One of the most important decision-making tools for business owners and executives is the return-on-investment (ROI) calculation. Every dollar spent by a company should be intended to produce profit to ensure its continued existence. After all, the primary goal of business is to earn profit or return-on-investment.
To be clear, the primary goal of profit should not be confused with the entrepreneur’s motive or purpose for pursuing business ownership. Motive and purpose may drive the business owner forward when the going is tough, but it’s profit that sustains the entrepreneur’s vision and passion.
Profit allows the business owner to pull a salary to support their family and provide funds for further investment to realize their purpose. Profitability is of primary importance in a series of goals toward achievement of entrepreneurial vision and purpose.
How to Calculate Return-on-Investment
We’ll try to keep this simple as most business owners aren’t here for a math lesson but for usable advice. It’s the concept that’s important for business owners to make better financial decisions.
The formula for calculating ROI is relatively simple and straightforward.
ROI = (Net Profit/Total Investment) x 100
To demonstrate, if you invest $100,000 into inventory and later sell for $120,000, you’ve earned a $20,000 profit. The $20,000 profit divided by the original $100,000 investment produced an ROI of 20%.
Applying ROI to Business Financing
There are a multitude of reasons for arranging a business loan. You may:
- Require short-term working capital until a customer pays their invoice.
- Need to hire a key employee to streamline operations.
- Want to invest in a customer acquisition marketing campaign.
- Purchase or replace essential machinery and equipment.
- Want to invest in new business opportunities.
- Need to purchase seasonal inventory in bulk.
All these motives for obtaining business financing have calculable, or at least estimable, ROI implications.
For example, a shortage of working capital or cash can prevent a business owner from investing in current and future projects. If payroll isn’t met, employees may refuse to work. If key suppliers aren’t paid, current projects may stall.
For example, if a $200,000 project producing $40,000 in profit can’t be funded due to a lack of cash, then the company stands to forego a $40,000 profit. But if the owner arranges a $160,000 short-term commercial loan plus $10,000 interest to fund the project, the company will realize a lower profit of $30,000 due to extra interest expense.
The ROI for the loan is 17.6% = $30,000 profit/$170,000 loan and interest. In this example, a short-term commercial loan to fund the project produces a favorable return-on-investment.
The scenario above is simple illustration of calculating ROI on business loan investments, but the concept applies to the other examples listed.
- The ROI on borrowing to hire a key employee to streamline operations is the value of cost savings plus profit increases from increased revenue/total loan costs.
- The ROI on a customer acquisition campaign is the estimated profit from new customers/total loan costs.
- The ROI on the purchase of new equipment are the cost savings generated and/or profit increases from increased revenue/total loan costs.
- The ROI on the replacement of essential equipment is the loss of profit the equipment generated/total loan costs.
- The ROI for new business opportunities is the estimated future profit increase/total loan costs.
- The ROI on purchasing bulk inventory in time for a seasonal upswing is the potential profit lost if not purchased/total loan costs.
Return-on-Investment on Long-Term Business Loans
Most of the examples discussed are based on short-term business financing. They’re designed as a learning tool to signify the importance of estimating return-on-investment for all business investment decisions. Even if there isn’t time for an in-depth calculation, executives can quickly visualize estimated financial benefits versus loan costs.
Calculating the ROI for long-term commercial financing becomes more complicated. Fortunately, in our digitized world the web offers convenient tools to simplify the process. Save the following links to your phone for easy access in the office or in the field.
Calculator.net has a free:
Does Business Debt Reflect Bad Decision-Making?
We’re taught from childhood that borrowing money to pay back later is bad decision-making. That if we want something, we need to find ways to earn and save money. Even though as business owners we know that there’s more to the equation, childhood conditioning can trigger an uncomfortable perception that debt reflects bad decision-making.
It is bad decision-making if business loan proceeds do not produce a return greater than the cost of borrowing. Taking this road will lead to debt dependency and eventual insolvency.
But business owners who take a clear-headed approach to calculating a return-on-investment based on the costs of the loan will see greater growth and prosperity.