This is a common question I get from the owners of businesses with whom I interact.
There is no right answer, but when you consider that putting your money in a bank term deposit at no risk will currently generate you about 3%, and a diversified share portfolio held over the long term will earn 7-10%, you have to consider the risk/reward you are prepared to accept.
The question should really be expanded into two:
- What is the financial return on the capital needed in the business
- What is the personal return that might accrue.
Dealing with the financial return, it is a simple equation:
EBIT/Net Assets = Return on Capital employed (ROCE)
EBIT, or Earnings Before Interest and Tax is a good measure as it reflects the true costs of running the business. Definitions do vary a bit, but usually it includes depreciation, a cost of replacing productive assets, but before the externally imposed Tax and interest which have little to do with the operations of the business.
Net assets is simply the result of subtracting Liabilities excluding equity, from the total assets of the business.
Businesses that have even moderately sophisticated financial management have usually reflected on the rates they see as acceptable, but as a rule of thumb, most manufacturing businesses should have an explicit minimum hurdle rate not less than 15% before new investments can be approved.
A business that has very few fixed assets, such as a consulting practice, could reasonably expect a far greater return on the assets employed, simply because there needs to be so few of them, the key asset is knowledge. The calculation here is more about the return on time spent rather than fixed assets, way harder to measure, but directly related to revenue.
Clearly the type of business has a profound impact on the numbers, so commercial context is important.
Dealing with the second perspective, the risk/return of being your own boss is a highly personal equation, resistant of any useful quantification, so my advice is always to do what ‘feels right‘ to you.
