Return on investment is an economic measure often used when buying a business. The measure can be simply defined as expected investment income divided by the amount of investment. To decide whether there will be a positive return on a business investment, the buyer of the business must compare the cost of the investment capital to the rate of return on the investment. Three factors affect the return on a business investment: purchase price of the business, estimated future profits of the business and the potential risk of the business.
Business Value
Business value is the basis for setting purchase price for a potential business buyer and thus a key factor to future return on investment. The lower the purchase price is, the higher the return on the investment potentially, and vice versa. Business valuation can be evaluated by looking into a business' book value. A business' accounting book consists of both assets and liabilities. Assets should be properly appraised by comparing their original costs to any depreciation and debt assessed against outstanding value. Subtracting liabilities from total assets to arrive at the business' worth, or value, is potentially a representation of the purchase price.
Business Income
Return on investment is also dependent on a business' ability to generate future business income. The higher the potential profits are, the higher the return on investment. To estimate potential future profits, the business buyer can use the business' historical income figures as reported in its past income statements as the basis for estimation. Assuming the business has been growing over the years, the owner of the business may insist on applying an average growth rate to better reflect future income levels. But the buyer likely maintains to adopt a more conservative approach.
Business Risk
Business risk is the possibility of future business results not meeting current performance measures, such as the uncertainty of delivering expected earnings results due to potential adverse business factors. On the other hand, the level of expected performance can also affect the risk of achieving its related outcomes. The higher the required return is, the more risky the return. Based on risk assessment on the business, the buyer may consider adjusting the previously estimated business income and the proposed purchase price accordingly.
Investment Return
To determine return on investment when buying a business, divide business income by purchase price, or the business value if the price has yet to be negotiated. To further decide whether the business provides the best investment opportunity, compare the calculated return on investment to the buyer's required rate of return on the investment capital, or the cost of the capital. If return on investment is higher than the cost of the investment capital, buying the business will make a profitable investment.
