Small Business Talk Jason Arsenault, CPA

Small Business Talk

By Jason Arsenault, CPA

Return on Investment (ROI)

This is a business term that we use to evaluate the profitability of an investment. For a small business owner that investment could be inventory. Let’s say that we own a tire shop and sell a set of four tires for $1000 and those tires cost us $500, that creates an ROI of 1 or 100%. It is a quick calculation of taking the profit of $500 and dividing it by the cost of $500. I imagine most small business owners aren’t spending a lot of time calculating ROI because it just doesn’t mean much.

What is important to a small business owner is cash flow. What if it took our tire shop two months to sell that set of four tires? Our competitor on the other side of the street sells that same set of tires for $650, giving them a much worse ROI of .3 or 30%. However, they are selling four sets of those tires a month, meaning eight sales to our one sale. That gives our competition a profit of $1200 every two months compared to our $500. In business more money always means better, doesn’t it?

The tire shop across the street had to hire an extra hand to help with the demand for their low-cost tire. They also are running an advertisement in the local paper and radio station so everyone will know about the huge savings. These extra costs are not part of the ROI calculation, but they are an important consideration of whether offering a price of $650 is worth it in the long run. As a small business owner, it is important to see the whole picture of your operation, it can be the difference between success and failure.

Net Income Formula

ROI is a great tool to evaluate a specific investment like inventory, but it falls short in giving us a better understanding of how your business is doing overall. You might have heard the term the bottom line. The net income formula gives you that very important bottom line and is often referred to as being in the black (positive income) or the red (negative income).

It is an easy calculation. You get a revenue number from all your sales and then subtract an expense number. Those expenses are your operating expenses like turning on the lights, payroll costs and a number of other costs. For an inventory business this number will also include the cost of goods sold.

Calculating this number is very important because it is going to tell us how we are doing financially. Do we have extra monies to put into marketing in an attempt to have even more sales next month? Or, do we need to really focus on cutting operating expenses because we are spending way to much

money? It is also the number that we take over to our Income Statement.

Financial Statements

The income statement is one of the documents you find in the financial statement package. You will also find the balance sheet and cash flow statement. All three of these statements work together to give you an overall picture of the financial health of your business. It can also be requested from your bank if you have borrowed money, or if you want to attract investors, they will want this financial information so they can decide if your business offers a good ROI on their investment. When you are selling tires all day and meeting the demands of your customers things like calculating ROI, using the Net Income Formula and preparing Financial Statements can just seem overwhelming. Being successful requires a team and Certified Public Accountants (CPA) are taught to understand the finances of your business. Find a CPA today that is there to help you succeed and answer important financial questions that your business needs to know the answers.