There is a number above all else that is the driving force for your business and interestingly enough most business owners even don’t know what it is. Do you? If you answered any of the following – Sales, Gross Profit or Net Income – you are only partially correct. It’s actually a complicated term – weighted average cost of capital (WACC) – but it’s actually a pretty simple concept.
So here is the simplicity of this idea. Obviously every for-profit business needs to make money (duh). And it’s risky to be in business (yep). And you would not do something risky unless it was worth it (almost always determined in business by how much money you can make). So wouldn’t it make sense to set a number on how much money you should be making each year in order to make sure your risk pay off? It absolutely would!
So how do we do this? Essentially we should consider how much money an owner puts in to a business (or we can use the assumed sales value of the business) and multiply that by an expected annual return rate. For example: if a shop called Dwayne Johnson’s Rocks is worth $800,000, and the required return rate (cost of capital) is 15%, then the owner should be making an average of 120,000 in profit every year (800,000 x 0.15 = 120,000).
So how do we come up with this specific number? While it can be complicated, we can simplify it so anyone can come up with something similar. Typically owning a private business is one of the riskiest types of investment you can have, so typically we would want to make a greater return than most investments. This includes the average CD (under 2%), corporate bonds (around 5%), and stocks (11.7% over the last 5 years). Our suggestion is to pick a rate higher than each of these numbers (due to risk) and use this as a benchmark for your business. This number will be a guiding light for you to make wise decisions on whether or not the investments in your business are paying off and if your company is netting enough profit.
So in short, every time you make a decision about investing you should know what the annual return rate needs to be. Make sure every time you project out your profit you are hitting this number over the long haul. With this tool, your decisions that have likely been based on cash flow will now change to decisions based on profit.