Meet my buddy ROI. ROI should be your friend too. ROI compares the money you earn to the money you invested. Very few entrepreneurs spend much time thinking about ROI, but that is a big mistake. ROI is a jealous fellow, always comparing himself to other potential friends. Also known as Return on Investment, ROI helps you determine the best use of the money you have earned. Before you invest any money whether in stocks, real estate, bonds or business, you should have a target ROI.
As a business owner-operator, you need to pay yourself a competitive wage for your contribution to the business. ROI is calculated on the income or loss of the business after you pay yourself. When evaluating the potential return of a business you must consider your loss of employment to work in the new venture. Let’s say you make $100,000 a year salary as a purchasing supervisor. You want to own a produce brokerage. In calculating your ROI, you must first replace your salary. Selling commissions of $100,000 are inadequate because you must pay rent, phone, insurance and other expenses. Once you have earned your money and paid your expenses, the amount that remains is your profit. If your new business cost $200,000 to start or purchase and your profit is $10,000, then your ROI is $5% ($200,000/10,000). The question you must ask before investing is whether 5% is an adequate return for the money you risked. Is there a better alternative? Many entrepreneurs should ask the same question every year, because their return is so low.
Investing in conventional investments like stocks or bonds is calculated in like manner. ROI has a financial cousin in the real estate investment world, it’s called a Cap Rate, short for Capitalization Rate. When advertising a real estate investment, the broker will usually promote the Cap Rate or the operating income earned before income taxes and debt service are paid compared to the asking price for the property. Let’s say you buy an apartment building for $1,000,000. After rents are collected and expenses paid for a year, your operating income is $80,000 or 8%. The Cap rate is 8% or 8 for short. Remember the advertized Cap Rate is the ratio that an investor may earn based on the asking price, not the price the seller paid.
ROI and Cap Rates are simplistic comparisons that don’t consider income taxes or debt service costs. Other considerations for real estate and business investors are deferred maintenance and retained earnings. As a property ages, the cost of major repairs or modernization increases. An investor should consider these costs as additions to the purchase price before calculating the Cap Rate. Payment of said costs, reduces the income to the owner but they increase the marketability of the property, both to lease or sell. Similarly, a business owner may re-invest in the business, especially during periods of growth, by buying new trucks, and other capital equipment or funding inventory for increased sales. The increase in equity from one year to the next should be considered as an improvement to the owner’s financial condition and indicate an increase in business value.
As you consider these fickle friends, here’s a saying to remember, “You can pick your friends and you can pick your nose, but you can’t pick your friends nose or wipe your them on your pants.”