You're an entrepreneur and have put time, money, and effort into your business. You want a good return on investment for all your work. Who wouldn't? But knowing your ROI isn't as straightforward as you might think.
The reason isn't some inherent difficulty with the basic ROI formula. It's a straightforward calculation. But even when you're talking about large companies, determining value can be tricky. When you have multiple ways of determining value, understanding which one to use can be a challenge.
The ROI formula
The basic idea of ROI is to express the additional money or value you have received -- the benefit or return you gained -- as a percentage of your initial investment. Here's the formula:
(Return/Initial Investment) x 100 = ROI
You multiple by 100 to convert the ratio into a percentage. So far, so good. As an example, you purchase a small business for $200,000. Through hard work, you build the business and sell it for $300,000. The return is the final sale price of $300,000 less your purchase price, the investment, of $200,000.
You've gained $100,000 in value. Divide that return by the investment and you get 0.50. Multiple that by 100 and your ROI was 50 percent.
Things get more complicated
That was a simple example. But chances are you've had to invest more in the business, reinvesting profits to grow it. That amount has to be considered part of the investment. If you put $20,000 of profits into the business, your investment is now $220,000, because the profits from the business you own is your money.
Now the return is $300,000 less the total investment of $220,000, or $80,000. Divide that by the $220,000 and then multiple by 100 and you get an ROI of just over 36 percent.
Here's another twist. The initial investment is still $200,000. You still put $20,000 of profit back into the business and eventually sell it for $300,000. But there was an additional $50,000 in profit that you took out of the business at the same time. So, the return has become $80,000 plus $50,000 for a total of $130,000. Your ROI has become 59 percent.
This is still a simple example. You'd likely have paid professionals like lawyers and accountants to help with the transaction. That would be considered part of the initial investment. Perhaps you took out a loan to make the purchase. Loan payments might come from the company, but it's still your investment, both the principal (the amount borrowed) and the interest you owe on the principal.
Bring time into the equation
Up until now, we've treated the purchase, sale, and profit extraction of the business as something happening virtually instantaneously. However, that isn't the case. You'll have owned the business for a period of time and the return spread out.
Using the last variation, with the $50,000 in profit, the total investment of $220,000, and the sale price of $300,000, add in a period of five years over which you own the business. The 59 percent ROI becomes 11.8 percent return a year.
Consider the time over which you invest as another way to look at the return. You could buy one of two businesses. When you sell one of them, you'd see a 59 percent ROI after 5 years. The other will only give you a 40 percent ROI, but that will come after two years, when you sell that business.
The first business seems to offer more, but it takes longer to do so, with an 11.8 percent a year return. The other company gives you 20 percent per year ROI. You won't make as much in total, but the higher annual amount lets you obtain your return more quickly so you can reinvest it. Depending on your circumstances and inclinations (like the amount of risk you're willing to take), one deal or the other might make more sense.
Time value of money
You can more directly comparison between two such opportunities with the concept of net present value, or NPV. It's a way of acknowledging that if you're getting a return on your money in general, an amount in the future grew from a smaller amount today. The higher future amount has enjoyed the chance to grow in value over time.
Another convenient ROI formula for small businesses
If you've been in business for a while, it might be tough to pull together all the numbers to calculate an ROI based on initial and ongoing investments. There's another way to get to a number that you can more easily update.
Working with your accountant, look at your company's balance sheet. Add long-term debt and owner's equity together from the liabilities half of the sheet. This shows the combination of the portion of company value that is yours and the value borrowed in the long term.
Together they are the equivalent of what you current have invested -- your money in the company and that which is borrowed. Divide the company's after-tax income, taken from the income statement, for the year by the combination of equity and debt you obtained above.
The advantage of this approach is that you can get the current value at any time by pulling a recent copy of your financials.