ROI versus IRR … In a Nutshell

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Both the CEO and the CFO of a large company told me that ROI and IRR are the same thing.  They’re not. Interestingly, both executives’ annual bonus was determined by how their ROI compared with other companies in the industry.

I worked for a big company that required a 16% after-tax IRR on new investments. As it happened, the company’s ROI was typically in the 16% range. The Director of Financial Planning told the operating teams that achieving a 16% IRR automatically resulted in a 16% ROI… But he was wrong. It was just a coincidence.

Another company required an 18% pre-tax IRR on new investments, and for several years reported an ROI of about 18%. That was also a coincidence.

ROI and IRR are very different calculations, and are used for very different purposes.

Return on Investment (ROI)

ROI is a measure of how effectively a company is utilizing its capital investment.  It measures the company’s profit during a fixed period of time, usually one year, divided by its average assets.

Calculating ROI

Pretax Profit Before Interest  /  Average Total Assets, excluding Capitalized Interest  (-)  Average Non- Interest Bearing Liabilities

Taxes and interest are excluded from the calculation in order to compare the performance of different companies more effectively. A company with a low tax rate, or a highly leveraged company will have very different result from those of a company that has higher taxes or operates with low debt levels, so this calculation removes those variables. Other calculations, such as Return on Equity (ROE) evaluate performance on a more comprehensive basis.

Non-interest bearing liabilities include items like accounts payable and accrued liabilities, which are effectively free financing, so the corresponding assets aren’t really considered to be an investment.

How Useful is ROI?

ROI is a widely used calculation, but we must remember that it measures only one year’s performance, so it can swing widely from year to year if earnings are volatile. This may not be a bad thing in cyclical businesses, in which all companies experience the same environment.

In my opinion, ROI is most useful in established companies that are not growing or contracting at a rapid rate. The book value of a young company or a growing company’s assets is likely to be relatively high, as they invest in future earnings, and haven’t charged off extensive depreciation and amortization.

Conversely, there is an old joke that the best way to increase your ROI is to go out of business, because your investment is declining as you sell off assets, while you still report income from the sale of those assets.

Similar Calculations

There are plenty of slightly different calculations such as Return on Net Assets (RONA), Return on Capital (ROC) and Return on Invested Capital (ROIC) that can be argued to be more representative of a particular company’s performance, but they all have the same basic objective.

Internal Rate of Return (IRR)

IRR calculates the compound rate of interest earned over the life of a specific investment, using not only the dollar amounts, but also the timing of cash expenditures and cash receipts.  Because it uses the concept of the “time value of money,” IRR is used to compare investment opportunities that have very different cash flows.

Calculating IRR

IRR is based on the concept of Net Present Value (NPV). NPV says that one dollar today is worth exactly one dollar. A promise to receive one dollar a year from now, however, is worth less than a dollar, because you’ve missed the opportunity to earn income on that dollar for a year. If you could earn 10% (the Discount Rate) on your investment, next year’s dollar would be worth only 90.9 cents today ($1.00 divided by 110%).  On the bright side, a future expense is also worth less today.

IRR is the Discount Rate at which the NPV of a series of cash flows is zero. That is, the interest rate earned over the life of an investment after the initial investment has been repaid.

Typically, interest and taxes are also excluded from the IRR calculation for comparison purposes, but of course, you will want to see the net leveraged IRR too.

How Useful is IRR?

If you have $1 million cash to invest, should you invest in the project that requires the entire investment up front, then pays nothing for 3 years, when it returns $1.5 million? Or should you go for the one that requires a $500,000 investment in each of the first two years, and then pays $350,000 a year for the next 5 years? There are obviously a lot of other factors to consider, but IRR will tell you which one pays a higher return.

Similarities Between ROI and IRR

None… ROI and IRR are entirely different calculations.

Does your CFO explain and discuss financial metrics with your management team?

What (Not!) To Do In Troubled Times – Part 1

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Regrettably, I’ve seen my share of companies in troubled times. Some CEOs step up and take effective action, but others are less effective. Here are some unfortunately common behaviors that have led to failure. This group of behaviors falls under the category:

Personal Interaction

Cut off communication – When things start to go wrong, your best friends can be a source of support and morale. But they should not be your only points of contact. Resist the urge to see only friendly faces and hear only from people who agree with you. Don’t close your door and hire a bulldog assistant to keep people away. The more people you hear from, the more you’ll understand changing conditions, and the better equipped you’ll be to deal with them.

Stop making field visits – In stressful times, don’t look at your office as a sanctuary. You are unlikely to learn anything useful there. The people who make and sell your product are the ones who can really tell you what is happening, and often how to make things better. And your attention is reassuring and inspiring to them.

Take long trips away from the office – Yes, bad times are stressful, but you can’t hide from them. Taking more personal trips and long weekends will just put you out of touch, and will send a very wrong message to your management team.

Make it clear that you only want to hear good news – We all like good news, but if you won’t hear the bad news, or require that all bad news have a positive spin, you’re going to lose your grip on the business. And you’ll look foolish to your management team.

Hold more long meetings – Meetings are necessary for communication. More meetings, longer meetings and meetings with more attendees can be detrimental. You may feel comfort in surrounding yourself with subordinates, but the more time you spend talking to them, the less time they can spend identifying and solving problems.

Think about it. Does any of this feel familiar? … Really think about it.

Profit Improvement – Simple Communication

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Pretty much every company wants to increase its profit, and most managers devote a large portion of their time to trying to increase revenues and margins, or reduce costs. As a financial manager and consultant, I have been involved in many profit improvement initiatives. Here are some examples – they are mostly from construction, retail and land development, but the concepts can be applied to any business.

Communication

Sometimes a simple conversation will solve your problems. This can be a natural process, or the result of an expensive and time-consuming structured organizational review. If you have a problem, talk about it.

A telephone call – The sales department of a homebuilder often selected lots for sale in such a manner that the engineering department had to return to the city with new plans for approval. This caused time delays for sales and frustration in the engineering department, and resulted in increased plan approval fees. A Six Sigma team approached the problem, creating wishbone charts, pareto charts and other analyses to identify the underlying problem, but could find no statistical pattern. Finally, the head of engineering telephoned the head of sales, and the problem was eliminated in five minutes.

A meeting – The buyers at a retail company weren’t getting all the information they needed from the accounting department, so they appointed a full-time administrator to track and report on outstanding orders and merchandise receipts. A meeting between the buyers and the accountants resulted in an automated report that solved all the buyers’ needs, and the administrative position was eliminated.

Bottlenecks – A land developer was experiencing chronic delays in processing grading permits. Business was booming, so every day represented delayed revenue and additional carrying costs on multi-million dollar developments. A Six Sigma team spent several weeks of process flow-charting and statistical analysis, only to learn that the manager in charge of grading applications was swamped, and had a long backlog. They added a part-time clerk, and the problem was solved. Asking a few simple questions much earlier would have been a lot easier.

Does your CFO encourage your operating team to communicate with each other?

What? … Manage Return on Equity?

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Return on Equity, or ROE, is a widely recognized measure of a company’s performance. Even though some senior executives’ compensation is based on ROE or a similar measure, many regard it as an academic, technical calculation, and wait until year-end for the accountants to give them the result.

ROE tells you how effectively you are using your company’s resources, and it CAN be managed. It is a tool that should be evaluated and refined constantly to ensure your business is headed in the right direction. It can be managed by breaking it down into its separate components:

The calculation of ROE is:

ROE = Profit Margin X Asset Turnover X Financial Leverage

Profit margin is your profit as a percentage of sales. No surprises here. You know your industry, and you know your company, and you know how to improve your margins.

Asset turnover is your sales divided by your total assets. Turnover drops when you carry more standing inventory than you need, or make capital investments before you really need them. Faster collection of accounts receivable will improve your asset turnover… And obviously, increasing sales will improve your turnover.

Financial leverage is your total assets divided by shareholders’ equity. Negotiating longer vendor payment terms can increase financial leverage. So can increasing debt, but that is a complex decision that should be discussed in depth with your CFO.

Does your CFO work with you and your operating teams to improve the components of ROE?

Profit Improvement – Cost Reduction

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Pretty much every company wants to increase its profit, and most managers devote a large portion of their time to trying to increase revenues and margins, or reduce costs. As a financial manager and consultant, I have been involved in many profit improvement initiatives. Here are some examples – they are mostly from construction, retail and land development, but the concepts can be applied to any business.

COST REDUCTION

Reducing costs can be as simple as finding a new supplier, but sometimes a more detailed analysis or a global approach can be effective.

Looking at the details – A retailer’s payroll is typically its largest expense. At one company, the standing order was to maintain payroll at 10% of sales. This worked consistently, but when we started to look at customer traffic patterns, we saw that staffing was not being increased at peak times, or decreased during the slow hours of the morning or evening. A new staff planning system improved customer service and brought payroll under the 10% target.

Statistical analysis – A homebuilder had a problem with windows leaking during rainstorms. Nobody really knew why, but replacement was costly, and it was a serious customer satisfaction problem. We formed a Six Sigma task force to gather and analyze the data. We broke down the data by community, by subcontractor, by supervisor, by manufacturer and installer until a pattern became evident. After a few changes, leaking window problems were reduced by 60%.

Centralization – At another retailer, repairs and maintenance expenses were the responsibility of the local management, and no amount of threats or encouragement could stop costs from increasing. We centralized the function in the corporate office, and made low cost arrangements with regional contractors, reducing costs by over 30%.

Glaring opportunities – A land developer always paid for up-front infrastructure costs – roads, sewer, etc. – on its development projects. This had a huge impact on cash flow and ROI. I learned that most cities are willing to finance these costs with municipal bonds. It wasn’t a secret, but the company never took advantage of the opportunity. I set about becoming something of an expert on the subject, and initiated over $100 million of cost savings that went straight to the bottom line when the developed properties were sold.

Planning – At a homebuilder, we carefully reviewed the cost of every house, and construction (or even purchase of the land) would not be approved until we were certain that projected profits met our investment return guidelines. Marketing would sometimes change design specifications, but the purchasing managers were often the ones who would drop the cost per square foot by changing a material or redesigning a minor architectural detail. This was sometimes a painful process, but the result was a low cost, high value product.

Does your CFO encourage your management team to look at cost reduction in a comprehensive way?

 

How Much Is It Worth? Uh… What? And to Whom?

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Many business owners are thinking it may be time for a change. And everyone has a different set of concerns.

– Do you really want the hassle of doing it all over again through the next business cycle?
– Is there enough cash to retire or move on to the next venture?
– Do you need cash now, or can you take it over time?
– Do you want to get out from under the personal guarantees?
– Continuity of the business.
– Welfare of managers and employees.
– Do you want to have an ongoing management role?

What Are You Selling?

Assets – You can sell off assets, pay off debt, and keep the difference. Selling to an opportunistic buyer would be quicker, but the price will be lower in the amount of their profit.

An Ongoing Business – Solid, predictable cash flows can be multiplied at an appropriate rate to calculate a selling price, and to set a time horizon.

A Business Plan – If it is already under way, you may be able to use projected cash flows to increase the selling price.

Your Wisdom and Expertise – This could justify an ongoing management or consulting role.

Who’s Buying?

Nobody – An orderly shut-down and sale of assets.

Financiers – Maybe, but only if the price is really, really right.

Employees or Family Members – They have a stake in continuing the business. This could take several years to accomplish.

Someone in the Industry – Someone who has an interest in entering or expanding in your market.

Each of these situations will have a very different value and personal outcome for yourself and your family.

Does your CFO have the knowledge and experience to advise you on a business exit strategy?