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How to calculate business returns in three easy steps

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Math may not be your strong point, but knowing how to calculate business returns can make all the difference between success and failure. Not to worry. I’m quickly going to show you how to determine one of the most important numbers in business.
 
You can acquire a business in one of two ways: buy it or build it.
  1. If you want to buy an existing business, how are you going to determine which one to buy?
  2. And if you want to build one, how are you going to give yourself the best chance of success.

The answer rests with the business return, also known as the internal rate of return or IRR.

The IRR basically tells you whether the cash flow of a business is worth your time, money and effort. If a business generates (or will generate) good cash flow, you will land up with more profits. And the higher the profits the greater the return. This gives you more reason to either buy or build a business.
 
►There are three steps involved in determining the IRR.
 
Step 1: Record or predict your annual business income or revenue and expenses over a certain period of time. One usually does this for a maximum period of five years.
 
Step 2: Determine your annual net cash flow. Cash flow tells you how much money is left over after all expenses and fees have been paid.
 
Step 3: Calculate the IRR on your business’s cash flow stream. You can easily do this with an Excel spreadsheet.
 
Let’s have a look at a simple example. Before you read any further, open the attached Excel spreadsheet ('Business return'). You will see an example of how to work out the IRR on a bank account earning interest.
 
Suppose you invested $10,000 five years ago in a CDA (Year 0, Cell G16).
 
 
 business return input 1 
 
 
The account paid you $1,000 interest income every year which you withdrew (Cells I17 to Q17). At the end of five years you close your account and get your initial deposit back (Cell Q19).
 
 
  business return input 2
 
 
Your cash flow (after expenses) is shown in Cells G20 to Q20. A negative cash flow represents money flowing out of your pocket and into your business. A positive cash flow means that money is flowing back into your pocket.
 
The IRR on the bank account is 10%. Place your computer's cursor over Cell G21 and have a look at the formula for IRR.
 
 
 business return input 3 
 
 
 business return input 4 
 
 
By the way, the return or interest rate that financial institutions quote you is NOT the IRR. They quote you what is known as a nominal return, which is a rate before expenses, tax and inflation.
 
That's why it is so important to calculate your IRR because it takes into account all related business costs. The IRR tells you what you are really getting back on your money or capital (Note, tax and inflation have been ignored in this example).
 
What happens to your return if you add in an account fee of $300 per year and keep the interest income the same? It drops to 7%.
 
 
 business return input 5 
 
 
Now, keep the fee of $300 and increase your interest income to $2,000 per annum. The IRR jumps to 17%. 
 
 
business return input 6
 
 
The moral of the story: To achieve great business returns, you must optimise your cash flows by increasing your income and lowering your expenses. 
 
PS: If you like sharing, don't forget to leave a comment. Thanks!
 
PSS: If you would like a copy of the excel spreadsheet example above, just email me at roberto@waytowealth.co.za with 'IRR' in the subject line.
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Business return.xls71.5 KB

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