"What's the ROI?" is the first question any investor asks and the last question many entrepreneurs can answer with precision. The concept seems straightforward — how much return do you get for the money you put in? — but calculating ROI for a new business is more nuanced than it appears, and getting it wrong can lead to costly decisions.
The basic ROI formula that most people know actually has significant limitations for evaluating new business investments. Understanding what it misses — and what metrics to use instead — is essential for making sound investment decisions.
The Basic ROI Formula (and Its Limitations)
Simple ROI = (Net Profit ÷ Total Investment) × 100If you invest $200,000 in a café and it generates $40,000 in annual net profit:
ROI = ($40,000 ÷ $200,000) × 100 = 20% per year
That looks good. But this simple calculation has three critical blind spots.
Blind Spot 1: It Ignores Time Value of Money
$40,000 earned in year five is worth less than $40,000 earned in year one. Simple ROI treats every dollar of future profit as equal to a dollar today, which overstates the true return.
Blind Spot 2: It Ignores the Timing of Cash Flows
A business might lose money for 18 months before turning profitable. Simple ROI uses total profit over total time, hiding the fact that you're bleeding cash for the first year and a half. The ramp-up period matters enormously for cash flow planning and risk assessment.
Blind Spot 3: It Doesn't Account for Risk
A 20% annual ROI on a stable, proven business is very different from a 20% annual ROI on an untested concept. Simple ROI doesn't adjust for the probability that the returns might not materialise.
The Metrics That Actually Matter
Professional investors and banks use three metrics that address these blind spots. Together, they give a complete picture of investment return.
Net Present Value (NPV)
NPV discounts all future cash flows back to today's value, accounting for the time value of money and risk. A positive NPV means the investment creates value; negative means it destroys value.
When to use: Every investment decision. NPV is the single most important metric because it directly measures whether an investment makes you wealthier or poorer in today's terms.Internal Rate of Return (IRR)
IRR is the annualised percentage return the investment generates, accounting for the timing of all cash flows. It answers: "What percentage return am I actually earning on this money?"
When to use: Comparing investments of different sizes and durations. A $100,000 investment with 25% IRR creates more value per dollar than a $500,000 investment with 12% IRR.Payback Period
How long until you recover your initial investment from cumulative cash flows.
When to use: Assessing time-based risk. A 2-year payback means your capital is at risk for 2 years; a 6-year payback means 6 years of exposure to market changes, competition, and economic shifts.How They Work Together
| Metric | What It Tells You | Limitation |
|---|---|---|
| Simple ROI | Quick ratio of profit to investment | Ignores timing, risk, and cash flow patterns |
| NPV | Total value created in today's dollars | Doesn't show percentage return |
| IRR | Annualised percentage return | Can be misleading for unusual cash flow patterns |
| Payback | Time to recover investment | Ignores returns after payback |
Use all three. If they all tell a positive story — positive NPV, IRR above your hurdle rate, payback within your tolerance — the investment merits serious consideration. If they diverge, investigate why.
ROI Calculation Examples by Business Type
Restaurant
- Investment: $300,000
- Year 1 net cash flow: -$20,000 (ramp-up losses)
- Year 2: $55,000
- Years 3–5: $80,000/year
The simple ROI of 17%/year slightly overstates the return because it doesn't account for the year-one losses. IRR of 17.8% is the more accurate figure.
SaaS Business
- Investment: $80,000 (development + 12 months' operating costs)
- Month 1–6: -$6,000/month (building customer base)
- Month 7–12: -$2,000/month (approaching break-even)
- Year 2: $48,000 net
- Year 3: $120,000 net
SaaS businesses with product-market fit can generate exceptional returns because the marginal cost of serving additional customers is near zero.
Hotel Development
- Investment: $12,000,000
- Year 1: -$200,000 (ramp-up)
- Year 2: $600,000
- Year 3: $1,200,000
- Years 4–10: $1,500,000/year
The simple ROI of 10.6%/year significantly understates the return because it doesn't account for the compounding effect and the heavy cash flows in later years. The IRR of 14.2% is more accurate and represents a solid return for a hotel investment.
Common ROI Mistakes
Forgetting opportunity cost: Your money could be earning returns elsewhere. If you can earn 8% in a diversified portfolio with minimal effort, your business investment needs to exceed 8% to be worthwhile — after accounting for your time, stress, and risk. Using gross profit instead of net: ROI must use net profit after all expenses, including owner's salary. If you're working 60 hours a week in the business and not accounting for the salary you should be paying yourself, you're overstating ROI. Ignoring the ramp-up period: Many ROI calculations use "stabilised year" profits, ignoring the months or years of losses that precede them. This dramatically overstates the true annualised return. Not discounting future cash flows: A business that takes 5 years to become profitable might show an attractive total ROI but a mediocre NPV once the time value of money is accounted for. Cherry-picking the timeframe: ROI over 10 years looks much better than ROI over 3 years for capital-intensive businesses. Make sure the timeframe reflects your actual investment horizon.The Bottom Line
Simple ROI is a useful screening tool, but it's not sufficient for serious investment decisions. NPV, IRR, and payback period provide the complete picture that investors and banks require — accounting for timing, risk, and the true cost of capital.
SimpleFeasibility calculates NPV, IRR, payback, and break-even automatically from real market data, with interactive What-If analysis to test how changes in revenue, costs, and timing affect your returns. Calculate Your Real ROI →Related Articles: