The Finance Gem 2023๐Ÿ’Ž Week #16

Cash Flow, Profitability, ROI, & IRR

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

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A couple announcements for this week

๐ŸŽฏ 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 

๐ŸŽฏ 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:

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

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

๐ŸŽฏ ๐‡๐จ๐ฐ ๐๐จ ๐ฒ๐จ๐ฎ ๐œ๐š๐ฅ๐œ๐ฎ๐ฅ๐š๐ญ๐ž ๐ญ๐ก๐ž๐ฆ?

โšซ IRR: NPV = โˆ‘(Cash Flow (t) / (1 + IRR)^t) = 0

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

๐ŸŽฏ ๐–๐ก๐š๐ญ ๐๐ซ๐ข๐ฏ๐ž๐ฌ ๐ˆ๐‘๐‘ & ๐‘๐Ž๐ˆ?

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

๐ŸŸข ROI: investment revenues, investment costs

๐ŸŽฏ ๐‡๐จ๐ฐ ๐ฌ๐ก๐จ๐ฎ๐ฅ๐ ๐ฒ๐จ๐ฎ ๐ฎ๐ฌ๐ž ๐ญ๐ก๐ž๐ฆ?

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

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

๐ŸŽฏ ๐‡๐จ๐ฐ ๐š๐ซ๐ž ๐ญ๐ก๐ž๐ฒ ๐๐ข๐Ÿ๐Ÿ๐ž๐ซ๐ž๐ง๐ญ?

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

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

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

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

๐ŸŸข ROI is easier to calculate and understand

๐ŸŸข ROI ignores the time value of money

๐ŸŸข ROI doesn't consider risk

๐ŸŸข ROI ignores cash flows

๐ŸŽฏ ๐‡๐จ๐ฐ ๐ฌ๐ก๐จ๐ฎ๐ฅ๐ ๐ฒ๐จ๐ฎ ๐๐Ž๐“ ๐ฎ๐ฌ๐ž ๐ญ๐ก๐ž๐ฆ?

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

๐ŸŸข 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๏ธโƒฃ ๐๐š๐ฒ๐›๐š๐œ๐ค ๐๐ž๐ซ๐ข๐จ๐:

๐ŸŽฏ Length of time required to recoup the initial investment

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

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

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

โŒ Does not indicate a project value for the company

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

2๏ธโƒฃ ๐๐ž๐ญ ๐๐ซ๐ž๐ฌ๐ž๐ง๐ญ ๐•๐š๐ฅ๐ฎ๐ž (๐๐๐•):

๐ŸŽฏ Difference between present value of cash inflows and outflows

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

โŒ Negative NPV indicates no go

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

๐ŸŸฐ Formula: NPV = Sum of Present Value of Cash Inflows โ€“ Sum of Present Value of Cash Outflows

3๏ธโƒฃ ๐ˆ๐ง๐ญ๐ž๐ซ๐ง๐š๐ฅ ๐‘๐š๐ญ๐ž ๐จ๐Ÿ ๐‘๐ž๐ญ๐ฎ๐ซ๐ง (๐ˆ๐‘๐‘):

๐ŸŽฏ 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Œ 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Œ Does not indicate the impact of the project on firm value in absolute dollars

โŒ Not additive like NPVs and therefore cannot be combined

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

4๏ธโƒฃ ๐๐ซ๐จ๐Ÿ๐ข๐ญ๐š๐›๐ข๐ฅ๐ข๐ญ๐ฒ ๐ˆ๐ง๐๐ž๐ฑ (๐๐ˆ):

๐ŸŽฏ 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Œ PI less than 1 indicates otherwise

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

โš ๏ธ ๐–๐ก๐š๐ญ ๐ญ๐จ ๐ฐ๐š๐ญ๐œ๐ก ๐จ๐ฎ๐ญ ๐Ÿ๐จ๐ซ:

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

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

โŒ Disclose assumptions or limitations in analysis to avoid misleading stakeholders

Investment Profitability - Oana Labes, MBA, CPA

10 Key Profitability Questions CEOs should ask

1๏ธโƒฃ ๐Œ๐š๐ซ๐ ๐ข๐ง๐ฌ

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๏ธโƒฃ ๐‘๐Ž๐„

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๏ธโƒฃ ๐„๐๐ˆ๐“

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๏ธโƒฃ ๐„๐๐ˆ๐“๐ƒ๐€

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๏ธโƒฃ ๐‚๐…๐๐ˆ

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๏ธโƒฃ ๐‘๐Ž๐€

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๏ธโƒฃ ๐‘๐Ž๐‚๐„

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๏ธโƒฃ ๐Ž๐‚๐… ๐Œ๐š๐ซ๐ ๐ข๐ง

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๏ธโƒฃ ๐Ž๐๐„๐— ๐Œ๐š๐ซ๐ ๐ข๐ง

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

A: Operating Expense Margin:

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

๐Ÿ”Ÿ ๐‘๐Ž๐ˆ๐‚

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?

โšซ Metric: Operating Cash Flow (OCF)

โšซ 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?

โšซ Metric: Operating Cash Flow to Current Liabilities Ratio

โšซ Formula: Operating Cash Flow / Current Liabilities

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

โšซ Metric: Cash Flow Return on Assets (CFROA)

โšซ Formula: Operating Cash Flow / Total Assets

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

โšซ Metric: Cash Flow to Net Income Ratio

โšซ Formula: Operating Cash Flow / Net Income

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

โšซ Metric: Free Cash Flow (FCF)

โšซ Formula: Operating Cash Flow - Capital Expenditures

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

โšซ Metric: Cash Flow to Investors

โšซ Formula: Free Cash Flow - Net Debt Issued

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

โšซ Metric: Cash Conversion Cycle (CCC)

โšซ 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?

โšซ Metric: Cash Debt Service Coverage Ratio (CDSCR)

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

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

โšซ Metric: Cash Flow Return on Investment (CFROI)

โšซ Formula: Free Cash Flow / Invested Capital

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

โšซ Metric: Cash Flow per Share (CFPS)

โšซ 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

๐ŸŸขKey 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.

๐ŸŽฏ 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

โšซKey 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:

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

The mother of Cash and EBITDA - compliments of Nicolas Boucher