By Doug Sanzone, Veterans Business Outreach Specialist
Photo Courtesy of VBOC of the Dakotas
About the VBOC
The Veterans Business Outreach Center (VBOC) program is designed to provide entrepreneurial development services such as business training, counseling, and resource partner referrals to transitioning service members, veterans, National Guard and Reserve members, and military spouses interested in starting or growing a small business. U.S. Small Business Administration (SBA) has 22 organizations participating in this cooperative agreement and serving as VBOCs.
Return on investment, discounted cash flow, net present value, etc. The list can go on and on, all differing methods by which we determine whether to invest or not. This can seem a little bit intimidating, but it doesn’t have to be. The mathematics and accounting processes themselves have been the same for over 500 years.
First, a little history into the development of financial accounting to help put things into perspective. The first financial mathematics book is Leonardo Fibonacci’s “Liber Abaci.” In this book from the 11th century, Fibonacci introduces Hindu-Arabic mathematics to Europe. This new way of doing mathematics was not yet widely known. Then two things happened that changed the world of finance forever.
The invention of the printing press and Luca Pacioli’s book “Summa de Arithmetica,” which was the first book to describe double-entry bookkeeping using Fibonacci’s mathematics; currently still the backbone of all our financial calculations. The printing press allowed for the mass distribution of “Summa de Arithmetica.” Its codifying and comprehensive explanations led the Medicis in Florence to adopt these methods commercially, directly leading them to their legendary business dominance. From double-entry bookkeeping to probability theory and computing, the mathematical principles of the most vital features of finance are all present in the “Summa de Arithmetica.”
These two texts led to the development in Europe of many of the tools of financial capitalism we still use today. Some of the financial products created were share ownership of limited liability corporations, long-term loans, insurance, annuities, mutual funds, derivative securities, and deposit banking. All are based on the premises described in these texts.
The business of financial calculation goes back a long time. There were no computers or sophisticated quantitative models. There are basic rules and simple algorithms to follow to be able to glean the information needed to operate a business. Financial data is nothing for you to be afraid of. The needs of small business financial calculations are very straightforward. The calculations themselves are easy; however, finding and using the correct numbers to make your calculations may take some creativity.
However, you, the business owner, can now feel comfortable about this because the information that truly matters to a small business will be known by you, the owner and entrepreneur. Your financial accounting ability is not what you need to worry about. The domain knowledge about your business will lead you in the correct direction. It only takes a basic commonsense knowledge of finance.
Key Numbers to Know
What are the most important financial numbers to know about your business? It is so easy to get bogged down in the minutia of your financials. Look at the basics that you already know, income and expense. The numbers themselves are not the value, but how you use, perceive, and project the numbers.
Let us look at one of the most common financial measures and see how it can be a powerful tool in evaluating your business.
Return on investment (ROI), ROI = (Total Income – Total Cost / Total Cost) x 100, will give you a percentage return on your investment. This calculation has obvious limitations since ROI does not consider the time it takes to make your return. The key here is for the business owner to understand whether this time is important or not.
For most small businesses, for most small purchases it will not be. When making a more costly purchase or when buying an item or making an investment that will have a long-term lifetime; time will be especially important.
As the business owner you will need to ask yourself; do I have a way to get a better return on my capital than the benefit I will receive in making this investment? But before we move on there is another factor other than ROI that must be taken into consideration. We must consider the risk involved with the investment.
Every investment is different
It is important that before you make an investment you do a case study to determine your expected ROI. Use the intimate information that you know about your business. Remember different investments justify different returns. A rule of thumb of higher risk should equal a higher return is a good place to start but there is a myriad of types of investments you can make in your business.
Capital improvements, equipment purchases, leasing additional space, hiring new employees, starting a new division, etc., are just a few of the ways you can invest. No matter the investment you are potentially going to undertake, doing a case study of the investment is extremely useful. Like any estimate, a case study can only give you an idea of how things will turn out but just like the projections you made for your business plan before you started your business, these projections can be used as a guide as to whether an investment has the appropriate potential ROI for the risk you will assume.
A case study should contain the following items:
- Objectives: A clearly defined set of objectives and expected outcomes.
- Costs: Measure all costs associated with the investment. This will include both direct and indirect costs.
- Benefits: Quantify the benefits resulting from the investment. This will include not only increased revenue but items such as increased productivity, improved employee turnover, or other tangible or intangible benefits.
- Calculate ROI: ((total benefit – total cost) / total cost) x 100.
Once you have calculated your ROI, you can decide whether the investment is warranted depending on whether the expected return corresponds with the business’s overall risk appetite and if the risk-adjusted return is better than the alternatives.
Examining what you are currently spending on your business by calculating the ROI for each expense item as an exercise, will be immensely rewarding. Along with finding ways that you are misallocating your hard-earned dollars, you will find you can make improvements in areas throughout your organization.
None of this analysis takes anything other than the knowledge you already have about your business. A deep knowledge of accounting and financial degrees is not necessary to do this type of analysis. Do not hesitate to do your own analysis. Do not become intimidated by balance sheets, income statements, and tax forms. Those documents are why you have an accountant or financial professional as part of your team.
ROI provides a valuable means to assess individual facets of your business independently. In essence, it boils down to one question: am I receiving adequate value for my investment?
VBOC of the Dakotas
701-738-4850
und.edu/dakotasvboc
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4200 James Ray Dr Grand Forks, ND