It’s often said that you need to spend money to make money. While that’s certainly true, it’s also unfortunately true that capital investments don’t always lead to great profits. To determine whether the investment makes sense for your business, you need to know whether your future gains will ultimately exceed the initial investment and other estimated costs—and if so, how long it will take to recoup them.
One way you can quickly evaluate the potential ROI of a major purchase before you pull the trigger is by calculating the simple rate of return. While the simple rate of return isn’t perfect and won’t take everything to account, it can be a method to measure whether a given project has high potential profitability and is worth further examination.
In this blog post, we’ll explore how the simple rate of return is calculated, what it means (and doesn’t mean) for your business, and why a great financing partner like Team Financial Group can help you make those major business investments that will drive future growth without putting your cash flows in jeopardy.
How to Calculate the Simple Rate of Return
As the name suggests, calculating the simple rate of return is indeed very simple. Here’s a step-by-step breakdown of the formula:
Estimate Annual Incremental Revenue
This is simply how much you expect to increase your total revenue (or decrease your current expenses, for example by using automation to reduce labor costs) after an investment. For example, if you expect that new equipment for your factory or expanding your delivery fleet will allow you to generate $70,000 per year in new revenue, that would be your annual incremental revenue.
Estimate Annual Incremental Expenses
Here’s where it gets just a little bit trickier. Most major capital expenses cost you more than just amount of the initial investment. You need to consider other long-term costs that result from the purchase, including:
- Increased operating expenses. For example, this might include cost of running and maintaining new equipment, and hiring new staff.
- Depreciation and lifespan. If you’re investing in new equipment, how many years of use do you expect to get out of it? What do you expect the salvage value (i.e., how much you can get for it when it’s time to replace it) to be?
Let’s consider an example.
Say the cost of purchasing new equipment is $200,000, and you expect that it will also increase your operating expenses by $15,000 per year. You expect to get 10 years of use from it, and then sell it for $20,000, so the annual depreciation cost would be $18,000. ($200,000 cost – $20,000 salvage value / 10 years).
Add these two figures together, and you get annual incremental expenses of $33,000 per year.
Calculate Annual Net Operating Income
If you’ve been following along so far, this step is easy—just take your annual incremental revenue and subtract your annual incremental expenses.
Using the examples above, if you estimate $70,000 in estimated annual incremental revenue and subtract $33,000 in annual incremental expenses, your annual net income would be $37,000.
Calculate Simple Rate of Return
Now, pull it all together. Take your annual net income and divide it by the initial cost of the investment. In this case, a $37,000 net operating income divided by $200,000 leaves you with a simple rate of return of 18.5 percent.
Advantages and Limitations of Using the Simple Rate of Return
The value of calculating the simple rate of return for your investment is that it gives you a quick, easy, and usually reasonably accurate (if somewhat rough) assessment of whether a particular investment would likely be worth it in the long run.
Typically, a business might set a minimum rate of return to determine whether a given investment would be worth it, or if money and resources might be better spent elsewhere on a project with higher profitability. If your simple rate of return clears the minimum by at least a few points, there’s a good chance it’s worth more serious consideration.
That being said, the simple rate of return sacrifices precision to achieve its simplicity, so if you’re doing your capital budgeting and weighing one or more major purchases, you’ll probably want to do a more detailed analysis.
Some important things that simple rate of return doesn’t account for include:
Even if, hypothetically, an investment would make you more money in the long run, you’ll never get there if you can’t afford the initial expense in the first place or can’t get financing on favorable enough terms.
Variability in Incremental Revenue and Expenses
The simple rate of return formula assumes that the amount of the increase in annual revenues and expenses will be constant, but in practice this is usually not the case. It may take you a few years before you’re able to reach your new capacity with new clients or orders. Likewise, operating expenses may be greater in early years (if, for example, there are significant hiring, training, or set-up costs) or in later years (for example, if you anticipate maintenance costs to increase as equipment ages).
Time Value of Money
Money earned today is more valuable than money earned in the future. The biggest reasons are inflation, and the fact that money you have now can be invested and gain interest over time. But the simple rate of return formula counts all income the same, whether it’s earned tomorrow or ten years from now. In other words, it does not adjust the income to its net present value. As a result, simple rate of return may overstate the actual rate of return, particularly if you expect your investment to produce income over an extended period of time.
Team Financial Group Helps Businesses Afford What They Need to Thrive
Major capital expenses are often necessary to help your business continue to grow and thrive. But identifying which investments will provide the greatest long-term profit is only the first step. Figuring out how you’re going to actually pay for them is just as important.
That’s why you need a financing partner who understands your business and can offer fast, flexible, and affordable options to help get your company from point A to point B.
In just over 20 years in business, Team Financial Group has helped companies just like yours secure a total $600 million in financing. We pride ourselves on being easy to work with, efficient, and fully committed to helping our clients achieve lasting success.
The content provided here is for informational purposes only. For financial advice, please contact our commercial financing experts.