The Power of IRR or Internal Rate of Return for small business growth.

IRR is a concept that is powerful to understand if you really want to grow a business.

Those three letters stand for “internal rate of return” and is a mathematical formula that is used to calculate the financial return on investment.

It’s often used to assess financial investments and their payoffs similar to Net Present Value (NPV) calculations.

Generally speaking, the higher the IRR, the higher the payoff of an investment.

IRR is considered the single most important performance benchmark for private equity investments.

The mathematical calculation of IRR is somewhat complicated however it can easily be done in excel.

Having said that, while the mathematical calculation of IRR is useful, the real power of IRR is in the logical thinking that it generates for a business owner.

You may well be thinking “I’m a small business owner, not an investor, why is IRR relevant to me?”

IRR is an often-overlooked metric that measures the return on an investment over a period of time.

The best business owners understand they are investors.

As a business owner you are constantly investing.

Investing your time

Investing your money

Investing your thinking

Investing in your people

And as a smart business owner, you will understand you only have limited amounts to invest.

Therefore it’s critical you maximise the return on your investment, whatever you are investing.

And therein lies the power of IRR.

IRR is a useful tool to identify in advance whether or not a project or large expense makes sense for your business.

Simply put, you can and should use the IRR concept to help identify higher investment potential for your small business.

Too many business owners haven’t identified their high leverage investments and therefore don’t consider how to improve the potential of their business.

And there is always a higher value investment somewhere in your business when you start to look.

Fundamentally, IRR thinking is about identifying and investing in the highest payoff activities in your business.

Most business owners will have more ideas on things they want to do to improve their business than they will have the time, headspace or money to implement.

Having a system to help prioritise improvement opportunities is really important for the business owner with too many good ideas.

From a purely financial point-of-view, IRR could be used to list out a range of investment opportunities and then rank them by their respective payoffs from highest to lowest.

This will help you prioritise your efforts on the projects that will deliver the best returns.

See the following example for a small business owner looking to invest in a range of capital improvement projects:

Based on the assessment of IRR, the business owner can easily see which order to prioritise their capital spending - to ensure they achieve the best results they can, with the limited resources available to them.

The other test IRR helps with is ensuring that any financial investment you make is greater than the cost of capital to make that investment.

For example, if you knew that you had a cost of capital (from a mix of investors, equity and bank debt) at an average of 14%, then it doesn’t make any financial sense in the example above to invest in the new equipment or fuel efficient vehicles, as you would effectively be losing money.

Making investments above your cost of capital is a critically important concept for business owners to understand and why many business owners unsuspectingly struggle to grow their business.

If you are often making investments that underperform your cost of capital, you will never substantially grow your business.

I was once working with a tourism business where, using basic financial modelling, we identified the business was operating at only 30% of full capacity.

Most of the gaps were in the off-season, and at either end of the working day.

The owner was working under the assumption that “that’s just what happens in this industry.”

We call this a ‘blind spot.’

For someone like me, this was an exciting opportunity.

If we could fill those vacant seats there would be almost no extra cost to the business and the upside to revenue would be significant.

A rough IRR calculation indicated we could see a minimum IRR of 100% on any investments into utilisation improvement.

The owner took some convincing, but he eventually agreed to invest around $50,000 into business and marketing expertise to help him develop a specific offer for his off-peak capacity.

It felt to him like a BIG investment, and he was terrified about the impact on cash flow when he saw the money flowing out of his bank account.

But his worry was short-lived as very soon things began to change.

After one year, his revenue was already up around $150,000, all from low season and off-peak bookings!

That’s a return of 300%!

If you took the time to identify investments that could return 300%, how many investments would you make?

The answer should be, as many as possible!

So what is an acceptable return on investment?

The technical answer is you should be making investments in your business that return higher than your weighted average cost of capital.

However, in the real life of a small business owner, we often see the decision making process is more complicated than that.

We need to consider:

Commonly in small business, we are investing large amounts of time to deliver improvement projects.

Whilst this makes a mathematical calculation of IRR more difficult, we can still use the IRR principle to improve our decision making.

Instead of return on financial investment, we can consider the return on our time investment.

This is one of the most important considerations for a small business owner, and is often poorly considered.

I frequently see business owners who are spending time on operational tasks, instead of delegating those tasks and investing their time in high payoff improvement activities that will see long lasting benefits for you and your business.

One example is investing time in our free short course which has helped many business owners free up considerable amounts of time in their week.

This is a sensational return on an investment in your time.

Here at Grow A Small Business we provide support, resources and networks to help you grow your business, with ease.

Finding a quality Adviser who can assist you thinking through the IRR of your opportunities is something we strongly recommend.

If you’re interested in finding coaches or mentors for your business I suggest you start by joining our Community, and asking our network for someone who might fit what you need.

We hold two webinars a month: