ROI stands for “return on investment,” and it’s a measurement of how much you earn on the money you spend or borrow. For example, if you buy a machine for $10,000 in January, but having the machine makes you $20,000 by the end of the year, the return on your investment is 200% because you made 100% of your investment back, and then doubled it. An ROI measurement can be applied to just about anything, from a machine to an employee to a location — or even to money you might borrow for your small business. What is Financing? Financing is money you borrow to move your company forward. You could use financing to hire people, purchase assets, move into new markets, upgrade your technology, or anything else. Regardless of how or where you apply financing, your goal is to eventually have that money produce a positive ROI (is it worth taking otherwise?). So how do you determine the potential ROI of financing? Here are a few simple steps to get started. Start by Calculating the Total Cost of Financing Obviously, there’s the money you’re borrowing. But on top of that will be interest you’ll have to pay as well as any fees. These should be taken into account when you calculate how to break even. For example, a $10,000 loan paid over 12 months at a 20% interest rate will take $11,290 in total revenue to break even. The extra $1,090 – that’s your interest. BTW, if you don’t have the full loan cost on hand, you can use a financing calculator to figure it out. Estimate the Result of Your Financing How much you’ll need to make is the easy part. The trickier component is projecting how much that single loan or other financing, which could be anything from a line of credit to a merchant cash advance, will produce. At this point, it’s time to do a bit of educated guessing. And it’s particularly challenging if the financing is being used for multiple reasons because some might yield positive ROI while others might not. But for the sake of simplicity below, let’s say financing is being used for a single specific purchase. Here are a few examples: With the new WidgetMaker Plus, a widget manufacturer can make 200 widgets per hour versus the 50 they’re making now with the original Widgetmaker. This will put them in more stores, which will open the market to new customers. A second delivery van will let a retailer deliver items to 30 customers per day, an increase from 15 customers previously. Hiring a CFO will give a lawyer more time to get out there and get new clients because they’re spending less time doing administrative financial stuff. Once you understand how your production will increase with the new investment, you can track your ROI. Increasing production means increasing sales. If the widget maker can make an extra 150 gadgets per hour and sell them for $10 each, then they will make $1,500 more per hour than they could before. If the average delivery order for the store is $45, the owner will make $675 more per day by doubling their deliveries. If the lawyer can land one new $12,000/year client a month, they’d make an additional $78K per year. With these calculations, you can track how much your business stands to profit from spending that extra money. Apply the ROI Formula The good thing about the ROI formula is that it never changes. Once you know it, you can apply it to any money you spend, whether it’s financing or retained earnings. This is the formula: ROI % Profit / Investment x 100 So, if $10,000 in financing that costs $11,290 with interest will generate an extra $15,000 in sales over the course of the year, the profit would be $3,710 ($15K – $11,290), and the ROI would be $3,710 divided by $11,290 x 100, which comes to 33%. BTW, if you need a refresher on gross profit and net profit, read this. What’s a Good ROI for Financing? So how much ROI do you need to justify financing? Honestly, that will depend on what you’re using the financing for because certain purchases will have different benchmarks. So, if we go back to our examples from above, the widget maker should expect a double-digit ROI because the machine is a single cost (minus yearly maintenance) and should keep producing ROI well after it’s paid off. On the flipside, the lawyer who hires a CFO will probably want to pay top dollar for that CFO and, even with that CFO installed and working, they can’t guarantee that they’ll close a $12K client every month. For that entrepreneur, anything above 0% ROI would be a win. Whatever your expectations are, this formula is an excellent guide for determining whether or not financing would be generally profitable for your business and so worth your time and investment. The Best Way to Ensure Positive ROI on Financing is to Find Affordable Financing If a certain loan or financing alternative isn’t a good option for your business, consider looking for other financing options that can help you to save. For example, you may find a different short term financing option with more favorable terms. You can also look into credit cards and equipment financing and other alternatives, depending on your needs. Lendio’s single application can match you with financing options that fit your business and financing plans and goals — plus you can access more than 75 lenders with a single application that takes about 15 minutes to complete. Visit our online lending hub to learn more. Disclaimer: The information provided in this post does not, and is not intended to, constitute business, legal, tax, or accounting advice and is provided for general informational purposes only. Readers should contact their attorney, business advisor, or tax advisor to obtain advice on any particular matter.