Written byReturn on investment (ROI) is the net gain from an asset or project expressed as a percentage of its cost, used to compare purchases and judge whether borrowing is worthwhile.
Also known as: ROI, return on investment, ROI calculation, return on capital
Key points
- ROI is net gain divided by cost, usually per year, so a machine, a vehicle and a campaign can be compared on one scale.
- When an asset's ROI is higher than the interest and fees on the finance that buys it, borrowing can add to profit.
- Lenders do not ask for ROI; they read cashflow and serviceability, but a clear ROI case shows how the asset will earn its repayments.
- ROI ignores timing and risk, so it belongs alongside payback period, total cost of ownership and the tax effects of depreciation.
How ROI is calculated
The basic formula is net gain divided by cost. A business that spends $100,000 on a machine that adds $25,000 of profit a year, after running costs, has a simple ROI of 25% a year. The useful version is stricter about both sides. Cost includes delivery, installation, training, insurance and the running costs the asset adds. Gain includes extra revenue, wages no longer paid to outsource the work, downtime avoided and, where relevant, what the asset will sell for at the end.
Two conventions matter when comparing figures. One is whether the return is before or after tax, since depreciation deductions change the after-tax figure and GST credits lower the cost for a registered business. The other is whether finance costs are inside the calculation or compared against it afterwards. Either is fine as long as the same convention is used for every option on the table.
ROI and the cost of finance
For a financed purchase the question is whether the asset earns more than the finance costs. If the machine above is bought on equipment finance, the yearly gain is compared with the yearly interest and fees, and the surplus is what the business keeps. When the gain covers the repayments with room to spare, the asset pays for itself from its own output and the owner's cash stays in the business as working capital.
This is also why the total interest and fees over the term matter more than the headline repayment. A balloon payment lowers repayments and can flatter the monthly figures without improving the ROI, because the cost is deferred rather than reduced.
Where ROI misleads
ROI is a single number, and it hides three things. It ignores timing: a project that returns its cost in year one and a project that returns it in year five can show the same ROI, which is why payback period and discounted measures such as net present value sit beside it. It ignores risk: a high return that depends on one customer is not the same as a modest return from steady work. And it ignores scale: a high percentage on a small outlay may add less to profit than a lower percentage on a large one.
Used with those limits in mind, ROI is still the quickest way to rank a shortlist of purchases and to decide whether finance is doing useful work or simply adding cost.
Example
A printing business in Shepparton is quoted on a digital press it would finance over five years. The owner adds up the jobs currently sent to a trade printer, the margin the business would keep by doing them in-house, and the casual wages saved on finishing work, then deducts consumables, service contracts and the extra power bill. The net yearly gain works out at close to a third of the purchase price. Set against the repayments on the five-year finance quote, interest and fees included, the press clears them with a margin left over, so the owner proceeds and keeps the cash reserve for materials.
Not to be confused with
- Yield
- yield measures the income an investment produces each year against its price, while ROI measures net gain, over the asset's life or per year, against cost
- Total cost of ownership (TCO)
- total cost of ownership adds up everything an asset costs over its life, which is the cost side of an ROI calculation
Frequently asked questions
What is a good ROI?
There is no universal figure. A return has to beat the cost of the money used to pay for it, whether that is interest on finance or the return the cash could earn elsewhere, with a margin for risk. Businesses often set their own hurdle rate and only proceed with purchases that clear it.
How is ROI different from payback period?
ROI expresses the net gain as a percentage of cost. Payback period is the time it takes for the gains to repay the cost. A purchase can have a strong ROI over ten years but a long payback period, which matters when cashflow is tight or the equipment could be obsolete before it pays off.
Does ROI include the cost of finance?
It can. Some calculations deduct interest and fees from the gain before working out the percentage; others compute ROI on the asset alone and then compare it with the cost of the finance. Both work if applied consistently. Stating which convention is used avoids a misleading comparison between options.
Do lenders look at ROI when assessing a business loan?
Not as a formal measure. Lenders assess capacity to repay from financial statements, bank statements and cashflow, and for larger deals may want a business case. A clear explanation of how the asset will earn its repayments helps a broker present the application, particularly for a start-up or a fast-growing business.
Related terms
Cash flow
Cash flow is the movement of money into and out of a business over a period; unlike profit, it tracks actual receipts and payments, so it measures liquidity.
Read definitionEquipment finance
Equipment finance is business finance used to buy or lease machinery, vehicles and other equipment, where the equipment itself secures the loan or is owned by the financier.
Read definitionTotal cost of ownership (TCO)
Total cost of ownership (TCO) is the full cost of buying, financing, running and disposing of an asset over a set period, not just its purchase price.
Read definitionDepreciation
Depreciation is the fall in an asset's value over time, spread across the years the asset is used so the cost can be claimed as a tax deduction.
Read definitionLease vs buy
Lease vs buy is the choice between paying to use an asset for a set term and owning it outright or with finance.
Read definitionCapital expenditure (CapEx)
Capital expenditure (CapEx) is money a business spends to buy or improve fixed assets such as buildings, plant and vehicles, rather than on day-to-day running costs.
Read definitionGo deeper
Sources
This article is general information only and is not financial advice.