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How To Calculate Your Break-Even Points and Return On Investment When Purchasing A Business.

If you are looking to grow your wealth with a fast-growing opportunity, buying a business may be a great option for you as compared to more passive investments such as buying real estate.

The problem is that when you’re buying something like real estate, calculating your return on investment is quite simple – it’s the costs of maintaining the property (i.e. mortgage fees) compared to the rent you can charge for the property.

Calculating return on investment for a business is not as easy. However, there is a nice and simple way to do it so that you too can assess potential businesses and whether they might give you a good return on investment like a piece of real estate.

Pros and Cons of Buying a Business

Buying a business can offer you many benefits, such as:

  • Generating a steady income stream
  • Leveraging the existing customer base and brand recognition
  • Expanding your network and influence
  • Taking advantage of tax deductions and depreciation
  • Having more control and flexibility over your work
  • Massively increasing value over just a few years


However, buying a business also comes with some risks and challenges, such as:

  • Paying a high upfront cost
  • Potentially assuming the liabilities and debts of the business
  • Dealing with legal and regulatory issues
  • Managing the employees and operations
  • Facing competition and market changes


Therefore, before you decide to buy a business, you need to do your due diligence and evaluate the financial feasibility of the purchase. One of the most important metrics that you need to consider is the break-even point.

The break-even point is the level of sales or revenue that covers the total costs of the purchase and operation. It tells you how long it will take you to recover your initial investment and start making a profit. The lower the break-even point, the faster you can achieve a positive return on investment (ROI). The sooner you achieve a positive ROI, the faster you’ll be putting tens of thousands of dollars of profit in your pockets!

In this Business Tip of the Week, we will show you how to calculate the break-even point of buying a business, using a simple formula and an example. We will also share some tips on how to lower your break-even point and increase your ROI.

The Formula for the Break-Even Point of Buying a Business

The formula for the break-even point of buying a business is as follows:

          Break-even point in years = Cash Investment/(Gross Revenue – Total Expenses – Interest Expense – Taxes Paid)

          Break-even point in dollars = Cash Investment/Break-even point in years

To use this formula, you need to know the following information:

  • The cash portion of the purchase price of the business: The purchase price of the business is the amount of money that you pay to acquire the business. It may include the value of the assets, the goodwill, the inventory, and the customer list. The key number you’re looking at here is the cash that you are paying to purchase this business and not the total purchase price.
  • The annual net income of the business: This is the difference between the total revenue and the total expenses of the business. It represents the profit that the business generates after paying all the costs, including interest, taxes and depreciation.
  • The total expenses of the business: Total expenses are the sum of all the costs that a business incurs to generate revenue. They include fixed costs, such as rent and insurance, and variable costs, such as salaries and inventory.
  • The annual interest expense of the business: This is the amount of money that you pay for interest on any loans or debts that you take on to complete the purchase of the business. Your interest expense increases the cost of the purchase and reduces the cash flow after you complete the purchase of the business.
  • The tax rate of the business: This is the percentage of the net income that the business pays for income tax. It varies depending on the legal structure and the location of the business in Canada.

An Example of the Break-Even Point of Buying a Business

Let’s look at an example of how to use the formula to calculate the break-even point of buying a business.

Suppose you want to buy a coffee shop with a purchase price of $500,000. The coffee shop generates $450,000 in gross revenue per year and has a total of $300,000 in expenses per year as follows – $200,000 in variable costs for inventory and salary and  $100,000 in fixed costs for rent and utilities.

The earnings of the coffee shop before taxes and interest is $150,000 per year. You plan on paying the purchase price with $300,000 in cash from your savings and you plan on taking out a bank loan for $200,000 at 10% interest per year. The corporate tax rate of the coffee shop is 12%.

To find the break-even point in years, you plug in the numbers into the formula:

          Break-even point in years = Cash Investment/(Gross Revenue – Total Expenses – Interest Expense – Taxes Paid)

          Break-even point in years = $300,000 / ($450,000 – $300,000 – $20,000 – $18,000) = 2.6 years

This means that it will take you 2.6 years to recover your initial investment of $300,000. Every dollar generated after 2.6 years is pure profit that you can withdraw from the business.

To find the break-even point in dollars, you divide the purchase price by the break-even point in years:

          Break-even point in dollars = Cash Investment / Break-even point in years

          Break-even point in dollars = $300,000 / 2.6 years = $115,384 per year

This means that in the first 2.6 years of owning this business, you need to generate $115,384 of net income per year to break even on your initial investment of $300,000.

The Formula for the Return on Investment of Buying a Business

Return on investment (ROI) is a measure of how profitable an investment is. It is calculated by dividing the net profit by the initial cost of the investment and multiplying by 100 to get a percentage.

The formula for the return on investment of buying a business is as follows:

            ROI = Net Profit / Cash investment

If we were to plug in the numbers that we calculated based on the coffee shop example above, we could come up with the following return on investment:

            ROI = $115,384 per year / $300,000 = 38%

This means you earn a return of 38% on your cash investment.

How to Lower Your Break-Even Point and Increase Your ROI

As you can see, the break-even point and return on investment of buying a business depends on several factors, such as the purchase price, the net income, the depreciation, the interest expense, and the tax rate. By changing any of these factors, you can lower your break-even point and increase your ROI.

Here are some tips on how to do that:

  • Negotiate a lower purchase price: The lower the purchase price, the lower the break-even point. You can try to negotiate a lower price with the seller by highlighting the weaknesses or risks of the business, such as low profitability, high competition, or outdated equipment.
  • Increase the net income of the business: The higher the net income, the lower the break-even point. You can try to increase the net income of the business by increasing the sales, raising the prices, reducing the costs, or improving the efficiency of the business.
  • Increase the depreciation of the business: Increasing depreciation reduces the taxable income of the business, which in turn reduces the taxes that the business has to pay. This increases the amount of free cash flow of the business, which means that the business can recover its initial investment faster. One way to increase the depreciation of the business is by replacing old assets with new or more assets, such as equipment, furniture, or vehicles, and claiming a higher depreciation rate on them. Be careful not to do this needlessly though as that would be a waste of assets that still have a useful life.
  • Reduce the interest expense of the business: The lower the interest expense, the lower the break-even point and the higher your return on investment. You can try to reduce the interest expense of the business by paying off your acquisition loan, refinancing the loans, or finding a lower interest rate.
  • Reduce the tax rate of the business: The lower the tax rate, the lower the break-even point. You can try to reduce the tax rate of the business by choosing a different legal structure, such as a corporation, or by developing a good tax strategy for your business income.


By following these tips, you can lower your break-even point and increase your ROI when buying a business. However, you should also consider other factors, such as the growth potential, a strong competitive advantage, marketing opportunities and risks, and the customer satisfaction of the business, before making your final decision.

Conclusion

Buying a business can be a rewarding and profitable venture, but it also requires careful planning and analysis. One of the most important metrics that you need to consider is the break-even point, which tells you how long it will take you to recover your initial investment and start making a profit.

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