Key takeaways:

• Financing costs refer to all the expenses related to borrowing money, including interest and any fees.
• ROI, or return on investment, is calculated by dividing net profit (or loss) by the cost of the investment.
• For small business owners with limited time and resources, calculating financing costs and ROI can be particularly challenging. Still, these metrics are essential for managing cash flow, evaluating investment opportunities, and deciding when to borrow.

When is it worth it to borrow money to grow your small business?

While small business owners sometimes have no choice but to borrow when cash flow is tight, at other times you’ll want to weigh the cost of financing against how much your business can make by leveraging debt. 

That’s where two important financial concepts come into play: financing costs and ROI in business. 

Here we’ll explain both and help you understand how to calculate financing costs and ROI, and provide practical tips and tools to help you simplify these calculations and make better financial decisions for your business.

What Are Total Financing Costs?

Total financing costs are all the costs that come with financing options, including interest and fees. 

Businesses have access to lots of financing options: business credit cards, microloans, merchant cash advances, vendor financing, traditional small business loans, and more. Having so many different financing options can be overwhelming for business owners. One way to quickly pare down your list is to find out what each type of financing costs. 

You’ll want to understand the:

• Interest rate?*
• Application fees
• Origination fees
• Annual fees
• Other fees

*Note that some types of financing do not state interest rates. Instead they may list a factor rate, or some other term to describe cost. This free business loan calculator can help you translate the cost to an APR. 

Sometimes fees are included in an APR, but not always. Check with the lender if you aren’t sure. 

How To Calculate Total Financing Costs

Calculating total financing costs is easy when you know and have all the financing costs; just add them up.

Where it gets trickier is making sure you have all the information regarding financing costs, and understanding how to compare one type of financing with another. 

In consumer financing, state and federal laws require lenders to disclose financing costs in ways that make it easy to compare offers. Shop for a credit card, for example, and you’ll see the same box disclosing costs on all credit card offers.  

There are no similar federal laws for business loans or financing, but some states require certain disclosures that make it easier to compare business financing costs. 

What Is Return on Investment (ROI)?

In its simplest terms, Return on Investment (ROI) is the return you make on an investment. When looking at it from a business perspective, it can help you gauge the profitability of an investment. It is often measured by how much money an investment makes, and the return usually falls into the category of either revenue or savings. 

ROI can come from various business activities, such as:

• Customer acquisition campaigns
• New equipment purchases or upgrades
• Marketing campaigns
• Product development

How To Calculate ROI

As previously mentioned, calculating ROI is relatively easy once you have the numbers you need. 

ROI = (net profit or net loss/ cost of investment) x 100

Here, net profit is revenue minus all expenses related to the investment. Also, ROI is typically expressed as a percentage, which is why it’s multiplied by 100 in these formulas.

We’ll give some examples in a moment. 

One thing to remember is that ROI doesn’t factor in time. To account for the time factor you can use an annualized return on investment formula. There are pros and cons to each ROI formula. With the regular ROI you can get a quick idea of the ROI of a particular investment/project at different periods of time. The annualized ROI gives you a better idea of the ROI of a project over its lifetime. 

If you want to calculate annualized ROI, you can use this formula:

Annualized ROI = {[1 + (net profit or net loss / cost of investment)] (1/number of years) – 1} x 100

When using either formula make sure you are using accurate numbers and have considered all costs of the investment and have an accurate net profit/loss.

Examples of ROI Calculations

Here are a few examples illustrating ROI for different investments: 

1. Product Launch Investment

The company invests $50,000 in launching a new product, including costs like manufacturing, marketing, and distribution. After six months, the new product generates $200,000 in cash. The total cost remains $50,000 with no additional expenses.

Initial Investment: $50,000

Net Profit: $200,000 (Revenue) – $50,000 (Cost) = $150,000
ROI: ($150,000 / $50,000) × 100 = 300%

For every dollar invested in the product launch, the company made $3 in profit, resulting in a 300% ROI.

2. Real Estate Investment

The business purchases a rental property for an initial cost of $150,000. Over one year, the property generates $18,000 in rental income, and after accounting for property management fees, maintenance, and taxes (totaling $3,000), resulting in $15,000 in net rental income.

Initial Investment: $150,000

Net Profit: $15,000
ROI: ($15,000 / $150,000) × 100 = 10%

The ROI of 10% indicates that the rental property returns 10 cents for every dollar invested in the first year.

Note, though, that this example doesn’t take into account the appreciation of the property which also affects the value of investment. 

3. Employee Training Program Investment

A company spends $5,000 on a training program aimed at improving employee productivity. After implementing the program, productivity increases, leading to an additional $25,000 in cash over the next quarter. The only cost associated is the initial $5,000 spent on training.

Initial Investment:$5000

Net Profit: $25,000 (Increased Revenue) – $5,000 (Training Cost) = $20,000
ROI: ($20,000 / $5,000) × 100 = 400%

The training program’s ROI of 400% shows that every dollar spent on training resulted in a $4 return in increased revenue.

Interpreting ROI Results

The next question, then, is “what’s a good ROI”? 

After all, entrepreneurs often have different options for how to invest their time and/or money. So they want to evaluate the potential investment performance of different options. 

Interpreting ROI results depends on several factors. 

• Length of the investment
• Type of investment
• Goal of the investment
• Business sector

A positive ROI, whether annualized or not, is on a holistic level a good thing. But it is important to check it during different periods of time.

For example the advertising campaign might have generated a ROI of 2% in quarter 1, 10% in quarter 2, 15% in quarter 3, and 1% in quarter 4. Looking at the ROI for the entire year could cause a business owner to not realize the ROI is decreasing heading into the next year. This may be expected for the business or it may not be, but either way it is important for the business owner to be aware and keep an eye on the ROI moving into the next year.

It is also worth noting that sometimes it will take time for an investment to pay off. A negative ROI may be unavoidable at the beginning of a project. 

If you calculate your ROI early on in a project, right after you have invested in a new expensive piece of machinery or have just paid for and launched your new ads, you will probably have a negative ROI. 

While it can be worth tracking this for future reference so you understand how long it usually takes to get a positive ROI for various projects/investments, don’t let it get you down. You may not need to pull the plug if you can wait long enough for the investment to pay off.

Remember: it often takes a while to see a positive ROI, so keep an eye on the numbers to make sure you are on the right track and to make informed decisions moving forward.

Similarly, ROI can diminish over time. In the employee training example above, there may be a higher ROI in the beginning, but that may diminish over time as employee productivity reaches a peak. 

How To Combine Financing Costs With ROI for Better Decision Making

Let’s return to the question we asked at the beginning of this article. “When does it make sense to borrow to invest in your business?”

To answer this, you need to consider both ROI and the risk of taking on debt. Combining financing costs with ROI leads to more accurate decision-making:

• More precise net profit/loss calculation
• More accurate cost of investment
• Helps prevent overstating or understating your ROI

Sometimes, the decision is straightforward. For example, if an entrepreneur faces high demand for their product, purchasing more inventory with a line of credit or a 0% intro APR business credit card may make sense. The expected sales increase can easily justify the financing costs.

However, predicting future outcomes isn’t always possible. Consider these risks:

• Market saturation leading to decreased demand
• Competitors copying your product
• Marketing efforts become less effective over time

Despite these uncertainties, comparing financing costs with ROI can still guide your decisions. Ultimately, deciding between risk versus reward is part of entrepreneurship. 

Sometimes, you may prefer a financing option with lower upfront costs, even if the total cost is higher. This approach gives you time to see a return on your investment. For example:

• Equipment purchase: A term loan might be better than a 0% intro APR business credit card. The loan provides more time to see a return, even though the overall cost may be higher.
• Marketing campaign: A 0% intro APR business credit card could be ideal, as marketing efforts often show quicker returns.

Remember, while it’s challenging to predict exact returns, understanding how financing costs affect your ROI can lead to more informed business decisions.

Common Mistakes in Calculating Financing Costs and ROI

It’s not always easy to calculate financing costs and ROI. Here are some common ROI Calculation Mistakes:

1. Not tracking over time: As mentioned before, ROI can and likely will change as a project progresses. Regular monitoring gives a more accurate picture of an investment’s performance over time. 
2. Poorly defined projects or goals: Vague project boundaries can lead to inaccurate ROI calculations. Clearly define what you’re measuring to ensure accuracy.
3. Using inaccurate numbers: Your ROI is only as good as the data you use. Ensure you’re working with precise costs and profits.
4. Confusing revenue and cash: Remember, cash can be revenue, but not all revenue is immediately available as cash. Customers may take time to pay, and some may not pay at all. Make sure you know the difference.

Financing Cost Calculation Mistakes

The cost of small business financing can be confusing. As we mentioned earlier, not all types of financing state costs the same way. Here are a few common mistakes: 

1. Confusing factor rate with interest rate: Factor rate is not the same as interest rate. Always convert to an annual percentage rate (APR) for accurate comparisons.
2. Overlooking fees: Many financing options come with extra costs beyond interest. Include all fees in your calculations for a true cost picture.
3. Ignoring opportunity costs: Some financing choices may limit your access to other options. Consider how each financing decision might affect future opportunities.

Not sure you can do this on your own? Let’s look at some tools and resources that can help. 

Tools and Resources

Here are some tools and resources to help you with decisions about financing and ROI.

Small Business Mentors

Consider getting help from a business mentor. Options include: 

• Local SBDC (Small Business Development Center): Offers free or low-cost financial consulting
• SCORE: Provides free business mentoring and educational resources
• Your accounting professional. Don’t be afraid to reach out to your CPA for personalized financial advice and ROI calculations.

Nav 

Nav is the only free financial health platform specifically built for small business owners to track and improve credit and cash flow health alongside a marketplace of financial products for every stage of growth. 

You’ll also learn how to establish business credit to unlock better financing opportunities. 

With Nav Prime, small businesses unlock the most comprehensive toolset to build business credit and manage financial health.