Join the Profitability Revolution

Investments: Conventional, Business Transactions and Internal Rate of Return

 Measures of Profitability for Investments

Most accounting firms and businesses must make a choice of which accounting method is to be used to reflect how earnings are reported, and consequently, how profitable, for tax purposes, the fiscal year has been for the business. These types of profitability alternatives provide little assistance to the business executive trying to determine which financial strategy is best for the business.

There are numerous tools that many businesses use to aid in this regard. Among the more frequently used tools are ratio and percentage analyses. However, even with the judicious use of profitability and activity ratios, liquidity ratios and financing ratios, these ratios are only effective when comparisons are restricted to an individual industry. The numbers only become meaningful when there is a trend developing over time, and then having the trend compared to the same or related businesses. Using ratio analyses, it is virtually impossible to compare the success rates of two companies when there is no commonality of business interests.

The apparent lack of a common measurement tool stimulates a series of questions. How profitable is this business? Has the profitability of business transactions ever been measured? Has the profitability of one business strategy ever been compared with another? What techniques can be used to compare the profitability of one business plan with another? All these questions can be summed up simply by asking, "How do you measure the financial success of a business transaction?" The answer is, "by knowing and understanding the internal rate of return for each transaction."

Conventional Investment Methods

Suppose $1,000 was to be invested into an interest bearing account. The account could be a money market account, a savings account, a certificate of deposit, etc. One of the methods for comparing the value of one account with another is the interest rate the account yields; however, that is not the full story. The daily (or monthly) compounding effect, i.e. earning interest on interest, has to be considered. Many agents furnish the annual percentage rate (APR) as a measure of profitability for each of their accounts. The APR includes both the compounding effect and the interest rate. Consequently, if all other risks being equal, it is prudent to invest the $1,000 into the account that yields the highest APR.

Investing $1,000 into an interest bearing account at 12% interest rate yields 1% per month plus the interest on interest. If the interest is compounded monthly the APR is 12.68% (daily the APR is 12.75%). Another phrase that can be used here is the internal rate of return (IRR), instead of the APR. In other words, "this $1,000 investment has an IRR of 12.75%". The APR and IRR is the same thing provided the compounding effect is daily rather than monthly. At 12.75%, it would take 5 years and 8 months for an investment of $1,000 to grow to $2,000.

Business Transaction Investments

Business people invest their money in working capital that yields profits for the company. That working capital is used to create hundreds or thousands of business transactions with their customers, and quite often, the business people do not have any idea how profitable any of these transactions are. They understand profits but fail to recognize the time value of money.

Most businesses offer credit, usually 30 days, to their business customers. Those customers normally pay in a timely fashion. Intuitively, business people understand that a 30 day receivable is much better than receiving the same money in 60 days. Seldom does a business person compare the profitability of those credit transactions because it can be difficult to do. Still, the computer makes it much easier. Therefore, why not measure the profitability of working capital investments and compare the IRR for the various credit transactions?

If business executives could look at the IRR comparisons of various strategies, then sound business decisions could be made quickly and conclusively. Conventional wisdom suggests they look at financial statements, aging reports, tracking reports, etc.; however, those reports rarely show the time value of money.

Why shouldn’t businesses invest their working capital money the same way as individuals invest their money into interest bearing accounts, i.e. by comparing the APR/IRR? Businesses could compare the IRR between the various strategies and make enlightened decisions that strategically direct the business. That would be a better way of doing business.

Investing working capital into a business transaction is quite different than an individual investing money into an interest bearing account. First, businesses can only survive, if they sell a product or service to customers who return all the working capital plus a profit within a short period of time. Second, individuals may be satisfied with a 100% return in 5 years and 8 months, but a business must return all their working capital and profit within days (greater than 100% return) or they are not in business very long.

Suppose a business invests $1,000 into a business transaction and the customer pays the business $2,000 in 30 days yielding a $1,000 profit. This transaction can be argued as yielding $1,000 per month for 12 months, or an annual $12,000 return on capital (or 1,200%), for an original investment of $1,000. This transaction actually yields an IRR is 853%, because future discrete payments are discounted to reflect the time value of money.

Internal Rate of Return

To better understand the IRR of investing in periodic transactions, consider investing $1.00 and the next day someone pays back the dollar and a penny. If this transaction is repeated for 365 days the individual would earn a penny a day and recover the original dollar each time. After 365 days, there would be $3.65 profit and the initial dollar. Therefore, the IRR for each of those 365 transactions would be 365%.

Whenever businesses extend credit to a customer, they have little control over when the customer decides to pay the bill. The business has its own working capital tied up for many days. In the chart below, a business sells a product (or service) to a customer and the net IRR indicates the value of each investment based upon the length of time the accounts receivable is outstanding. In this transaction, the investment in working capital is $600, and when the customer pays the $1,000 bill, the gross profit is $400. As expected, the IRR for the transaction diminishes quickly as time goes by. Note that business transactions are much more profitable than investments in ordinary interest bearing accounts.

The following chart shows the profitability of a business transaction where the investment in working capital could be outstanding from 15 to 90 days. This is the first of many charts used throughout this publication that display a bar chart that use 2 vertical axis. The left vertical axis is associated with the left column (stacked bar) of the column pair and the right vertical axis is associated with the right column (single bar) of the column pair. This type of chart might be at first confusing, but the additional information the charting technique provides is extremely useful.

Business Transaction Profitability
Working Capital

3W Internet Corporation commits its resources to support every alternative financial specialty that is described in this primer. Although all the computations featured in this document have been thoroughly checked and tested, there may be some functions that rely upon other financial concepts methods, strategies and ideas using software, and protocols not developed by 3W Internet Corporation. 

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