ROI formula referenced above: sometimes it’s really hard to estimate the initial and ongoing investments you’ve poured into your venture. Most standard ROI calculators are of little help here too. But there still should be some way, right? Yup. In fact, you have another way to calculate the return of investment from your small business. Here’s what you’ll need to do.
Have a sit down with your accountant (or put the accountant hat yourself) and scrutinize your company’s balance sheet. What you’ll want to capture is the following figures:
- Long-term debt
- Owner’s equity
Now add these two numbers together. The final figure will represent the combo of the company value that is yours plus the value borrowed in the long term. That’s a more accurate dollar equivalent of what you have invested in your biz.
Next, find your income statement, and jot down the company’s after-tax income. Note: it should be for the same year as the previous figures.
Finally, here’s your new ROI formula:
After-tax Income / (Long-term debt + Owner’s equity) x 100% = your annual ROI
The advantage of such an approach to calculating return on investment is that you can get a fresh number every time you need it. Plus, you do not actually need to seek a buyer to get a dollar figure of your business value.
But we are not fully done just a year. There are several other ROI numbers you’d likely want to know as a small business owner.
The ROI of Inventory Purchases
If you are running a product-based business (e.g. an e-commerce store that’s sourcing and supplying its own inventory, not dropshipping), then most of your cash can be tied up in the said inventory. And it can be both an asset and a liability.
Businesses who underestimate the cost of the inventory they have, usually have low inventory turnover ratio (= the products are no flying off the shelf) and are actually losing money. How much money are we speaking?
Well, that’s what GMROI can help you determine.
GMROI stands for Gross Margin Return on Inventory Investment and it’s a handy tool for gauging your inventory, sales, and profitability levels at the same time. In short, it helps you understand if you are earning a sufficient gross margin on your products, compared to the investment in inventory you had to make, so that you could generate those gross margin dollars in the first place.
GMROI Formula + Example
Gross margin return on investment figure tells if you are getting value (=profit) from your inventory investments. As long as it’s higher than 1, you are doing alright. Positive GMROI means that you are selling the merch for more than it costs.
Now let’s do a quick calculation. The GMROI formula is as follows:
$ Gross Margin / $ Average Inventory Cost = GMROI
Let’s quickly go through every term:
- Average inventory cost – usually it’s item price minus discounts plus freight and taxes. To calculate the average number, you’ll need to add the beginning cost inventory for each month plus the ending cost inventory for the last month divided by two.
- Gross margin – the difference between net sale of goods minus the cost of goods sold.
Now let’s illustrate this with a quick example. Awesome Hat Store buys $1,000 worth of inventory every month. And gets a profit of $8,000 in July.
So the GMROI calculation will go like this:
$8,000 / $1,000 = 8% GMROI
To get an even deeper level of insights you can also calculate the dollar equivalent of your GMROI. The formula is as follows:
Annual Sales/ (Avg Inventory Cost + % Gross Margin) = GMROI
So that hat business had a good year and got $50,000 in sales. Their average inventory cost was $18,000 and they increased their profit margin to 55%.
50,000 / (18,000 x 55%) = $5,5.
Now they are earning approximately $5.5 for every $1.00 invested in inventory. That’s not too great, but not shabby either.
Calculating GMROI for individual inventory categories can be an incredibly handy practice that will help you better manage your stock levels and prices. As the sample calculation showed the initial numbers may seem good, but a more detailed examination can show you that some of your products are not generating solid ROI.
Beyond the outline approaches to calculating ROI, you can also choose to assess the value of other actions within your business. For instance, you can (and absolutely should!) measure the ROI of any marketing activity you are engaging in. As well, be sure to keep an eye on the ROI of equipment investment. The numbers can clearly tell you whether you really need to buy that piece of machinery or can get better off with leasing it or perhaps even outsourcing the manufacturing to someone else.
Same goes for software. Will paying for a tool X, give you any benefits? These should not necessarily bear a dollar equivalent. After all saved time and sanity is priceless.
Finally, the least conventional approach to measuring business ROI is through social responsibility. That is trying to estimate how your business is making an impact on the local economy, locale and environment.
Now you have it, all the different ways of calculating return on investment for your small business.
Photo by Tuur Tisseghem