If you own your own shop, you need to know when to invest in your business and when to keep your powder dry. I’ll show you how to answer this question. But first lets’ understand why even successful business owners find this a difficult question to answer.
First, remember that we are dealing with a future that is unknown. You don’t really know how your investment is going to payoff – or if it will payoff at all. That’s called risk. The second obstacle is your emotions. If you’ve built your business from scratch you have a great deal of “you” invested in your enterprise. You identify your own success with your business success. For that reason many people invest way too much money in their own business. They keep investing even after the market tells them it’s a mistake and they suffer huge losses as a result.
How do you make sure this doesn’t happen to you? Ask these 5 questions:
1. Is your business profitable now?
Before you make any investment in your business (in time or money) you must know if it is profitable or not. You’d be surprised how many people simply don’t know. Of course the first step to determine your company’s profitability is to examine your financial statements. This presupposes you have budgeting software like Quickbooks or YNAB for your business and you keep it updated. Many small business owners simply assume that if they have money left over at the end of the month, they have a profitable business.
This is not a good system because it doesn’t really allow you to see what is working and what isn’t. And if there is a problem you’ll soon start running deficits. Of course, by the time you start losing money it will be too late to do anything about it. Solve this by putting a budgeting system in place. This information is absolutely critical to running a successful small business. If you don’t run such software, the very best investment you can make is to purchase a program and get trained on how to use it.
I must admit that this isn’t sufficient. Even if you use business budgeting software, your business still may not be profitable. Make sure that you pay yourself a decent wage before you calculate profit and loss.
For example, you might have a side business that earns an annual profit of $20,000 after tax. You also calculate that you work 1000 hours on the business and that you could earn $40 an hour working overtime at your existing job. That means the labor cost is an additional $40,000. Now you can see that the business you thought made $20,000 profit actually losses $20,000 each year.
If your company is not profitable, any proposed investment has a high hurdle to climb. It must turn the company into a profitable enterprise. If not you should close shop and find something else to do with your time that does pays off. Consider starting a freelance business to provide the some aspect of your current business to your profitable competitors.
2. How will the additional investment impact net income? For how long?
Let’s assume that your company is profitable. You run a pizza shop and you can buy an extra oven for $5000 that will enable you to earn an extra $500 a month in net profit. Further assume that the oven will be operational for 5 years before you have to replace it. That works out to a total profit of $30,000 over 5 years ($500 a month x 12 months x 5 years). That my friend is a spicy meatball pizza and a great investment.
You may not know exactly how much net profit the investment will earn and for how long. That’s OK. Don’t freak. You can assign a probability to the equation and make an informed decision.
Let’s assume that you determine that there is a 40% chance that the return will be at least $30,000 over 5 years. So you can reasonably expect to earn 40% of $30,000 or $12,000 on a $5000 investment over 5 years. That’s still pretty darn good.
I strongly suggest you speak to 3 or 4 other trusted business associates or your accountability partner to make sure your numbers are reasonable. Often you can get these numbers from the person selling the equipment. Ask the salesperson for references so you can confirm the returns were as good in practice as they are presented.
3. How long does it take for the investment to pay for itself?
Let’s say you don’t know how long the investment will continue to pay but you still want to determine your risk. Calculate how long it takes for the investment to pay for itself. In the case of the oven investment, you are investing $5000 one time for a payback of between $200 to $500 a month (remember the 40% discount we calculated above). If you are a pessimist, use the $200 monthly return. Doing so, it will take $5000/$200 or 25 months before the oven pays for itself. That’s a bit over 2 years.
Does your lease give you another 2 years (minimum)? What is happening to your market? Is it growing or shrinking? Is competition moving in? What is the likelihood that you’ll be able to capture those extra gains for at least 2 years? If the chances are high, it’s a good investment. That’s because every month you operate the oven after this initial 2 year period that oven is going to generate profit that goes straight to your bottom line.
4. What happens to your business if you don’t make the investment?
Let’s assume that you don’t expect to earn extra profits by making the investment. But because of the competition, you feel you must put that oven into service or your business is doomed. You figure that if you don’t make the investment, sales will decline by $500 a month until you become unprofitable and are forced to close.
If you have some basis for assuming that by making the investment, you’ll be able to keep your profitable business up and running, it makes sense to write that check. If the business is declining and even the new oven won’t stem that tide, close shop now or sell your business.
5. What happens to your business if you do make the investment? What will you save?
Let’s assume that you don’t run a pizza shop but an accounting service. You have an opportunity to host your computing services on the web or leave things as they are. You currently spend about 15 hours a month messing around with the computers. If your labor cost is $40 an hour, that comes out to $500 a month in labor or $6000 a year. On top of the time you spend, you also shell out $4000 a year for equipment and professional maintenance. Your total computer cost is $10,000 a year.
But you do your homework and determine that you can spend $700 a month ($8400 a year) and host the computing on the web. You’ll estimate that your annual labor cost will drop to $600 and your hardware cost will drop to $1000. That means your total computing cost drops to $9000 vs. the $10,000 you currently spend.
In short, by investing this money, you’ll save $1000 a year plus a great deal of aggravation.
In this case, it makes a great deal of sense to invest the $700 month. So even if this investment doesn’t generate more revenue, it reduces your cost and frees up time so it’s a worthwhile investment.
If you have your own shop, how do you decide when to invest money in your business?