In a recent post, I discussed the various types of profits that are used for many purposes. It got me thinking, I know everyone wants to make a profit – but not many smaller businesses think about what is a reasonable profit.Generally in small business people either start off the business from scratch or buy it from someone else. The earnings expectations differ depending on this:
Start from scratch – the owner expects to at least earn what they could as an employee, plus a bit more for the pain and effort of running the business.
Purchased – the owner still wants a reasonable “salary” type return plus want some return on their investment on the purchase (quite often this is tied to paying interest on debt used for the purchase).
Whilst both of these are valid, there are not particularly economically rigorous. A far more rigorous approach is based around Return on Equity or ROE. ROE is NPAT divided by equity (or capital or your investment) and measures how efficiently a business generates profits given how much money is tied up in it
Every business has some level of investment by its owners. In a purchased business, the purchase price plus transaction costs is an obvious investment.
However, even start-ups have an investment – even if it just an old desk, chair and filing cabinet that you use to run the business. But what about your car that you use half for business, the advertisements in the local paper, the computer you use, your time (you may earn the same salary you expect as an employee but work twice as many hours).
If you are a business owner, you should be clear in your expectations about what an acceptable return on your investment is. Whilst there are many formulae and bases for calculating return, ultimately it is the owners call as to what is acceptable.
In the next post we will look more closely at the ROE calculations and give some guidance as to what is acceptable and what goes into determining your profits used in calculating ROE.
Marshall Vann – Realistic Business Solutions
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