What is return on investment?

Definition

Return on investment is the extra leftover an outlay produced, written as a percent of what you spent. On the books, this is a ratio read from extra profit and extra cost, not a ledger account you debit.

A florist uses it after a wedding-show booth to see the extra leftover against the booth's cost. The percent is the story; the dollars of leftover are only the first half of the math.

It is not a Balance Sheet line. The books already hold the spend and the extra leftover; this reading restates them as a rate.

Stay with the percent when you read it. A larger leftover can still be a weaker rate if the outlay was larger too.

Where it shows up

Balance sheet: Related to the asset or spend that produced it.

P&L: Related to the extra profit against the extra cost.

Cash flow: Related to whether that profit actually showed up as cash.

See also: Payback Period · Capital Budget · Net Present Value

When you look at your Income Statement, this percent is not its own printed account. You build it from the extra gross profit the outlay produced, then divide by what you spent.

When the percent is high, the extra leftover was large next to the outlay. When it is low or negative, the spend did not earn its keep in leftover, even if revenue rose.

The Balance Sheet does not print this rate. The booth cost, or any asset the spend created, sits there or has already gone through as marketing expense.

On the Statement of Cash Flows, paying for the booth and collecting the extra jobs are the cash events. This percent does not itself move cash.

How it works

Start with the extra leftover the outlay produced. The usual small-shop form subtracts the cost from that leftover, then divides by the cost.

Write the result as a percent. Extra leftover of $10,000 on a $4,000 booth is ($10,000 − $4,000) / $4,000, or 150 percent.

Build the percent in this order:

• Start with the extra leftover the outlay produced.
• Subtract the cost from that leftover, then divide by the cost.
• Write the result as a percent.
• Keep the same outlay and the same leftover window so the rate is about this spend.

Use the same outlay and the same leftover window. Mixing last year's booth cost with this year's leftover will not tell you this show's rate.

Stay with this rate when you read it. A dollar leftover that looks large can still be a weak percent if the spend was large.

Contribution margin on the extra jobs is often the leftover you want, because it leaves out rent that would have been there anyway. Net income can also be used, but it pulls in costs that did not move with the booth.

Do not treat a high percent as proof the cash is in the till. The extra leftover can sit in unpaid invoices while the booth was paid in cash.

A later year of leftover from the same spend is a new reading, not the first one restated. Name the window so anyone can see which leftover you used.

This page stays on leftover against cost. How long the extra cash takes to cover the outlay, and what later cash is worth today, are different questions.

Example

Stem & Petal, a florist, spends $4,000 on a wedding-show booth. The show brings $10,000 of extra gross profit from new events that would not have booked without the booth.

Subtract the $4,000 from the $10,000, then divide by $4,000. The rate is 150 percent.

If the same booth had brought only $4,000 of extra leftover, the rate would be zero. The spend paid for itself in leftover and no more.

If half of the extra leftover is still sitting in unpaid invoices, the Income Statement rate can still be 150 percent. The cash reading would be lower until those invoices clear.

The florist does not post a line that says this rate. The books post the booth as marketing expense and the extra sales and costs; the percent is the reading you calculate.

A second show at $6,000 of spend and $9,000 of extra leftover would be 50 percent. Dollars of leftover can look fine while the rate is weaker than the first booth.

Common mix-ups

This rate is not the same as the extra leftover in dollars. The leftover is the numerator story; this reading is leftover against cost.

This rate is not the same as how long the spend takes to come back in cash. That clock is payback period, a different question.

This rate is not the same as cash in the till. A 150 percent reading can sit in unpaid invoices while the booth was paid on the card.

Related terms

• Payback Period: How long it takes an investment to return its own cost in cash.
• Capital Budget: The plan for major asset purchases over a period.
• Net Present Value: The value today of an investment's expected future cash flows, net of its cost.
• Marketing Expense: The cost of advertising, campaigns, and demand generation.
• Return On Assets: Net income measured against total assets.
• Capital Expenditures: Spending to buy or improve long-lived assets.
• Sensitivity Analysis: Testing how much the outcome changes when one assumption moves.
• Contribution Margin: Revenue minus variable costs, showing what is left to cover fixed costs.