ROI Defined
A common method of determining if money should be invested into a business is determining its ROI. Calculating ROI is most useful when trying to decide where you should invest your money. You should also be familiar with the concept of ROI to understand what lenders and investors want when you are looking to use their funds.
ROI is not only useful to determine if you should invest in the startup of a business, but it will also be useful when the business is up and running. You can calculate a return on investment for money put into different types of advertising to find out which is most successful. You can also calculate the return on investment for hiring new employees to see if new employees will really make the business more profitable. There are many other ways to use ROI which will be discussed later on
The ROI FormulaFollowing is the ROI formula. It is okay if you don’t understand it at first; several examples will be given to show how you can calculate your ROI.
| ROI = | (Ending Cash – Investment) | x 100 |
| Investment |
When you enter this into a calculator, you type:
[Ending Cash] – [Investment] / [Investment] x 100 =
Here is an example of how to calculate your ROI:
Let’s say Barry loaned Jake $100. At the end of the month, Jake gave Barry $100 back plus $10 in interest. The Ending Cash is $110; the Investment is $100. So the formula looks like:
| ROI = | ($110 – $100) | x 100 |
| $100 |
In a calculator, Barry would enter:
110 – 100 / 100 x 100 =
This gives Barry a return of 10% for that month.
The ROI becomes very useful when comparing different options for investing money. For example, if Barry had put that $100 into a savings account at 2% per annum interest instead of loaning it to Jake, at the end of the month Barry would have $100.17. The formula would have looked like:
| ROI = | ($100.17 – $100) | x 100 |
| $100 |
In a calculator, Barry would enter:
100.17 – 100 / 100 x 100 =
If Barry had put the money in that savings account he would have made a return of 0.17% during that month. This is much less than the 10% he made by loaning the money to Jake.
When comparing different ROIs, it is important that the amount of time is the same. If Barry compared the money loaned to Jake for one month to the return he would have received from the savings account during one year he would have received a different answer.
Everybody uses ROI differently. A bank, for example, offers lower interest rates on loans secured by collateral (such as a house or other tangible assets) than they do on loans not secured by collateral. The reason banks charge more interest on unsecured loans is because of risk. If a borrower fails to payback a loan secured by a house, the bank can take the house and sell it in order to recuperate all or part of what the borrower still owes. If a borrower fails to payback a loan that is not secured with collateral, the bank may not get any of its money back. The bank requires a greater ROI when the risk is larger, so it charges higher interest rates.
A general rule-of-thumb is:
Low Risk = Low Return
High Risk = High Return
If there is a low risk that money invested will be lost, then the required ROI will be low. If there is a high risk that money invested will be lost, then the required ROI will be high.
It is important to think about ROI and how it will affect your decision, and the decision banks and investors will make if you seek financing through them. There are several questions a potential business owner should ask to determine if they should take the plunge and start a business:
- How much can the business make in a year?
- How much will it cost to start the business?
- What is the business’s ROI?
- What is the ROI if the same money was put in a savings account?
- What is the ROI if the same money was put in stocks?
- How much will I earn as an employee? Is it more or less than what the business will earn?
While it is important to determine where would be the most profitable place to put your money, there might be other issues that are more important to the business owner. For example, it might be worth it to a business owner to take a drop in pay if they value the greater control over their time that they would gain from owning a business instead of working as an employee.
Bank ROI
Banks generally lend to people and businesses that the bank considers to be a low risk. This means that most entrepreneurs with startups have a difficult time getting financing from banks.
Banks consider a loan to someone buying a house as a low risk because the bank can foreclose on the house if the loan is not paid back. Even then, banks try to lower the risk more by lending to people with good credit scores and a history of job security. If you approach a bank for financing, you will need to show the bank that your business is a low risk and that they are almost certain to get a return on their investment.
When a bank loans money to someone, the bank is investing in that person. As with all investments, the bank expects to get a return or to make money from the investment. Because banks loan to low risk investments, they require a lower return or a lower ROI.
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Investors ROI
Banks deal mainly with low risk loans that provide them with safe, but low returns. For this reason, banks are more likely to finance existing businesses that are less risky than startups.
Investors are much more likely to invest in startups and new businesses. However, because new businesses have a high risk of failing, investors look for higher returns on their investments. Investors want to put their money into businesses that are likely to be extremely profitable. Investors can put their money into bank accounts, stocks, or any number of places where they could make a decent return, so businesses need to show that they can provide a high enough ROI and low enough risk to convince investors to finance the new business.
Angel investors and venture capitalists are often of particular interest to entrepreneurs. These types of investors generally invest in startups (especially of new technology). They want businesses in which they invest to have an ROI of 1,000% (or ten times the amount they invest) within five years! The reason they want such a high return is because of the high risk.
Many startups fail and there is a high likelihood that investors will lose their money. If they invest in ten high risk companies most will fail or only provide a marginal return. However, if just one out of the ten companies provides the investor with a 1,000% ROI, the investments as a whole will at least have broken even and received the return that keeps the investor in business.