Keep ROI and ROE top of mind when making decisions.
[dropcap cap=Y]ou may often hear the phrases “return on investment” and “return on equity” being used when the financial performance of a business is being analyzed. Like many people, you may wonder exactly what these terms are all about. Both are relevant when determining if you are getting a good return or profit from the money you have invested in your store. [/dropcap]
Every investment has an opportunity cost. If you make a decision to invest your money in one place, then you have to forego another opportunity someplace else. This is true of all things you spend your money on. Let’s assume you’re hungry and are deciding between buying french fries or a hamburger (you only have enough money for one or the other). By definition if you order the french fries you then can’t have the burger — the decision has cost you the opportunity to order the burger.
It is the same when you make an investment decision. If you have decided to buy or invest in a jewelry store then you have foregone the opportunity to invest that money elsewhere. When making the choice it is important to compare the investments and the best way to do this is to look at the ROI (return on investment) and the ROE (return on equity).
Let’s assume you are choosing between continuing to own or invest in your store, or putting your money somewhere else. (You may think that once you have made the decision to invest then the process has ended. However you should continually be looking at your store and asking, “Would my money be better utilized elsewhere?”)
To help decide, let’s first look at ROI. Return on investment is the percentage return you get from having your money in the business. It is the same measure as if you had put money in the bank. If the bank is paying you 3 percent interest on your funds, then your ROI is 3 percent — you will get $3 income for every $100 invested. When you evaluate the ROI for your business you are asking yourself the same question: How many dollars will you get back for every $100 you invest in your business?
Let’s say Bob could sell his business tomorrow for $500,000. He is earning $100,000 profit each year after paying himself a wage for working in the store (you should always deduct an amount for your physical labor before calculating the ROI). In Bob’s case his ROI is 20 percent ($100,000/$500,000) as he receives $20 for every $100 he has invested in the business.
What if Bob has only invested $250,000 of his own money in the business and the rest has been borrowed from the bank? The answer to this is his ROE (return on equity). If he has made $100,000 and only invested $250,000 of his own money then his ROE is 40 percent ($100,000/$250,000) as he receives $40 for every $100 of his own money invested. ROI measures the return on total funds invested in the business — ROE measures the return on the owner’s funds invested, commonly called equity.
On the face of it, Bob’s business investment looks to give a pretty good return — after all, it beats the 3 percent paid by the bank! Bear in mind however, there is a much greater risk involved in investing in a business than depositing the money in the bank (although events of the last two years might suggest otherwise!). Risk is the biggest factor in determining what return you should expect. The higher the risk, the higher the return you need to compensate. Bob’s business could be vulnerable to an economic downturn, a decision by authorities to start road repairs outside his store, a competitor opening nearby, or a host of other factors that could potentially wipe out his profit.
You should regularly review the ROI and ROE on your business to ensure it is giving you a suitable return on the money you have invested versus other alternatives. The risk has to reflect the reward, and if your reward isn’t high enough then it’s time to take action.