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- The Finance Gem 2023๐ Week #16

# The Finance Gem 2023๐ Week #16

## Cash Flow, Profitability, ROI, & IRR

**Welcome to this week's edition of The Finance Gem ****๐**** where I bring you my unabbreviated Linkedin insights you loved - so you can save them, and those you missed - so you can enjoy them.**

This newsletter edition is brought to you byย **Financiarioย -ย The Financing Advisory Firm for Growing Businesses**.ย **Financiario**ย supports the vision of CEOs and expands the capacity of CFOs, to help companies to strategically plan and manage their financing requirements.ย Financiario prepares dynamic financial models and financing memorandums that help companies plan strategically, they help expedite the closing of financing transactions, and they enable you to position your business for long term profitability, solvency and liquidity.ย

Before we get on with this week's newsletter,ย ย The Cash Flow Masterclass**ย launches on Monday, May 1**. This is a one-of-a-kind, on-demand video course which will teach you to master cash flow full cycle, from Accounting to Finance and finally, to Strategic Business decision making.ย **ย ****Pre-Order The Cash Flow Masterclass Today, and transform your business, your career and your earnings potential!**ย

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**A couple announcements for this week**

๐ฏ I was just **ranked No 27 in the Top 200 Worldwide Linkedin Creators by ****Favikon****. ** Also the 4th Female in the Top 30, and the 2nd Canadian in the ranking.ย

๐ฏ I am **holding a 1 hour EBITDA masterclass webinar in partnership with CPA Ontario on May 31**. Join me if you'd like to learn the main shortfalls of EBITDA and how they can lead to disasters, the typical adjustments employed by the industry to respond to these many shortfalls, and what reasonable EBITDA alternatives are available

**This week's strategic finance insights:**

**IRR vs. ROI****4 key Ways to Measure your Investment Profitability****10 Key Profitability Questions CEOs should ask****10 Essential Cash Flow Questions & Ratios you need to know**ย

**Accounting vs. Finance KPIs**

**Without further ado, let's begin:**

**IRRย vs.ย ROI**

IRR and ROI are both financial metrics used to evaluate investment profitability and to compare the profitability of different investments.

Except one of them is misleading.

It tells you nothing about risk. And ignores cash flows.

IRR is the break-even discount rate. ROI is just the rate of return.

Let's compare:

โซ IRR (Internal Rate of Return): The discount rate making the Net Present Value (NPV) of investment cash flows zero.

๐ข ROI (Return on Investment): A financial ratio measuring the profitability of an investment as a percentage of the initial investment.

๐ฏ ๐๐จ๐ฐ ๐๐จ ๐ฒ๐จ๐ฎ ๐๐๐ฅ๐๐ฎ๐ฅ๐๐ญ๐ ๐ญ๐ก๐๐ฆ?

โซ IRR: NPV = โ(Cash Flow (t) / (1 + IRR)^t) = 0

๐ข ROI: investment net profit / cost of investment x 100

๐ฏ ๐๐ก๐๐ญ ๐๐ซ๐ข๐ฏ๐๐ฌ ๐๐๐ & ๐๐๐?

โซ IRR: Time value of money, cash flow timing, cash flow amounts, discount rate, project duration, risk.

๐ข ROI: investment revenues, investment costs

๐ฏ ๐๐จ๐ฐ ๐ฌ๐ก๐จ๐ฎ๐ฅ๐ ๐ฒ๐จ๐ฎ ๐ฎ๐ฌ๐ ๐ญ๐ก๐๐ฆ?

โซ IRR: to evaluate investment profitability, compare different investments, determine break-even discount rate.

๐ข ROI: to measure investment efficiency & profitability, help decide where to allocate funds.

๐ฏ ๐๐จ๐ฐ ๐๐ซ๐ ๐ญ๐ก๐๐ฒ ๐๐ข๐๐๐๐ซ๐๐ง๐ญ?

โซ IRR is complex due to the fact it considers the time value of money

โซ IRR accounts for cash flow timing and amounts, providing a more accurate profitability picture

โซ IRR considers risk by accounting for the required discount rate to achieve a positive NPV

โซ IRR may produce multiple solutions or none, making it difficult to interpret when cash flows both positive and negative over life of project

๐ข ROI is easier to calculate and understand

๐ข ROI ignores the time value of money

๐ข ROI doesn't consider risk

๐ข ROI ignores cash flows

๐ฏ ๐๐จ๐ฐ ๐ฌ๐ก๐จ๐ฎ๐ฅ๐ ๐ฒ๐จ๐ฎ ๐๐๐ ๐ฎ๐ฌ๐ ๐ญ๐ก๐๐ฆ?

โซ IRR: Avoid when investment cash flows are expected to be both positive and negative during project

๐ข ROI: Avoid when time value of money, cash flow timing, and risk are crucial in investment decisions. Also avoid when comparing projects of different sizes because it will mislead you into choosing the wrong project (highest return % vs. highest value/NPV $$).

IRR vs. ROI - Oana Labes, MBA, CPA

**4 key Ways to Measure your Investment Profitability**

1๏ธโฃ ๐๐๐ฒ๐๐๐๐ค ๐๐๐ซ๐ข๐จ๐:

๐ฏ Length of time required to recoup the initial investment

โ๏ธ Suitable for short-term projects or those with low risk

โ Does not consider time value of money or future cash flows

โ Does not take into account the cash flows that occur after the payback period

โ Does not indicate a project value for the company

๐ฐ Formula: Payback Period = Initial Investment / Annual Cash Inflows

2๏ธโฃ ๐๐๐ญ ๐๐ซ๐๐ฌ๐๐ง๐ญ ๐๐๐ฅ๐ฎ๐ (๐๐๐):

๐ฏ Difference between present value of cash inflows and outflows

โ๏ธ Considers the time value of money >> positive NPV indicates a profitable project;

โ Negative NPV indicates no go

โ Long term forecasting of cash flows and assumptions may be difficult

๐ฐ Formula: NPV = Sum of Present Value of Cash Inflows โ Sum of Present Value of Cash Outflows

3๏ธโฃ ๐๐ง๐ญ๐๐ซ๐ง๐๐ฅ ๐๐๐ญ๐ ๐จ๐ ๐๐๐ญ๐ฎ๐ซ๐ง (๐๐๐):

๐ฏ Discount rate at which NPV of all cash inflows and outflows equals zero

โ๏ธ Considers the time value of money and is easy to understand

โ๏ธ Higher IRR implies a more profitable project

โ There can be multiple IRRs (if cash flows are both positive and negative) making it difficult to conclude on what the true return is

โ Does not indicate the impact of the project on firm value in absolute dollars

โ Not additive like NPVs and therefore cannot be combined

๐ฐ Formula: NPV = 0 = (Cash Inflow / (1+IRR)^n) - Initial Investment

4๏ธโฃ ๐๐ซ๐จ๐๐ข๐ญ๐๐๐ข๐ฅ๐ข๐ญ๐ฒ ๐๐ง๐๐๐ฑ (๐๐):

๐ฏ Ratio of present value of cash inflows to initial investment

โ๏ธ Considers the time value of money >> PI greater than 1 indicates a profitable project;

โ PI less than 1 indicates otherwise

๐ฐ Formula: PI = (Sum of Present Value of Cash Inflows) / Initial Investment

โ ๏ธ ๐๐ก๐๐ญ ๐ญ๐จ ๐ฐ๐๐ญ๐๐ก ๐จ๐ฎ๐ญ ๐๐จ๐ซ:

โ Don't use metrics in isolation and combine with qualitative analysis factors like risk, market conditions, and strategic fit

โ Ensure projections are based on realistic assumptions and account for full project costs and benefits

โ Disclose assumptions or limitations in analysis to avoid misleading stakeholders

Investment Profitability - Oana Labes, MBA, CPA

**10 Key Profitability Questions CEOs should ask**

1๏ธโฃ ๐๐๐ซ๐ ๐ข๐ง๐ฌ

Q: What are the different levels of our profitability, how to we compare with industry benchmarks, and how do we improve them?

A: Gross, Operating, and Net Profit Margins:

Gross Profit Margin = (Gross Profit / Revenue) x 100

Operating Profit Margin = (Operating Income / Revenue) x 100

Net Profit Margin = (Net Income / Revenue) x 100

2๏ธโฃ ๐๐๐

Q: How can we assess the returns provided to our shareholders and how do we improve them?

A: Return on Equity (ROE):

ROE = Net Income / Average Shareholders' Equity = Profitability x Efficiency x Leverage

3๏ธโฃ ๐๐๐๐

Q: How do we evaluate profitability before accounting for interest and taxes and how do we optimize it?

A: EBIT Margin:

EBIT Margin = (Earnings Before Interest and Taxes / Revenue) x 100

4๏ธโฃ ๐๐๐๐๐๐

Q: How does our EBITDA margin track to industry benchmarks and how can we reduce non-operating expenses?

A: EBITDA Margin:

EBITDA Margin = (EBITDA / Revenue) x 100

5๏ธโฃ ๐๐ ๐๐

Q: How to evaluate efficiency in converting our net income into cash flow from operations and how do we improve our cash flow management?

A: Cash Flow to Net Income (CFNI) Ratio:

CFNI Ratio = Operating Cash Flow / Net Income

6๏ธโฃ ๐๐๐

Q: How do we determine the returns we generate on each dollar of assets of the business and how can we optimize our asset utilization?

A: Return on Assets (ROA):

ROA = Net Income / Average Total Assets

7๏ธโฃ ๐๐๐๐

Q: How can we enhance our return on capital employed, and are we allocating capital effectively across the business?

A: Return on Capital Employed (ROCE):

ROCE = EBIT/ (Long Term Debt + Equity)

8๏ธโฃ ๐๐๐ ๐๐๐ซ๐ ๐ข๐ง

Q: How do we measure how well we convert revenue to operating cash flow ?

A: Operating Cash Flow Margin:

Operating Cash Flow Margin = (Operating Cash Flow / Revenue) x 100

9๏ธโฃ ๐๐๐๐ ๐๐๐ซ๐ ๐ข๐ง

Q: How can we optimize our operating expense margin to improve profitability?

A: Operating Expense Margin:

Operating Expense Margin = (Operating Expense/ Revenue) x 100

๐ ๐๐๐๐

Q: How can we improve our ROIC, and are our investments generating sufficient returns for shareholders?

A: Return on Invested Capital (ROIC):

ROIC = EBIT (1-tax) / (Long Term Debt + Equity - Cash)

Profitability KPIs for CEOs - Oana Labes, MBA, CPA

**10 Essential Cash Flow Questions & Ratios you need to know**

1. Is this company generating positive cash flow from operations?

โซ Metric: Operating Cash Flow (OCF)

โซ Formula: Net Income + Non-cash Expenses (e.g., depreciation, amortization) + Changes in Working Capital

2. What is this company's ability to meet its short-term obligations using its operating cash flow?

โซ Metric: Operating Cash Flow to Current Liabilities Ratio

โซ Formula: Operating Cash Flow / Current Liabilities

3. How effectively is this company using its assets to generate cash flow?

โซ Metric: Cash Flow Return on Assets (CFROA)

โซ Formula: Operating Cash Flow / Total Assets

4. How much of this company's net income is being converted into cash flow from operations?

โซ Metric: Cash Flow to Net Income Ratio

โซ Formula: Operating Cash Flow / Net Income

5. Is this company able to cover its capital expenditures with the cash generated from its operations?

โซ Metric: Free Cash Flow (FCF)

โซ Formula: Operating Cash Flow - Capital Expenditures

6. How much cash flow is available to this company's investors (both debt and equity)?

โซ Metric: Cash Flow to Investors

โซ Formula: Free Cash Flow - Net Debt Issued

7. How effectively is this company managing its cash conversion cycle?

โซ Metric: Cash Conversion Cycle (CCC)

โซ Formula: Days Sales Outstanding (DSO) + Days Inventory Outstanding (DIO) - Days Payable Outstanding (DPO)

8. How leveraged is this company, and can it comfortably meet its debt obligations?

โซ Metric: Cash Debt Service Coverage Ratio (CDSCR)

โซ Formula: Operating Cash Flow / Total Debt Service (Principal + Interest)

9. Is this company generating a sufficient return on invested capital?

โซ Metric: Cash Flow Return on Investment (CFROI)

โซ Formula: Free Cash Flow / Invested Capital

10. How efficiently is this company generating cash flow for its shareholders?

โซ Metric: Cash Flow per Share (CFPS)

โซ Formula: (Operating Cash Flow - Preferred Dividends) / Weighted Average Number of Common Shares Outstanding

10 Cash Flow KPIs - Oana Labes, MBA, CPA

**Accounting vs. Finance KPIs**

๐ขKey Accounting KPIs include:

1. Accounts Receivable Management KPIs help assess the effectiveness of a company's credit and collection policies.

2. Accounts Payable Management KPIs evaluate how efficiently your company manages its payments to suppliers and other creditors.

3. Inventory Management KPIs measure the effectiveness of inventory management, determining how quickly a company sells and replenishes its stock.

4. Asset Utilization KPIs evaluate how effectively your company uses its assets to generate sales

5. Cash Flow Management KPIs assess the efficiency of your company's cash flow management, providing insights into working capital requirements and cash flow optimization strategies.

6. Profitability and Margins KPIs help determine the effectiveness of your company's pricing strategies, cost control, and inventory management in generating profits.

๐ฏ Finance KPIs focus on the financial performance of a company and help assess value creation by measuring financial health, ability to generate profits and ability to manage capital appropriately

โซKey Finance KPIs include:

1. Profitability KPIs provide insights into your company's ability to generate profits and create value for shareholders.

2. Cash Flow Management KPIs help assess your company's ability to generate cash from operations

3. Capital Structure KPIs evaluate your company's capital structure, financing costs, and financial risk

4. Liquidity Management KPIs measure your company's ability to meet its short-term financial obligations

5. Shareholder Value Creation KPIs evaluate your company's ability to generate returns for shareholders and distribute profits through dividends.

6. Asset Management KPIs measure your company's efficiency in generating returns on its assets and invested capital

Accounting vs. Finance KPIs - Oana Labes, MBA, CPA

**Next steps for you to consider:**

**Pre-Order The Cash Flow Masterclass**to enjoy a low introductory price only until May 1, 2023. Check it out at**oanalabes.com****Looking for 1-1 coaching? -****B****ook my calendar directly here****Sponsor this newsletter -**partner with me and bring your business in front of a highly engaged professional community made up of CFOs, CEOs, CPAs, MBAs, FMVAs, Controllers, Finance Managers, Presidents, Business Owners, and upcoming leaders.**Book directly here.****Forward this newsletter -**to help your network enjoy it the way you do. Your friends and colleagues will appreciate your thoughtfulness and will respect your deep knowledge of finance.**Subscribe to The Finance Gem**ย ๐- to receive my newsletter directly next week, in case this email was forwarded to you by one of your thoughtful friends or colleagues.**Click here to sign up**

Thanks so much for reading. See you next week.ย

The mother of Cash and EBITDA - compliments of Nicolas Boucher