Sarah Mae Ives Mentor & Facebook Ads Strategist founder Sarah Mae Ives says “when creating a new business, it all comes down to return on investment (ROI) when defining whether the effort is worthwhile. “Sure it can be exciting to put together something new and plan to make your impact on the world; you also need to justify the investment.”
It’s usually a safe bet that someone isn’t building a new business only for fun and is unconcerned about making their money back.
What is ROI?
ROI is a way to measure the performance of a business or investment by evaluating its profitability or efficiency. The goal is to directly measure the return on the particular investment relative to its cost. Once calculated, the ROI can be used to compare the investment against others to deduce if it is worthwhile.
How is ROI Calculated?
ROI is a straightforward calculation. Take the expected return of the investment and divide it by the investment’s cost and express it as a percentage or ROI% = Net income / Cost of Investment x 100
If your new business is expected to make net profits of $60,000/yr and your initial expense to start the company is $200,000, the calculation will be $60,000 / $200,000 x 100 = 30%.
Should you have a second business option that costs $300,000 to start and nets $110,000 a year, the equation is $110,000 / $300,000 x 100 = 36.6%.
Now you can compare the two. If you can invest the other $100,000 to start the second business, you should choose it over the first option.
If it looks to you like the extra $100,000 investment is only giving you an additional 6.66% return, that’s a misinterpretation. It’s resulting in a 36.666% return across the entire $300,000 invested. Investing that extra $100,000 has increased your total returns by almost 55%.
But Wait, There’s More
“ROI isn’t just a measure for evaluating all investments,” says Sarah Mae Ives. “This means that calculating the ROI of the business you’re about to create will also tell you how it performs against other alternatives, like buying stocks.”
Based on the greater risk associated with starting your own business, it needs to provide a higher ROI than if you just put your money in the market and did nothing else.
An 8% annual return is typically considered suitable for stock market investments, and 10.5% is an excellent return for stock market investments.
Investing in a small business dictates that your return is higher than a passive, lower-risk investment in the stock market. Experts typically advise that you want a 15-30% small business return to make it worth your time.
If you calculate your potential ROI and it’s hitting that sweet spot, it’s worthwhile.
Does ROI Reflect Your Time and Effort?
Most likely, you are planning on making a living from your business, which means you must pay yourself. Your pay is a business expense, just like any other employee pay, meaning ROI doesn’t represent your invested time and work. ROI is the profit after all expenses are deducted.
Well, sort of. Were you to sell the business; the prospective buyer would more than likely consider your income as part of the business value rather than an expense. If the business is making that theoretical $110,000/yr and you’re paying yourself an additional $50,000/yr, a prospective buyer would probably view the yearly profit as $160,000/yr.
Additionally, that ROI may be a return on investment, but that return will eventually show as your income unless reinvested in the business.
Owners tend to put in more work than they pay themselves for. It’s a lot of work to own a business, so the ROI does have your commitment to the business hidden within it. After all, the company wouldn’t be returning that ROI if it wasn’t for your efforts.
Does ROI Have Some Disadvantages?
While it is the best way to compare a business investment against other potential investments, ROI has a few disadvantages, just like any measurement of success.
Risk requires a higher return on investment, and that’s why very safe investments like high-quality bonds return much lower percentages on the investment. ROI does not adjust for the risk of the business as it is simply representative of yearly profits against the investment.
ROI can also be an exaggerated number. If your calculations omit certain expected costs that you’ve missed, your ROI will be too high and not an accurate representation against which to measure investments.
Lastly, ROI does not take into account how long you hold the investment or the passage of time, which can cost you the opportunity of investing elsewhere that might provide a better return. ROI is a measurement at certain points, whether yearly or overall, from the start of the business until it is sold, and those measurements don’t chart what happens between measurement periods.
It’s Still the Best Way to Evaluate Business Prospects
You’re planning your new business, the budget is in place, and the yearly net profit looks solid. The ROI is calculated; you compare it against other potential investments and see you’re handily outperforming them. That’s the single best indicator you should go for it and start the company.
Properly measured, ROI tells you if you’re about to realize your dream and make the best choice. It’s an essential valuation when creating a business.
About Sarah Mae Ives
Sarah Mae Ives is an entrepreneur and social media ads expert who created her agency, Sarah Mae Ives Social Media Inc. in 2016 to help strategize ad campaigns and social media for multi-million-dollar business launches. She has grown her agency to tens of thousands in ad spend each month.
She studied sociocultural anthropology at Western University in London, Ontario before continuing her education at Carleton University, where she received her MA in sociology and anthropology in 2006. In the same year, Ives received a creative writing certificate from Humber College.