How to answer a common question about a new businessThe minimum profit method can provide decision-making tools to nonfinancial managers and investors.
Many investors ask how much net profit they should expect to make by starting a new business. There is no easy answer to this question. Profit margins vary by industry, type, size, and age of the business, among other factors. However, the minimum profit method can provide some decision-making tools to nonfinancial managers and investors.
A minimum profit for an investor in a new business can be calculated up to a certain extent by using the following method:
Minimum profit = Interest on fixed deposits + owner compensation + industry risk factor
An investor can earn risk-free and guaranteed profit by keeping money in a fixed deposit bank account instead of investing in a business. This is considered a safe investment because the principal amount is always guaranteed. It can be argued that minimum profit from a new business should at least cover what would have been the investor’s risk-free profit had the money been deposited in a fixed deposit account.
When a new business is started, it is assumed that the investor/owner has to leave a current job to manage the business if he or she is already working. It means the owner has to earn at least an amount equal to his or her current salary from the business. It can be argued that minimum profit should take into account an owner salary factor. There are two ways to calculate owner salary if the owner is currently not working. First take open market value. Based on owner skill and experience, what would the owner be paid by an employer in today’s market? Second, what do the owners of similarly sized companies in the same industry pay themselves?
An investor takes financial risk when a business is started. Each industry has its own risks and rewards factors. There is a possibility that the investor will not make any profit and might lose all or part of the investment. It can be argued that the investor should be compensated for taking financial risk by starting a new business and that a risk factor should be added in the minimum profit computation. The financial risk needs to be measured. Value at risk (VaR) is a technique used to measure and quantify the risk of loss for investments over a specific timeframe. The risk factor can be calculated in many other ways. There is no perfect risk measure. As an alternative for your planning purposes, add an estimated risk factor of say 1% to 5% to your minimum profit calculation.
What is the benefit of calculating and knowing minimum profit? It can support an investor in decision-making. Investors will calculate minimum profit at the planning stage before starting a business and will check industry position. Is it possible to earn this much profit in a particular industry or not? The investor will be encouraged to invest if other companies in the industry are making more profit than his or her minimum profit. The investor will rethink the investment strategy if other companies in the industry are earning less than the minimum profit. It can be used as a decision-making tool before investing in a new business.
Minimum profit can be used for strategic planning. A successful business will always have strategic plans in place that align to the company’s business objectives. These plans will be supported by budgets and forecasts that reflect the financial position of the business. The team preparing the budget knows that it is very difficult to prepare an accurate budget for a new company, when there is no past financial data and history of the company. It will be easier to prepare a budget for a new company if the budget team knows their minimum profit.
There are many accounting methods and techniques to evaluate and calculate return on investment (ROI) for a new business. However, an investor needs good accounting knowledge to conduct such investment valuation or will require expert services.
— Shafi-ur-Rehman, FCMA, CGMA, has worked as a finance manager for the past 24 years, joining Bin Habib Group Dubai as finance manager in August 2004 and subsequently being promoted to general manager in 2008. To comment on this article or to suggest an idea for another article, contact Kim Nilsen, the publisher of FM magazine, at Kim.Nilsen@aicpa-cima.com.