Simplifying Return On Investment
by: Jim Deyo
I recently had a discussion with a small business owner about an investment in a second location that he was considering. After going through his financials, which he had done a great job of putting together, I asked him what he thought his Return On Investment for the project should be. The answer I got to my question was in the form of another question – “what’s that?”
Small business owners have to deal with ROI questions a lot more often than they think and the concept doesn’t have to be as complicated as a financial analyst, or a CPA makes it sound. So, let’s define in simple terms what ROI really is.
Investment: The amount of money you have to spend to do something – anything, really, like buy a truck or a building, start a new product line, hire another employee, or even decide to spend your valuable time on some project. This investment can be cash that you have on hand, or money that you borrow.
Return: The income, or cash stream that you expect to receive over some reasonable, predefined time period, because you made the investment.
ROI: The average interest rate that you will earn over your predefined time period for trading the money you have today for the income you will earn in the future.
A Good Deal: The present value of the income you get in the future exceeds the investment you make today.
When you think about ROI, it’s important to remember that you have to equate the value of the investment you are making today with the value of the cash you will receive in the future. In other words, you have to think about the present value of those future cash flows, because they are not worth as much in the future as they would be if you had them today – if you had them today, you could invest them and earn interest. So, in ROI calculations, the discount rate is the assumed interest rate you will “earn” on those future cash receipts.
There are really just a couple of things about the Return On Investment concept that are important to keep in mind. First, it represents a very useful thought process that should be applied to a lot of the decisions small businesses have to make. Doing the calculations and knowing the numbers is not nearly as important as just thinking in terms of ROI. Investments are not always those big deals where we actually write a check. Sometimes they are as simple as how people are going to spend their time, or the additional income you might realize from selling more of your product or service. We have choices about what people do, how they spend their time, and what things we are going to emphasize; applying the ROI thought process makes it easier and more efficient to choose between the alternatives that you have.
Second, think for just a moment about what the discount rate, or the ROI calculation really means. Assume that you have $100,000 to invest and that you have three investment alternatives. You can invest the money in government bonds and get a “risk free” return of about 4%. If you prefer to invest the $100,000 in the stock market, you’re taking on more risk, so you need a higher return – maybe 8% to 10% to compensate you fairly. Now, what if you want to invest the money in buying, or starting your own company? If you can get 4% with no risk and 10% by going into the stock market, what return do you need to risk losing all of your $100,000 – maybe 15% to 20%? Every investor has a different tolerance for risk and will make different assumptions about what the investment potential might be. The point, though, is that some things are inherently riskier than others and you have to properly take that into consideration.
About The Author:
Jim Deyo is the President of Business Advisor Online, an internet based service that provides small businesses with the ideas they need to grow and the resources they require to make the right decisions. As a former Sr. Vice President with a major banking institution, Jim worked extensively with small and medium sized companies and has over 30 years experience in commercial and consumer lending, accounting, finance, marketing, and strategic planning. Visit the website at www.businessadvisoronline.com and sign up for a six week free trial of the service, or e-mail Jim at jimdeyo@businessadvisoronline.com.
March 2006
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