If you plan to start and run a successful business, you must try to accurately predict the rate of return on your investment. This analysis must be done before you ever think about opening the doors. If done correctly, this calculation will show whether or not you will have enough money to stay in business long enough to get out of the red. Your return on investment will let you know if and when your business opportunity will make money and whether this venture is worth your energy, money, and time.
Return on investment (ROI)
Simply put, the ROI is a ratio of the money that has been added or subtracted (gained or lost) to the amount of money that initially funded the enterprise. Return on investment is typically calculated on an annual basis, centered around either the calendar or fiscal year.
There are many elements that make up your ROI, including (but not limited to) the following:
- Inventory expenses
- Production expenses
- Outside expenses
- Sales
- Cash flow
- Sources of financing
- Unexpected expenses
If you have several choices of business opportunities, you need to determine the return on investment for each one and compare them to each other in order to choose the one that is the best fit for you. For example, let’s say you can take a job that pays you $20,000 per year, but it will cost you $1,000 in travel expenses to commute for that year. If you plug in 45 hours per week as the amount of time this job will cost you (this includes your commute), your rate of return is not very high ($20,000-$1,000/45 x 52 = $8.52 per hour). You are working a lot of hours for a little bit of money.
If you were also offered a position that would pay you $200,000 per year, with $2,000 in travel expenses annually, and you have to work 48 hours per week, which scenario offers more money? The second one, of course ($200,000-$2,000/48 x 52 = $79.33 per hour). Even though you will spend twice as much to commute and it will cost you 156 more hours per year at work, your rate of return on your investment of work hours is more than 800 percent higher in the second scenario!)
ROI is simply a math calculation of what you put in compared to what you get back (or what it costs you). It is a way to compare how one investment will perform when held up to another. It is expressed as a percentage and is based on returns over a set time period, usually one year. In other words, your return on investment will equal the current value of your net benefits, or your gross benefits less any ongoing costs, over a period of time and then divided by your initial costs.
For example, a 25 percent annual ROI means that a $100 investment would return $25 in one year. After one year in business the total investment of $100 would become $125.
Calculating your ROI
There are three basic steps to figuring out your ROI.
- Write down the total investment you will make in your business. Include any fees and expenses you may have to pay during the year. For example, if you purchase a piece of property for your business that costs $10,000, plus a $1,000 attorney’s fee for the paperwork and title work and an additional $500 for miscellaneous costs such as the recording fee, your total investment would be $10,000 + $1,000 + $500,which would equal a total of$11,500.
- Determine your amount of profit or loss associated with your business investment. If you were to look one year later at the value of the property where you opened your business, would it have increased in value? Let’s say it did, increasing by $3,000. So after one year, the $10,000 property is now worth $13,000. After one year, although you spent $11,500, the additional value of your property means you profited by $1,500 ($13,000 property value – $11,500 initial costs and expenses).
- To find your ROI, divide the profit by the total investment. In this case, $1,500 would be divided by $11,500, and the ROI would have been a little more than 13 percent.
You can use ROI calculations to compare different investment opportunities. If you choose to do so, be sure all fees and expenses have been included so that you are making a fair comparison. Any ROI calculation you use that does not include such fees and expenses will result in misleading ROI estimate figures. While ROI tells you what percentage return you can expect to get in terms of a profit or loss over a specified period of time, it does not tell you anything about the magnitude of the project. So while a 124 percent return may seem initially attractive, would you rather have a 124 percent return on a $10,000 project or a 6o percent return on a $300,000 investment? Obviously, the latter scenario is better!
If you are starting from scratch with a new business, project your ROI using the best estimates you can develop based on your knowledge of the business you plan to start and the current demand for your product or service.
