An investment made in your business that generates an acceptable Rate of Return (RRR) on the sales it generates reduces both the cash pressure and risk exposure on the business.
For example, a significant investment in a business that doesn’t generate the planned sales increases will always result in greater cash pressure, risk exposure, and stress on ownership to generate higher profits to recover from the failed investment. This is why gauging a business investment’s risk before it is incurred is critical to your peace of mind and cash conversion into profits from sales.
Primary Implication
Overview
Is Your Investment Worth the Risk? Use the Required Rate of Return to Know
When considering an investment, you need to know if it’s worth the risk. This is where the Required Rate of Return (RRR) comes in. It’s the minimum profit you’d accept to make the investment worthwhile. Think of it as your “hurdle rate” – the return needs to jump over this hurdle to be considered.
There’s also the Internal Rate of Return (IRR), which estimates the actual profit the investment might generate. Both RRR and IRR help you assess if an investment makes financial sense.
Why Investors are Cautious
Most investors aim for an average annual return of 10% on long-term stock market investments. But stocks come with risks, even if they seem less risky due to many investors participating.
Small businesses often face an uphill battle attracting investors because significant returns can take years. This is why many small business owners rely on personal savings or loans to get started.
The Value of RRR for Small Business Owners
Calculating RRR is crucial for small businesses making major investments. It helps weigh one investment against another or compare it to your minimum desired return.
Think of it like this: when you invest in a big purchase, you’re committing your resources, like firing a rifle with only one bullet. You might not have the funds for another major purchase until the first one pays off.
An Easier Alternative to Calculating the RRR
Calculating RRR and IRR can be complex. They involve factors like discount rates, net present value, and more. But there’s a simpler way for small businesses to assess risk:
- Convert the investment cost into needed sales: If an investment costs $100,000 and you want a 25% return, you’ll need $400,000 in sales to recoup your investment ($100,000 / 0. 25 = $400,000).
- Estimate the time to reach those sales: Use the “double your money” rule to gauge how long it might take. For example, if you want to double your money in 5 years, aim for an approximate IRR of 15%.
Here’s a quick guide:
- 1 year = 100% IRR
- 2 years = ~40% IRR
- 3 years = ~25% IRR
- 4 years = ~20% IRR
- 5 years = ~15% IRR
Combining the sales needed with this “double your money” estimate allows you to make quicker, more informed investment decisions.
The Bottom Line
Ultimately, the key question is: how long will it take to earn back your investment? This depends on how quickly your small business can generate sales. No fancy calculation can replace a realistic assessment of your sales potential.