Return on Investments Explained

Welcome back guys! Hope your Spring is treating you well J Now I want to continue on with our topic of opening up a successful fashion store, the next area I want to cover is your Return on Investment. You really do need to have a good estimate of your return, to make sure the money you put in your store is going to come back to you at some point, and hopefully with new friends!

In our last blog post I showed you how to see if your daily operations would allow you to break even. Now I want to revisit the start up costs for your store, your initial investments, to see not only if your sales for the expenses make sense, but to see if the money that was invested to open up your shop will be made back over a reasonable amount of time.

The Return on Investments (ROI) calculation is used to evaluate the performance of the cost of your investment, to your total gain on the investment.

Return on Investment = Net Income / Investment

Net Income is your after tax profit (revenue – all expenses – taxes)

Say you’ve put $50,000 into creating your store. You have furniture, lighting and décor etc., these are your assets, they differ from your operating expenses because they are tangible and not directly related to the production and sale of your goods. $50,000 is your investment.

Now what’s your Net Income? It’s your gross profit, or all of the profit you made selling your goods, minus the expenses related to buying or producing those goods. Expenses could be the raw materials you used to make your products, the salaries of the people that made them, your phone and electricity bill, and your rent. Let’s say you made $10,000 this month total, and your expenses were $9000. Your Net Income would be $1000.

Your Return on Investment for this month would be $1000 / $50,000 = 0.02 or 2% per month, (which is 24% annualized return.) For this example you would have a 2% return on investment for this month, which is great – you’re making money. At this pace it would take 50 months to fully pay off your initial investment because 100% / 2% = 50 (4 years and 2 months)

If your ROI results are less then 0% then you’re losing money, and you need to go back and figure out where you can trim some of your expenses or introduce a strategy to bring up your profit like a sales event.

Practical Uses for ROI

ROI calculation can be used to see how a change in the way you do business affects your return. For example, you could see if the advertising campaign you had last month was effective. To start with, you need to have at least a few months of numbers to make a comparison. Say you ran an online advertising campaign and compared to the last several months with all the inputs remaining as close to the same as you can, you see your ROI increased, therefore it was a success. Calculating ROI monthly will show you the buying cycles of your customers too, it is expected you will make more money in December then February, so remember these calculations will show you trends, take them into consideration if you are trying to analyze a change in your business operations.

You can also use ROI to project future returns on an investment. If you have good estimates of what your costs and market demand are for your goods, it can be a good place to start if you are deciding whether or not to invest in the business or project. It can also be a tool to use to convince other investors to come on board with you too.

The important thing to remember while using the ROI calculation is to always be consistent. Different people include different elements into the equation that will change your results. For your own usage, in order to compare month to month ROI, you have to use the same inputs. Calculate it as close to the same way as you can every time so you will be able to see what months you had a better return.

A Note on Risk

When calculating your Return on Investment, keep in mind that you should have in place a Target Percentage that you need to achieve in order to make the business venture worth it, and to judge if the investment is doing well. You know for example, that with less risk you can put your money in mutual funds and get 7 – 10% return on your money. Operating in fashion retail has many more risks than this, low sales is only one of the risks. Because of this you have to give yourself your own target, say 15 – 20% ROI to know that your effort is worth it. You have to ask yourself, ‘Is this really the best place to put my money?’ ‘Is it really worth the effort?’ Keep this in mind.

ROI Analysis Example

ROI can be useful in daily business operations as a decision making tool to decide between 2 scenarios, since your target ROI can be appraised for the overall business as well as for individual business investment decision:

The choice is between investing in a luxury fashion store interior for $300,000 or staying basic and cool for $50,000.

You estimate that the high end store will bring you $15,000 of net income while the basic cools store will bring you $10,000. We also know that the average market rate for mutual funds return is 7%.

If one was looking which investment will bring me higher net income it is clearly the luxury concept with the $15,000. However, if we analyze the return on investment we can see that the luxury store return on investment is only 5% while on the basic store it is 20%. So from this prosepcive the basic store has much higher return on investment. But a critique can say I still prefer $15,000 over $10,000 and this is why we should remember that there are always other market alternatives to investing our money. We should not get blinded by our enthusiasm over a certain concept.

Imagine if you can find 5 basic stores at $50,000, the investment will be the same as the luxury stores but the net income for the sum of their net incomes will be $60,000 versus the $15,000 of the luxury store. But let’s assume there are no five basic stores but only when. Even then, it is better to invest in a single basic store for $50,000 and put the rest of the money with mutual funds that yield 7%. This will mean earning $10,000 on the store and $17,500 on the mutual funds (7% at $250,000). Thus, the basic store and putting the money at other earning assets earns $27,500 for the same investment as the luxury store that earns only $15,000.

 

This oversimplified example tells us that a store owner should never focus on the net income only,but rather on how well his/her investment is yielding as a percent of the investment.

 Further analysis on Return on Investment at Solution Martix

Wikipedia also has a good ROI explanation

Further information on opening up and running a successful fashion store can be found in our Sarinas Blog

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