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How Do You Know if You're Good?

One of the most effective ways of assessing financial performance and making good decisions is by determining your return on investment, or ROI. A good understanding of the ROI will help you go a long way in making the right choices in business and in life. Here’s what it is, and how you can benefit from knowing how to figure it out.

The ROI is a financial formula used to determine, as its name would imply, the return on a given investment. In other words, it is used to calculate how profitable one particular investment choice is compared to other possible investment choices. Here is the formula:

ROI = (Gain from Investment – Cost of Investment) / Cost of Investment

Here’s a simple example of how this formula is used. Suppose you’re faced with a decision on whether to invest in ‘Decision A – Buy New Equipment’ or ‘Decision B – Upgrade Old Equipment’, and you have already determined your cost-benefit analysis that the potential gains and costs of each decision.

Suppose that the potential gain from Decision A – Buy New Equipment is $10,000 and the cost of the new purchase is $2,500. The ROI in this simplified example would then be: ($10,000-2,500)/2,500, or 3.0.

Now suppose that in the alternative decision, Decision B – Upgrade Existing Equipment, the anticipated gain from the decision is $8,000 and the cost of the upgrade is $1,500, the ROI of this alternative decision would be: $6,500/1,500, or 4.33. The decision to upgrade the existing equipment yields an ROI significantly higher (44%) than the decision to purchase new equipment, thus the upgrade decision would be the choice to make.

If you’re not comparing two or more decisions, but only looking for whether or not to make one particular decision, the ROI formula would indicate that it’s wise to proceed only if the ROI is greater than zero. But this makes sense, since you’d never want to invest in something which costs more than it yields, would you?

If you’re new to understanding financial performance formulas, you might want to begin by reading a quick primer on financial ratios.

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