Emotions play a big part in many small businesses. And that’s often for good reason: a passion for whatever it is that the business makes or does, a commitment to the industry sector, or a happy way of working.
But business owners can sometimes allow their emotional investment in the organisation to cloud their financial judgement.
It’s a useful exercise to weigh up your business as just another investment that needs to make a return on your capital. If your capital wasn’t in the business it could be invested elsewhere.
So how do you work out what rate of return on capital is appropriate for your business?
Known as the Capital Asset Pricing Model, you start with the premise of a ‘risk-free rate’.
Generally you take a 10-year government bond rate (currently about 3.5 per cent) as a surrogate for a risk-free rate.
So, if you’d say your business is more risky than a risk-free rate, you’d need to achieve a rate of return higher than 3.5 per cent.
Then, if you were to invest in a broad portfolio of publicly-traded blue chip stocks, you could expect a return of between 6-8 per cent above the risk-free rate, which would be about 10-10.5 per cent (assuming a risk-free rate of 3.5 per cent and an average portfolio return of 7 per cent).
The rate of return of an owner of one business in one industry in one city, that’s not publicly traded, should be significantly higher than that so you’ll need to calculate how much more risky your business is compared with a broad portfolio of blue chip stocks.
While there are endless measurements and calculations that can be made, it’s not necessary to get “too pedantic”.
Let’s pick a figure that’s the appropriate benchmark for your business. Say it’s 20 per cent. So if you’re actually getting 2 per cent, you know you’ve got something to really focus on.
The calculation is a better measurement of the value of the business to owners.
Most business owners can tell you the dollar profit they’ve made. Often they’ll say: ‘That’s a 10 per cent return’, and when you quiz them further and ask 10 per cent on what? They’ll say, ‘On my sales’.
So they might have had sales of $10 million at a profit of $1 million and think they’ve got a 10 per cent return. Well, they’re just looking at one part of the equation – the profit and loss – not the balance sheet.
Every business is fundamentally the same. It’s a pot of money made up of equity funding (your own money you’ve invested) and debt funding (money you have borrowed from the bank, bank overdraft, lease equipment etc).
Then you give your customers credit terms (accounts receivable/debtors), you invariably have stock you invest that money in (you’ll get credit terms from your suppliers, so you’ve got to take off creditors); you may have some plant and equipment that you need; and you may have bought some good will. That’s your pot of money.
What you need to be measuring your profit against is that pot of money, not your sales. You don’t say I made $1 million in profit and $10 million in sales therefore it’s 10 per cent. That’s the wrong thing to look at.
Some of our clients are achieving a return on capital of as much as 90 per cent.
When a business owner understands the concept of the pot of money and they can see that if they reduce the size of their pot – in other words the amount of capital invested in the business – and keep their profit the same, then the return on their capital goes up.
In other words…
- Sales and profits are two important business measurements but knowing the return on your capital gives you a better idea of how you’re faring
- Understand how to measure the value of your investment in your business
- Set a benchmark to guide your future actions