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Why is Return on Investment an essential measurement standard for businesses?

ROI is an essential measurement for businesses because it allows the business owner/ investor the opportunity to see how effectively the business is using its cash and equity resources. Experts at The Houston Chronicle point out that this important metric can be used by both small and large companies, since both types of companies generally have scarce financial resources, and small companies are more limited in what they may be able to do with their financial resources, since they lack the myriad financing options that large companies may access.

What is the main purpose of using ROI calculations or techniques?

The main purpose of using ROI calculations or techniques is to measure how much money is earned (profit) for every dollar of expenses. If a company is earning more than 0%, it is earning more money than it is spending. If the company is generating very high ROI, and increasing its ROI each month, quarter, or year, it is very efficient at deploying its capital.

How else do businesses use ROI in their decision-making process?

ROI enables the business to see what capital investment option might generate more returns for the business. In this way, businesses may make relatively safer, more profitable decisions. For example, a company may use ROI to analyze whether the company should hire sales people, with all of the inherent costs, or use an outside firm to generate sales, but give up a certain percentage of the income to cover the outsourcing expense. By accurately projecting or budgeting the expenses related to a direct sales activity, as compared with an outsourced sales activity, the company may make a proper financial-based decision.

What are some limitations to ROI analysis?

As with many metrics used by businesses to analyze their success, each metric does have its limitations. With ROI, especially forward-looking projections of possible returns, you must make accurate assumptions. When you want to use ROI accurately, you should be careful not to overstate the income generated by the idea, or understate the expenses re-

In the real world, can ROI analysis be used to analyze any investment decision?

No. In the real world of business, many activities cannot be modeled using ROI analysis. There is also nearly no practical way to control the many variables that influence a company's ultimate earnings, so it is not practical to use ROI analysis to see whether you should, for example, subsidize employee health club memberships, if doing so does not directly or greatly affect your company's earnings. It may be a great idea, and may be just what the company needs to do to retain or attract employees, but it would be difficult to analyze the return on this type of investment.

lated to the idea. Businesses also may not capture all sources of expense, or all future sources of income. Businesses also typically overstate the time frame needed to generate the return, and may understate the amount of time needed to actually implement the idea so that it may begin to generate a return, so it is prudent to estimate this time accurately. If your assumptions and numbers are accurate, you can see if the possible return justifies the investment. ROI calculations also do not take into consideration the risk inherent in the idea or investment. When a company considers several options, it may include a probabilistic factor for the assumptions, such as a 90% chance of hitting the revenue targets if the idea is implemented.

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