Evaluating investment risk is simplified using the “Double Your Money” method, which focuses on the time required to generate sufficient sales to recoup the investment and achieve desired returns.
Primary Implication
How many years it takes to double your money from your investments in your business is a function of the size of the investment and your ability to earn targeted profit returns from your sales.
Waste money by overspending to convert sales into profits, and you will increase the time it takes to generate a return, no matter the investment size. This is why the Business CPR™ Management System is foundational to positioning you to earn the profits on your sales to produce an acceptable return on your business investments.
Overview
Most small business investments aim to double the owner’s money. Because of the scarcity of money to invest, a typical small business owner won’t get many shots at hitting a business-changing investment that would be considered a “home run.”
Once personal money or debt financing is committed to a large asset purchase, it’s committed. It is like trying to hit a home run with only one pitch. Small businesses will not likely have the cash to make a second large purchase until they have repaid through returns earned to cover an investment already made. No matter how confident a small business owner is that a significant investment will generate more profits than it costs, it will always be a risk until the profits materialize.
The problem with calculating the probable risk of an investment using either the Required or Internal Rate of Return (IRR) is neither calculation uses readily available information produced by your financial statements. For example, the IRR formula uses discount rates to make the Net Present Value (NPV) of all cash flows equal to zero. The problem with this complicated math is the need to know the beta coefficient, cash inflows, discount rate, initial cash outflow, and years involved. This is why financial experts advise you use the prebuilt Excel formulas to do this math. The problem is calculating IRR is its over reliance on assumptions.
Use the “Double Your Money” method to help you better determine if the proposed investment is worth the risk. For example, you want to double your money on a planned new piece of equipment in five years. To calculate what the rate of return should be on that investment, divide 100% by five to get an approximate Rate of Return of 15% ((1/5) x 0.75) where 5 is the number of years, and 0.75 is the “double your money rule of thumb” estimate of the investment value.
Below are the most common Rate of Return approximations you will ever need to perform the “double your money” risk component of a planned investment quick calculation:
1 Year = 100% IRR
2 Years = ~40% IRR
3 Years = ~25% IRR
4 Years = ~20% IRR
5 Years = ~15% IRR
Confirming how much you have to sell to return your investment is more straightforward when cross-checked against the required rate Double Your Money rule of thumb. The above example shows that you will meet the required return in three years or less by generating $400,000 in new sales on the equipment purchase of $100,000. If new sales take four or more years to generate $400,000 the planned $100,000 piece of equipment is not the best investment for you to make.
Laying the sales value of an investment required to hit your profit goal with the “Double Your Money” using a Required Rate of Return approximation, such as your profit return target as a percent of Net Sales, helps you see what an investment has to sell to earn you a planned return. Using this method to help you make a go/no go investment decision is driven by how fast you think you can generate the sales needed to repay the investment. Not on market forces assumptions that require higher math.
An alternative method for determining the risk of an investment for a small business is to convert the cost of the investment into sales required to earn the investment back is the New Investment Validation Calculation.
The worst thing you can do for your business is to trade a dollar for four quarters or less. You avoid doing this by using the New Investment Validation Calculation to make smarter decisions in your business.
Say an investment costs $100,000, and you want a 25% return on that investment. I.e., you have a goal of earning 25% in Net Income in your business. The sales value of that investment is $400,000 (100,000/.25=400,000). This means you will need to generate $400,000 in sales to return your $100,000 investment. The better question is, how long will it take to generate the $400,000 in sales? It is a better question than applying a discount rate to cash inflows and outflows.
The bottom line on investment decisions is about time—how long will it take to earn a return on your investment? This time question is always driven by how fast you can generate the required sales tied to the investment through your business. Failure to generate the new sales the investment promises to generate will never earn the required return, no matter what calculation you use to gauge the risk of the investment.