The old adage “You need to spend money to make money” may be good advice, but spending money needlessly will not necessarily deliver positive results for your small business. How you’re spending money, how much you’re spending, and what you are getting in return is critical to growing your business wisely. Success depends on keeping track of both expenses and profits on a continuous basis.
One of the most frequently used methods of measuring the profitability of a small business is calculating the return on investment (ROI). At its most basic, ROI is a financial ratio used to measure the benefit from an investment, or what you get back from every dollar you put in.
Although the concept behind ROI is fairly straightforward, there are several different ways to calculate it. Generally speaking, you can determine ROI by dividing your business’s net income for a defined period of time by its invested capital.
Specifically, you take the earnings generated by any investment, subtract the investment cost, then divide the result by the investment cost and multiply by 100 to get a percentage. For example, the ROI of buying stock shares for $250 and selling them for $300 is 20 percent. The formula looks like this: ROI = (Earnings – Cost)/Cost X 100.
Using ROI to Make Investment Decisions
While ROI is a common metric for gauging overall profitability, calculating bottom-line return is just one consideration. In fact, every business expense, including time, money, and resources, is an investment that has the potential to generate a return.
ROI can be used to help you make decisions about where and how to invest in growing your business, such as determining the effectiveness of your business planning, marketing strategy, or your pricing structure; the profitability of inventory; and the viability of equipment purchases. For example:
- Business planning: Your investment in business planning is the sum of the time invested by you and your team, plus the cost of any outside help you engaged to develop your plan. Because the business planning process sets goals, establishes responsibilities, and helps with focus and prioritization, the return on this investment can be measured by factors including decisions made, performance improved, increased accountability, and goals achieved.
- Marketing: Some marketing programs will have a high ROI, while others end up costing more than the money they generate. In fact, determining your profitability on intangible expenses like marketing and advertising can be challenging. Small businesses that use newspaper, radio, or television advertising as their primary marketing tools often find it difficult to measure effectiveness unless they are using an incentive to track response. However, the impact of Internet and social media campaigns can be calculated using tools such as Google Analytics, which tracks website traffic and conversion statistics on resulting purchases. Using the ROI formula can give you a clear picture of your marketing results.
- New employees: Expanding your team is typically one of the largest expenses for small business owners. Because every new employee has the ability to add value to your company, it’s also an investment that can generate significant returns. It is important to make sure the ROI is worthwhile before investing in hiring and training new staff.
- Equipment: Many small businesses need to purchase new equipment in order to grow. Whether you’re looking to upgrade your computer system or add to your fleet of trucks, chances are you’re looking at a sizeable investment. Calculating the potential ROI before you lay out the cash will help you gauge whether or not you’re making a wise decision that will support future profitability.
Managing Expenses to Manage Growth
Calculating profitability is a key measure of the success of your business, and examining your expenses is a critical part of the equation. Recording and reviewing your business expenses on a regular basis gives you a good idea of revenue earned against money spent. It allows you to pinpoint unnecessary expenditures and know when it’s time to cut costs. Ultimately, this helps small business owners plan for the future with more clarity and confidence.
Monitoring expenses can feel overwhelming, but there are steps you can take to simplify the process and help your business grow in both ROI and company size. For example, creating and maintaining a budget requires you to estimate what your expenses will be for the coming year and determine whether spending is in alignment with what you’ve allocated.
Implementing an automated expense system will reduce the time involved in tracking and reporting as well as help you increase spend insight. Programs like QuickBooks and Sage50 generate financial reports that make it easy to track your expenses on a weekly and monthly basis. You should personally monitor your company’s financial performance and keep track of transactions and revenues. This will allow you to instantly spot trends and problems and make the necessary adjustments to control costs.
No two companies are alike, and how you spend money is unique to your goals, business, and industry. However, every small business can benefit from tracking the ROI associated with every major expense. Doing so will help you prioritize where to spend now and determine how to invest wisely in the future.
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Summit Financial Resources specializes in working capital financing for small to medium-sized businesses that need increased cash flow. We provide working capital financing through invoice factoring, asset-based lending, inventory lending, and equipment financing.