Internal rate of return (IRR) is one of the most critical metrics used for financial decision-making but it’s also one of the most complex. The new fiscal year is well underway, which makes it the ideal time to solidify your financial strategy for the coming months by leveraging IRR calculations.

Join us as we explore how to calculate IRR and outline the value this metric provides small to mid-sized businesses.

What Is the Internal Rate of Return? 

The internal rate of return is a financial metric used to evaluate the profitability of potential investments. It represents the discount rate at which the net present value (NPV) of all cash flows (both positive and negative) from a project or investment equals zero.

Essentially, the IRR is the annualized rate of return an investment is expected to generate over its lifetime. 

The formula for IRR is as follows: 

internal rate of return formula

This seems pretty complex and may not look like your usual formula, but don’t worry. We’ll get into some specific examples of how to apply this formula below. For now, just know that both business-to-consumer (B2C) and business-to-business (B2B) companies use it to guide initial investments and ensure positive cash flows. 

When using IRR to make financial decisions, you should consider an investment attractive if its IRR exceeds the cost of capital or a targeted rate of return. 

Understanding the Concept

Think of IRR as a tool that helps you figure out how good an investment might be. Imagine you’re upgrading the equipment at your business, and you want to know how much profit you’ll make each year until you make your money back. The IRR helps you see this yearly percentage.

Instead of just getting your money back, you’re trying to achieve a consistent yearly profit percentage. If this profit percentage is higher than what you’d expect from putting your money elsewhere, it’s a good deal. Insights like these assist with financial planning and decision-making.

In simpler terms, the IRR is a way to measure an investment’s profitability using a percentage. This percentage helps you compare different investment opportunities to get the best return. 

Best Uses of IRR

The internal rate of return can help you decide between different investment opportunities and maximize expected cash flows. You can also use these insights to estimate your compound annual growth rate (CAGR) and maintain positive cash flows. 

Additionally, IRR serves as a valuable tool for decision-making in capital budgeting. You can use the information gleaned from your IRR calculations to better understand expected business performance, inform stakeholders, and promote financial transparency.

Determining When to Use IRR

The internal rate of return calculation is useful for estimating project profitability. However, it has a few notable limitations.

IRR is most effective when you’re evaluating projects with conventional cash flow patterns and mutually exclusive investments. It isn’t the best option if investment opportunities have unconventional cash flows or when comparing investments of varying durations.

For instance, suppose that one investment has a duration of 36 months and another has a duration of 48 months. In this scenario, you can’t effectively compare the potential return on these investments, as they have different durations, margins, and other variables.

The concept of internal rate of return is sophisticated and can be difficult to understand at first. That’s why it’s important to familiarize yourself with related concepts, such as earnings before interest, taxes, depreciation, and amortization (EBITDA), cash flow, and CAGR. Let’s explore some of those terms in greater depth. 

Understanding EBITDA and IRR

EBITDA gives you an idea of your company’s operational profitability without the effects of financing decisions, taxation, or accounting practices regarding depreciation. It’s often used to compare profitability between companies and industries, as it focuses on earnings from ongoing operations.

EBITDA offers a good starting point for your cash flow projections. Since IRR calculations require a series of expected cash flows, beginning with EBITDA allows you to estimate operational cash inflows before accounting for capital structure, taxes, and non-cash accounting items. You can then adjust these projections for other variables to arrive at the net cash flow for IRR calculations.

Moreover, EBITDA helps you assess the efficacy of an investment without the noise of financial structuring or tax regulations. In turn, IRR provides a measure of the investment’s overall attractiveness by taking into account the time value of money and a comprehensive view of cash flows.

Together, these metrics can offer a more nuanced view of your company’s financial health and potential. An investment with high EBITDA margins might not always result in a high IRR, especially if your upfront costs are significant. 

Other Terms You Need to Know

To reliably use IRR calculations to inform financial decision-making, it’s necessary to become acquainted with a few other terms. One must-know term is “initial investment,” which refers to the upfront expenses associated with starting a project or venture.

In the context of IRR, the initial investment represents the negative cash flow at the beginning of an investment period. IRR is the discount rate that makes the net present value of all cash flows from a particular project equal to zero. The initial investment appears as a negative figure in your IRR formula.

Positive cash flows are the net amounts of cash received over a period. For IRR calculations, these inflows are the result of operational earnings, sales, or other income that can be linked to your investment. Positive cash flows are vital for an investment to be considered viable.

Another concept you should be familiar with is the compound annual growth rate or CAGR.

CAGR formula

While you won’t use CAGR directly in your IRR calculations, it serves as a complementary metric. CAGR provides a smoothed annual rate of return, assuming your investment grows at a steady rate. Conversely, IRR accounts for the actual cash flows and their timing, offering a more complex and accurate reflection of profitability.

How to Use the Internal Rate of Return

Before you can use the internal rate of return formula to guide decision-making, you must first compile all expected cash flows from the investment, including the initial expenditure and subsequent inflows. The initial outlay is almost always a negative number, while inflows should be positive. 

When calculating IRR, you’ll likely need a financial calculator or spreadsheet software, as applying the formula involves finding the root of a polynomial equation. In other words, you’ll need more than simple algebra to determine your IRR.

Step-by-Step Guide to Calculating IRR

There’s no straightforward way to solve for IRR directly using the standard formula. Instead, you’ll need to understand the key concepts behind IRR calculations and customize the formula based on the unique variables relevant to your business. That said, this process includes some general repeatable steps.

  1. Gather Your Cash Flow Information

First, you need to know all the cash flows associated with the investment. This includes the initial investment and all subsequent inflows and outflows over the life of the investment. List these values chronologically. 

  1. Understand the IRR Formula

Carefully review the IRR formula, remembering that you’re trying to solve for the “R” or “IRR,” depending on how you set the equation up. You’ll need to know the other input variables, including cash flow and the number of periods (e.g., 12 months, three years, etc.), in order to proceed.

  1. Set Up Your Equation

Document your initial investment and the associated negative cash flow. Then, write out all subsequent cash flows and their respective time periods. Typically, you’ll calculate the internal rate of return in annual increments. However, you can calculate IRR at monthly or quarterly intervals. 

  1. Use Financial Software or a Calculator

The most practical way to find your IRR is to use a financial calculator or spreadsheet software with built-in IRR functions. Experiment with different tools and find the option that’s the most user-friendly. 

  1. Input Your Cash Flows Into the Tool

If you’re using a spreadsheet, list your cash flows in a column and use the “=IRR()” function. If you’re using a financial calculator, input each cash flow sequentially. Follow the software’s instructions to compute the IRR.

  1. Analyze the Result 

The result of your internal rate of return calculation is the annualized effective compounded return rate. If the IRR is greater than your required rate of return or the cost of capital, the investment is considered potentially profitable. 

However, simply being in the green isn’t enough to justify an investment — you must ensure that the projected returns meet or exceed your minimum profit goals. Keep in mind that you can also use IRR calculations to compare multiple investment opportunities and see which option is the most viable.

Things to Avoid When Calculating IRR

The internal rate of return calculation is designed to inform investment decisions. As such, it’s crucial to steer clear of common pitfalls so you don’t inadvertently undermine your decision-making process. Specifically, you’ll want to avoid making the following errors.

Ignoring the Scale of the Project

IRR doesn’t account for a project’s scale. A smaller project may have a high IRR but contribute less in absolute terms to profit. When comparing projects that are substantially different in terms of scale, you’ll need to adjust for these variations to obtain an apples-to-apples comparison. 

Overestimating Cash Flows

It’s generally smart to be conservative in your cash flow projections. Overly optimistic projections can lead to a misleadingly high IRR. Being conservative is especially important if you’re working with tight margins. 

Neglecting the Time Variable 

Different projects may have different durations. Comparing IRRs without considering the time value of your money can lead to skewed decisions. 

Examples of Calculating Internal Rate of Return

To better illustrate the concept of internal rate of return, here are three real-world scenarios that showcase the value of IRR calculations.

Product Launch

Let’s say your small business is evaluating a new product launch with an initial investment of $100,000. Your expected cash flows over the next five years are as follows:

  1. Year 1: $20,000
  2. Year 2: $30,000
  3. Year 3: $40,000
  4. Year 4: $30,000
  5. Year 5: $20,000

To calculate IRR, you would set the NPV equation to zero and solve for “R.” Using a financial calculator or spreadsheet, you would find that the IRR is approximately 12.41%.

After analyzing this figure, you might conclude that the project is viable if the expected rate of return exceeds your cost of capital, which is 10%. You could then explore strategies for improving your IRR, such as negotiating better terms with suppliers or finding ways to enhance the product’s revenue in earlier years.

Expansion Project

You can also use the IRR formula to evaluate the viability of business expansion projects, such as opening a secondary location or adding onto your existing space.

For instance, suppose that you own a small cafe and want to expand the building, which involves an upfront cost of $50,000. Your expected cash inflows from the extra space over the next four years are as follows:

  1. Year 1: $10,000
  2. Year 2: $15,000
  3. Year 3: $20,000
  4. Year 4: $25,000

As explained, you’ll set the NPV equation to equal zero and solve for “R.” Then, you’ll solve the formula using your spreadsheet software or calculator. The IRR of this project would be roughly 16%. 

From here, you’ll need to determine your cost of capital and decide whether the IRR offers healthy enough margins to make the project worthwhile. If the numbers make sense, you can proceed with the investment.

Technology Upgrade

Technology investments are something every small business owner can relate to. In this scenario, your small manufacturing firm plans to invest $80,000 in new technology. You expect these investments to generate additional cash flows for the next five years. Your cash flow projections are as follows:

  1. Year 1: $20,000
  2. Year 2: $25,000
  3. Year 3: $30,000
  4. Year 4: $35,000
  5. Year 5: $40,000

Once again, you’ll set the NPV equation to zero and use calculation software to solve for “R.” The IRR might come out to be roughly 18%, depending on certain other variables.

Overall, an IRR of 18% represents a good return on a technology upgrade, especially if these figures are above your company’s required rate of return. 

Improving IRR Performance 

Conducting IRR calculations is only the beginning of your analytics journey. Once you understand a potential investment’s internal rate of return, you can explore ways to improve profitability. Here are some helpful examples.

Cost Reduction Initiatives

There are several ways to drive down the costs of your project, such as renegotiating rates with your suppliers, improving processes, or implementing automation. Don’t look for a quick fix — instead, focus on achieving incremental improvements in multiple areas of your business.

Revenue Optimization

Diversifying and expanding revenue sources can substantially improve a project’s IRR by introducing new cash inflows. This could involve expanding into new markets, developing additional products or services, or leveraging existing assets to generate additional income. 

Risk Management 

Identify potential risks that could cause you to miss your revenue goals and do your best to mitigate them. Such risks may include product launch delays, technology implementation issues, or construction mishaps.

While you can’t control or prevent all risks, minimizing their potential impacts can help protect your IRR. 

Integrating IRR Calculations Into Business Decision-Making

The internal rate of return represents a cornerstone of financial analytics and provides a valuable piece of the business performance puzzle. By leveraging this dynamic formula, you can make informed decisions and promote the long-term success of your company. It may be a bit more daunting than simpler financial health analysis techniques, but the insights that it can provide can be absolutely invaluable. Luckily, spreadsheet software and financial calculators make it drastically simpler for those of us who aren’t itching to do the complex math ourselves.