IRR stands for Internal Rate of Return. But, what does that mean to you as a small business owner? Why is it important and how can you use it to increase the value of your business?
Well, for starters, it’s one of the best metrics you can use to measure the performance of an investment, whether that’s an investment you made in the stock market or an investment in something like a business you own.
IRR is somewhat comparable to ROI, which stands for Return on Investment, but IRR is a bit more complex and comprehensive as a metric. The main difference between the two is that IRR is used to identify annual growth rate whereas ROI calculates the total return on an investment from start to finish.
But, we’re getting a little ahead of ourselves. Let’s talk about IRR meaning first and then dig into why it’s important to understand and measure, especially if you’re the owner of a small, growing business.
What is IRR?
As mentioned above, IRR stands for Internal Rate of Return. And, it measures just that, the performance and return rate of an investment, project, or capital expenditure. Sounds simple, right? Sort of. Calculating it can be complicated, and you can use the metric in a variety of ways.
For example, you can use IRR to help compare how well one investment is performing against another. Or, in a business setting, you can use it to help gauge whether or not it makes sense to continue to invest time and resources into one project versus another.
Really, IRR is about measuring the value of something. In a more complex sense, IRR allows you to measure the interest rate on your returns when the net cash related to that investment equals zero. Looking for a full definition? Chron explains it well. It is the “interest rate that makes the cash outflows spent on an investment equal the cash inflows that come into the company as a result of the investment.”
How to Use IRR in Your Business
Okay, so you might still be thinking, “I understand the meaning of IRR, but how does that apply to my business?” Well, as mentioned, it can be useful if you are investing in different projects within your business and want to know which is providing you with more value and, therefore, in which you should continue to invest your time and resources.
You don’t necessarily have to understand the IRR formula. Honestly, there’s actually really no point in trying to do that as it’s super complex and there are spreadsheets and software that can help you determine IRR. However, it helps to know how to apply it to your business: use IRR to calculate whether or not your company made or lost money on an investment or project.
It’s that simple, really! You don’t need to be the one calculating IRR, but you do need to understand that when you have the Internal Rate of Return, you can compare it to the IRR for another investment or project to determine which was more profitable.
With that information in hand, you can make more well-informed financial decisions about where you need to shift around your business investments and resources. If you find that one project had an extremely low IRR compared to your other projects, it’ll make more sense to shift resources away from the project with lower returns.
Why not just use ROI? Sure, you could. But, IRR provides you with a deeper, more comprehensive look at the long-term rate of return of individual projects and investments. It’s hard to use ROI to measure the rate of return over the course of, let’s say, 20 or 30 years.
IRR Real World Example
To understand IRR, it helps to understand the cost of capital, which is “a company's calculation of the minimum return that would be necessary in order to justify undertaking a capital budgeting project, such as building a new factory.”
When you are able to determine your business’ cost of capital, you’ll need to make note of that percentage. Let’s say it’s 5%. To make any investment, whether that’s an external investment like an acquisition or an internal investment in a project, worth your money, the IRR needs to be higher than 5%, which is your cost of capital.
Let’s say you have the opportunity to acquire a smaller business and take over their operations and production process. You use software or have your accountant take a deep look at the numbers. They say that, based on everything, after investing in the acquisition, the IRR would be 7%. This would be an investment you’d want to look into.
What’s considered to be a “good” IRR to aim for? It varies across different industries and what you need the number for. If you’re a new entrepreneur and you’re talking to VCs, they’ll likely want to see an IRR of at least 30%. This allows them to double their investment value over the course of three years. However, if you’re just using it to calculate the value of a project within your already funded business, an IRR greater than your cost of capital is good.
Increase the Value of Your Business with Wealth Stack
Increasing the value of your business starts by looking at the details. Understanding the meaning of IRR can help you compare investments and the profitability and viability of certain projects. However, outside of that, you might find that you need access to more resources that can help you scale once you’ve identified which projects are worth your time.
The Wealth Stack Growth Pack offers you the ability to access those kinds of resources, including the following digital advisory services:
- The tools and resources you need to learn how to invest in your employees, attract and retain top talent, and access the funding you need at the terms you want
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- Access to a platform where we will provide you with capital introductions to investors and alternative sources of funding
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