The Finance Gem 💎 Week #29: IRR, ROI and KPIs

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This week’s Strategic Finance Insights

  • IRR vs. ROI

  • DuPont Analysis

  • Accounting vs. Finance KPIs

  • 𝐀𝐜𝐜𝐨𝐮𝐧𝐭𝐢𝐧𝐠 VS. 𝐅𝐢𝐧𝐚𝐧𝐜𝐞

IRR vs. ROI

They’re both financial metrics used to evaluate investment profitability and to compare the profitability of different investments.

🎯 Definition:

⚫ IRR (Internal Rate of Return): The discount rate making the net present value (NPV) of investment cash flows zero.

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

🎯 How do you calculate them?

⚫ IRR: NPV = ∑(Cash Flow_t / (1 + IRR)^t) = 0

🟢 ROI: (Investment cash flow - cost of investment) / cost of investment

🎯 What drives IRR & ROI?

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

🟢 ROI: Investment cash flow, cost of investment, project duration, risk.

🎯 How should you use them?

⚫ IRR: Evaluates investment profitability, compares different investments, determines break-even discount rate.

🟢 ROI: Measures investment efficiency, compares different investments, decides where to allocate funds.

🎯 How should you NOT use them?

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

🟢 ROI: Avoid when time value of money, cash flow timing, and risk are crucial in investment decisions.

🎯 How are they different?

⚫ IRR is more complex, considering the time value of money.

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

⚫ IRR may produce multiple solutions or none, making it difficult to interpret

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

🟢 ROI is easier to calculate and understand

🟢 ROI ignores the time value of money

🟢 ROI doesn't consider risk

DuPont Analysis

Want to know how to measure overall Financial Performance?

DuPont Analysis will tell you everything you need to know.

What is the Dupont Analysis?

🎯 A financial performance framework that breaks down the key reasons behind your company's return on equity (ROE)

If you track ROE, you probably calculate it with the simple formula:

ROE = Net Income / Shareholders Equity

❌ While this is helpful as an easy to understand profitability ratio comparable across companies, it is also misleading because high ROE could be achieved with high leverage and poor working capital efficiency, which will jeopardize your business long term health and sustainability.

✔️ In contrast, DuPont breaks down ROE to show it as a factor of profitability, asset efficiency and leverage.

🎯 That way, you know exactly what’s driving your ROE.

ROE = Profitability x Efficiency x Leverage

🎯 Here’s the formula:

ROE = Net Profit Margin x Asset Turnover x Financial Leverage

🎯 Let’s break it down on more level:

ROE = [Net Income / Sales] x [Sales / Average Total Assets] x [Average Total Assets / Average Shareholder’s Equity]

🎯 Here’s what DuPont does:

✔️ Helps you drill down into the drivers behind your company's profitability

✔️ Helps bring a deeper understanding of your company's financial performance and the factors that influence its ROE

✔️ Helps identify areas for improvement, optimize resource allocation, and enhance financial performance.

🎯 Here’s how DuPont works:

1️⃣ Net Profit Margin is the proportion of profit generated from revenue after accounting for all expenses, taxes, and interest.

✔️ The Net Profit Margin can be further analyzed into:

a. Gross Profit Margin

b. Operating Profit Margin

c. Pre-tax Profit Margin

d. Effective Tax Rate

2️⃣ Asset Turnover is the efficiency of your company's asset usage to generate sales.

✔️ The Asset Turnover can be further analyzed into:

a. Fixed Asset Turnover

b. Working Capital Turnover

3️⃣ The Equity Multiplier is a measure of financial leverage, showing the proportion of assets financed by debt vs equity.

✔️ The Equity Multiplier can be further analyzed into:

a. Debt Ratio

b. Equity Ratio

Accounting vs. Finance KPIs

🎯 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

⚫Key Finance KPIs include:

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

2. Cash Flow Management KPIs help assess a company's ability to generate cash from operations, which is critical for growth, reinvestment, and debt repayment.

3. Capital Structure KPIs evaluate a company's capital structure, financing costs, and financial risk, informing decisions on debt and equity financing.

4. Liquidity Management KPIs measure a company's ability to meet its short-term financial obligations, providing insights into its liquidity position and financial stability.

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

6. Asset Management KPIs measure a company's efficiency in generating returns on its assets and invested capital, providing insights into asset utilization and capital allocation.

🎯 Accounting KPIs focus on the day-to-day operations of a company to help measure and monitor financial operation efficiency, and the effectiveness of assets, liabilities, and cash flow management

🟡 Key Accounting KPIs include:

1. Accounts Receivable Management KPIs help assess the effectiveness of a company's credit and collection policies, as well as the efficiency of managing customer payments.

2. Accounts Payable Management KPIs evaluate how efficiently a 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 a company uses its assets to generate sales, helping identify areas for improvement and better resource allocation.

5. Cash Flow Management KPIs assess the efficiency of a 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 a company's pricing strategies, cost control, and inventory management in generating profits.

𝐀𝐜𝐜𝐨𝐮𝐧𝐭𝐢𝐧𝐠 VS. 𝐅𝐢𝐧𝐚𝐧𝐜𝐞

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Thanks so much for reading. See you next week.

Oana

The mother of Cash and EBITDA - compliments of Nicolas Boucher