What Is IRR and Why You Should Use It As A CEO
Equity or investment firms primary metric is IRR or internal rate of return. It allows a business to calculate the profitability of an investment. And in the context of an investment firm, its easy to understand why its one of the most common metrics.
It’s a valuable tool for any CEO, even startups. As we’ve mentioned a few times, capital allocation is the #1 job of a CEO. So before deciding where to invest your capital, you should consider what the return would be on the investment.
Considering Capital Allocation
As A Startup
If you are relatively new business you may find yourself in a position with limited capital and/or needing to seek additional capital. While taking on investors is a several topics to themselves, IRR can be a powerful tool for both validating where you use your limited capital AND conveying the potential return on the investment to external funders. It is also another tool in determining whether you even need external investors.
When seeking a block of finding from external investors most startups will set out a budget. They will calculate the how much they need and what it is for. They will also usually try to articulate how their current business is performing. The stronger the latter is the better in making a case. However, just like if you want to sell you want to speak like the buyer, if you want an investor calculating the IRR of their capital and it’s use is a great way to speak their language. It also shows a maturity of consideration and calculation.
Before Using Credit Lines Or Loan
IRR is also useful when you are considering taking on a business loan or credit line. While these forms of funding are common for service and low available capital businesses to even out cashflow, they are also often used for capital investments. Restaurant expansion, new location, additional product line and many more are common reasons a business may seek a line of credit.
While there are a lot of budgeting factors to consider in whether you could take out that line of credit or loan for the capital investment, few answer so easily “is it worth it”. IRR when factoring the cashflow of repayment gives you an easy to digest figure to calculate whether the long term return the business is potentially worth it. It also makes it very easy to compare total value of multiple potential capital investment options side by side.
Things To Consider When Using IRR
IRR as a metric will give you a total potential for return, and whether an opportunity is worth your capital. However, it doesn’t answer a few other vital questions. First, it doesn’t represent actual dollars. Second it doesn’t give you cash flow projects. So a highly capital intensive investment with low cashflow but high return in the long run will have a high IRR even if cashflow is poor along the way. IRR is still important in these contexts, its a way you can consider whether the capital allocation is worth it perusing at all.
Another consideration, like any forward looking calculation the metric is only as good as the inputs, even when considering it’s limitations. An accurate Pro Forma and estimates are critical.
Also, IRR for all its strengths and time consideration is still fairly linear. It doesn’t take into account the adjusted rate of return when capital is reinvested. If you need to reinvest capital in order to achieve the IRR (and you most likely will), then you’d want to consider a modified IRR (MIRR) as well. I’m not going to dive deeply into MIRR because it’s more of an operating measure. In most of the example context here we are primarily discussing “is it worth it”. This is where IRR is most useful. If you are planning to invest in a company or get into equity based businesses than you may want to consider advanced metrics.