It is common for business owners, employees, and startups to overlook the three critical levels of return elements required to make a business truly successful. Planning sessions often begin by facilitating a dialogue and openly calculating the level of returns required for business success with shareholders, owners, staff, and employees. This method gains broad acceptance of the required business returns.

There is often a widespread misconception that owners make a fortune while staff earn just a salary or wage and are expected to care for the business as if they own it. Taking all participants through the three levels of return adds significant impetus and sets the scene for any planning day.

Level One – Return on Investment

Every business investment requires a return, whether a capital return or income return or a combination of both. Accumulating asset values and distributing profit generate the capital and income return, respectively. Therefore, unless a business can produce both, the investment can be considered speculative. While there is nothing wrong with a speculative investment, provided the risks are understood, frequently, those that succeed produce very high returns, while the vast majority generate losses. A true investment is a business with an established income stream, an asset base, and a record of distributing a portion of its profit to shareholders. Defining an acceptable return is critical for any business.

What is a reasonable return on investment?

This question is often posed to all employees and staff at the commencement of planning sessions, and responses often indicate that 20% is not uncommon or unrealistic.

Level Two – Return on Our Time

Most people start a business because they are skilled in a particular area and believe they can do better, more enjoyably, and with greater rewards than working for an employer. Unfortunately, the majority of businesses either fail financially or fail to come close to achieving the desired outcomes. Owners often become slaves to their businesses, believing they are indispensable, and most fail to understand that they need to generate an income that is not dissimilar to the salary or wage they can obtain working for an employer. If the business they are commencing cannot generate a margin and a gross contribution sufficient for the owner to draw an equivalent wage, the decision to go into business should be seriously considered.

What is a commensurate salary?

Clients often draw much lower incomes than those they could command, and this is usually balanced by their quality of life, with the business absorbing a broader range of expenses than an employer would. While in a start-up phase, a lower than commensurate salary or income is acceptable. All businesses need the capacity to generate a commensurate return for the owner’s time.

Level Three – Return on Activity

Every business is in the business of making money, and making money relies on making a profit after paying taxes.

Although start-up businesses often make losses, they are supported by assumptions and sufficient capital until they start generating profits. Therefore, if the premises are conservative enough, such businesses can afford to incur losses for a certain period.

What constitutes an adequate return on activity?

Many reference sources, including industry benchmarks and public information on companies in similar sectors, can provide the answer. However, our experience shows that most successful privately owned businesses generate profits well above publicly available benchmarks. Thus, to determine the desired level of profitability, it is helpful to consider how the profit needs to be applied relative to the business’s nature and scope. Is there a large inventory, work-in-progress, or debtors? Are there high-value assets required to produce goods or services? How labour-intensive are the processes?

As a general rule, the required level of profitability can be calculated as follows:

1. About one-third of the net profit should be retained for servicing and expanding the asset base and systems of the business (e.g. replacing machinery, systems, IT infrastructure, pay rises, increased working capital, etc.).
2. Shareholders require the dividend, which typically accounts for another one-third of the generated profit, irrespective of whether it is paid.
3. The remaining cash generated can be used for discretionary purposes (e.g. staff bonus schemes, additional products or services, etc.). The third element is equivalent to the amounts calculated in one and two combined. Together, these three amounts give the required level of profitability for the business, which typically ranges from 10% to 30% of turnover after tax. It is rarely lower.

We now have the three levels of return that every business should be striving to achieve:

1. Return on investment
2. Commensurate income
3. Business return

When these levels are calculated transparently, there is a clear understanding and respect for the required operating profit for the business. Often, there is a significant gap between the current levels of return and the required level, which becomes the difference between struggling and succeeding. The required level of return becomes the accepted benchmark for all future activities to strive to achieve.

We now have the primary financial goal!

More importantly, all staff and employees will understand the goal and accept that it is reasonable. By now, the business has probably undergone a review, whether a desktop diagnostic analysis or a broader review process. This review will indicate the timeframe over which it is realistic to expect this level of return to be achieved. This may be a one-, three-, or even five-year timeframe. The milestone must be communicated and agreed upon as being achievable.

We now have the primary milestone!

It is worth noting that most businesses fail. Eighty percent of businesses fail in the first five years, and 80% of those that succeed fail in the next five years. Although an unrelated statistic, 95% of small to medium businesses do not plan, and the correlation is compelling. If you fail to plan, you are planning to fail. To increase the likelihood of success, every business must have a well-prepared and implemented business plan.