You have probably heard the word ‘investment’ before. You might have heard your mom or dad say ‘we have to invest in a new toaster’ before purchasing it for your kitchen. What did they mean by ‘invest’, though? Now, let's outline the concept of investment in a business context. What is an investment? Why and how exactly do businesses invest? Read along to find out more.
Investment definition business
Making investments is an essential part of running a business. Investment refers to the act of buying an asset to make a profit from its use.
Simply put, it is when a business spends money on something that will help it make financial returns.
Hand holding coins, Wikimedia Commons
Why do businesses invest?
Investment is a crucial element for every business. Without making an investment, it would be impossible to establish a business and keep it running. This is because for a firm to earn money, it needs some assets to start out and generate profits from.
Many businesses invest money in software that automates their operations, making them more efficient and effective. For example, e-commerce companies such as Amazon make use of software that allows them to control and keep up their stock without physically counting the products.
There are two types of assets a business can invest in:
tangible assets
intangible assets
An asset is everything that a business owns. Profit is money earned by a business after paying all of its costs.
| Tangible assets | Intangible assets |
| Definition | physical goods | non-physical goods |
| Example | cash, land, buildings, machinery, vehicles | patents, copyright, trademarks, software |
Companies that produce goods would not be able to do so without investing in some type of building. For example, chocolate manufacturers such as Cadbury have to invest in factories to have a place to produce and pack their chocolate bars.
However, even if a firm has all the assets necessary to operate, it can invest in developing new products. In doing so, it needs to spend money on research and development, production, marketing, etc. Such investment can not only extend the range of products the company offers, but also increase profits.
Some firms regularly invest money in developing new products. For example, technology companies such as Apple launch new smartphones at least once a year. This way they bring customer attention and remain competitive.
Types of investments
Depending on a business, its situation, and the type of goods or services it offers, it might need to or want to make different kinds of investments. The types of investments a company can make include land and buildings, machinery and vehicles, and new products.
Investments: Land and buildings
The majority of businesses require land and buildings to keep their operations running. The kinds of properties may vary depending on the products offered by a firm. They could be farms, car parks, factories, warehouses, offices, or other premises.
Companies that produce clothes and accessories typically need to invest in both land and buildings. For example, Louis Vuitton requires factories to sew its clothes and warehouses to store them. What is more, it requires buildings for its physical shops. The company also needs offices for its employees who work in research and development, marketing, finance, etc.
Investments: Machinery and vehicles
Many companies also need machinery and vehicles to supply their goods or services. These may also vary depending on the products they offer. These items could be computers, software, cash registers, cars, vans, buses, and so forth.
Food retailers usually need to invest in both machinery and vehicles. For example, Asda requires cash registers to calculate and register transactions it makes when selling groceries to customers. It also needs computers and software to keep track of inventory levels. What is more, since Asda offers delivery services, it also needs vans to transport products to customers.
Investments: New products
Some established businesses try developing new products. In doing so, they aim to attract customers and remain competitive. To develop new products, they need to invest in numerous things such as research and development, production, marketing, etc.
Coffee shops regularly invest money in developing new products. For example, Pret A Manger launches new drinks several times a year. To do so, it needs to spend money on research to get to know the demand as well as customers’ needs. It also needs to develop new recipes. Moreover, it has to invest in advertising to draw customer attention.
Investment analysis
Before making any investment, businesses should always make sure that it is worth it. This means that they need to ensure that the investment will bring them profits rather than losses. To do so, they should analyze the investment using one of the three methods: return on investment, the average rate of return, or break-even analysis.
Return on investment
Return on investment (ROI) is a method of analysing the profitability of an investment.
Return on investment (ROI) is the ratio between return (profit) and cost of investment.
Return on investment compares the overall return (profit) and cost of investment. It is expressed as a percentage of the original sum invested.
If the return on investment is 30%, it means that the overall profit from the investment will be 30%.
Investments: The average rate of return
The average rate of return (ARR) is a method that helps to decide whether an investment is worthwhile or not.
The average rate of return (ARR) is the average annual return (profit) from an investment.
The average rate of return compares the average yearly return (profit) from an investment considering the cost of it. It is expressed as a percentage of the original sum invested.
If the average rate of return is 20%, this means that the average yearly profit from the investment will be 20%.
To learn more about this concept and how to calculate ARR, check out our explanation on the Average Rate of Return.
With every investment comes the risk of losing invested capital. Some investments are considered low-risk and some high-risk. Usually, high-risk investments offer higher potential profits in a short period of time but are associated with losing the majority of the invested money. On the other hand, low-risk investments are safer but offer lower, stable profits over a longer period of time.
Examples of high-risk investments:
- Hedge funds
- Venture capital
- Cryptocurrencies
- Penny stocks
Examples of low-risk investments
- Saving accounts
- Treasury securities
- Money market funds
- Preferred stocks
Investments: Break-even analysis
The break-even level of output is important for businesses to calculate in order to know how many units of a product they need to sell to recover total costs.
Break-even is the level of output at which revenues from sales equal total costs. It is the number of units a firm has to produce and sell to recover its total costs.
When a business reaches the break-even level of output, it recovers all of its costs. When the level of output is below the break-even level, a business will suffer a loss. When the level of output is above the break-even level, a business will make a profit.
If the break-even level of output is 50, it means that a business has to produce and sell 50 units to recover the cost of investment.
As you can see, it is impossible to establish and run a business without investing. However, before making any investment, it is important to analyse that investment to ensure it will bring profits rather than losses. A deliberate and worthwhile investment can be a key to the success of a firm.
Investments - Key takeaways
- Investment refers to the act of buying an asset to make a profit from its use.
- Simply put, it is when a business spends money on something that will help it to make money.
- Without making an investment, it would be impossible to establish a business and keep it running. For a firm to earn money, it needs assets such as land, buildings, machinery, and vehicles to produce goods or services.
- Businesses can invest in tangible assets (physical goods) and intangible assets (non-physical goods).
- Even if a firm has all the assets necessary to operate, it can invest in developing new products.
- Depending on the business, its situation, and the type of goods or services it offers, it might need to or want to make different investments.
- Types of investments are: land and buildings, machinery and vehicles, and new products.
- To make sure that an investment is worthwhile, businesses can analyse it using three methods: the return on investment, the average rate of return, and break-even analysis.
- The average rate of return (ARR) is the average annual return (profit) from an investment.
- Break-even is the level of output at which revenues from sales equal total costs. It is the number of units a firm has to produce and sell to recover its total costs.
- The return on investment (ROI) is another method to analyse the profitability of an investment.
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