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Business return: How to determine whether a business has any real power under the hood

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What do all great entrepreneurs have in common? They know how to work out their business return, one of the most important numbers in investing and business development.
 
Picture this, a flashing red Ferrari parked on your driveway. I’m not a car-man but even I wouldn’t mind taking that baby for a spin. Speed and power pristinely packaged in a slick red film of Italian tinfoil. Nice!
 
What makes it a powerful car? I have no idea. All I know is that I learnt to associate the brand Ferrari with power and speed.
 
Now picture this, two identical looking Ferraris on your doorstep. The only difference being, one is the real thing and the other a fake. How would you go about identifying the real Ferrari, the machine that car enthusiasts have come to love?  
 
You could have a look at the engine designs or take each car for a test drive. Whatever method you use, there is a way to determine which car will deliver the expected driving performance.
 
Let’s say I ask you to have a look at two Ferrari dealerships. How will you determine which business is the better one? You could examine their monthly sales, admin processes, leadership or operational expenses.
 
 
Measuring business return
 
 
What about two different investments, a bank account and a mutual fund? How will you know where to place your money? You could speak to a stock broker or financial planner.
 
Whether it’s a business or investment product there is only one measure of performance – the business return.  
 
Does that mean we should treat an investment like a business? Absolutely! All of the following are examples of businesses:
  • Investing your money in a fixed deposit
  • Investing in the stock market
  • Buying investment property
  • Buying a franchise
  • Writing a book for the purpose of publishing it
If you give up some of your resources in anticipation of getting something back, you are creating a business. It’s as simple as that.
 
Barring the forest fairies that are purely after world peace, every entrepreneur wants a return for the time, effort and money they put into building and running a business.
 
That return is based on income, but more specifically the cash flow over time after all expenses have been paid (i.e. net cash flow).
 
Technically speaking, this return is known as the internal rate of return or IRR. The greater the IRR over a certain period of time the better and more productive the business.
 
To determine the return/IRR, you need to have an understanding of a businesses cash flow. Look at the two examples below.
 
►Example 1
 
Suppose you deposit $10,000 in a bank account and earn $1000 in interest per year. Each year you withdraw the interest. After five years you take your money out of the bank. What is your business return (or IRR) over the five year period?
 
Your cash flows look as follows:
 
Year 0: Deposit $10,000
Year 1: $1,000
Year 2: $1,000
Year 3: $1,000
Year 4: $1,000
Year 5: $1,000 plus your $10,000 back (Total: $11,000)
 
The return or IRR is 10%.
 
►Example 2
 
Suppose you buy a burger business for $100,000. Your cash flow after expenses is shown below. After five years the value of your business is $200,000.
 
Year 0: $100,000 investment
Year 1: $4,500
Year 2: $4,000
Year 3: $7,500
Year 4: $200
Year 5: $1,000 income plus busines value of $200,000 (Total: $201,000)
 
The return or IRR is 18%.
 
Based on the returns, which business would you buy, the account paying 10% or burger outlet paying 18%? In this case, burger is best as the return is far more superior.
 
►To sum it up:
  1. Business return or IRR is the most important indicator of performance.
  2. The greater the IRR the more productive the business.
  3. Don’t ignore risk. If there is a good chance that you may lose everything, it doesn’t matter what the IRR is. It may not be worth your while.

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