Post 7: Measures of Financial Success - Earnings and Cashflow Metrics

Evaluating Company Performance

Choosing an appropriate and relevant set of performance metrics is very helpful for assessing the ongoing viability and ultimate success of an investment. Investors, each with their own strategies and objectives, may prioritize some metrics over others, often choosing to highlight those that present their investments in the most favorable light - this is particularly true when going out to raise additional funding. The numbers reported must also be shared with as much transparency as possible as each stakeholder’s ultimate return may differ from the reported value due to taxes, leverage profile, etc.

In this fun read, we will focus on three of my favorite metrics: one, which that is economic-earnings related: Return on Capital Invested (ROCI) and a pair that are cashflow-focused: Internal Rate of Return (IRR), and Multiple on Invested Capital (MOIC).

Free Cash Flow Conversion

The portion of your revenue that converts into cash in the bank. It’s that simple. I have seen businesses running at 30%+. Those are the real diamonds

Return on Capital Invested (ROCI)

If you have read the previous posts, you will understand my strong preference for cashflow related measures, because what is simpler than understanding cash going out of your bank account and returning to your bank account having grown a little bit. However, I believe there is value in a measurement that highlights the earnings potential of the business, particularly over an extended time frame. ROCI serves as a critical metric for evaluating the efficiency with which a business generates income relative to the capital it has deployed. This metric is particularly useful for comparing the performance of companies across different industries because it focuses on income generation without being influenced by variations in capital structure. I like the use of this metric in retail, where a large capital expense for a store is returned over years (or decades) as the store generates increasing amounts of revenue and ultimately, earnings. Plotting the return on capital invested over time, demonstrates how much incremental earnings are generated for a $1 invested today.

Internal Rate of Return (IRR)

The IRR is used to calculate the annualized return rate of an investment, considering all cash flows - or said more simply, how much I made every year on a dollar invested over a particular time frame.

It is favored by investors involved in long-term investments, such as those in venture capital and private equity, because it provides a nuanced view of an investment's performance over time. The IRR is particularly advantageous in scenarios where the timing and magnitude of cash flows are crucial factors.

IRR is both intuitive and generally comparable across different entities. For example, for companies that invest in healthcare private equity firms, a comparison of the IRRs of past private equity funds launched by those firms is generally an accurate approach.

Multiple on Invested Capital (MOIC)

MOIC offers a straightforward metric for assessing the gain on an investment by comparing the exit value to the entry value. Its simplicity and direct approach to measuring value creation make it appealing, especially in growth equity and venture capital contexts. MOIC is beneficial when investors seek a clear and concise indicator of the growth achieved through their investment.

For me, this is the simplest and probably most instructive metric: cash received from an investment divided by cash invested (independent of when the investment was made). To me, 5 times my money sounds way more intuitive than 24% IRR

Choosing the Appropriate Metric

Choosing between metrics often depends on your criteria, including investment horizon, the nature of the investment, and market conditions.

• ROCI is suited for analyses that require a comprehensive view of capital efficiency and cross-sector comparisons. Think big investment upfront followed by income generated to more than cover that investment over time (think retail stores, industrial equipment investments, etc)

• IRR is preferred for investments characterized by significant, variable cash flows over time, providing a detailed perspective on return rates. I like this to private equity investments in which you invest $100 today and hope to make over $200, 4+ years later. The quirk with IRR is if you create a lot of value quickly - e.g., doubling your money in a year drives an IRR of 100% which will only worsen over time despite incremental cash generation. e.g., if you invest 100 at day 0, and get 200 after a year, IRR is 100%, but if you are paid back $500 in year 5, the IRR drops to 38% (still good but not nearly as good as 100%)

• MOIC is ideal for investors who value simplicity and a straightforward assessment of value creation from the inception to the conclusion of an investment.

• BONUS: In most cases, due to the quirk highlighted above with IRR, most investors prefer to report both IRR and MOIC because you want to maximize the $ return (e.g., 5x return in the example above) while contextualizing that it was generated rapidly (38% IRR)

Preferred Metrics for Cash Flow and Earnings

When focusing on annual cash flow measures, free cash flow conversion (the percentage of revenue converted into free cash flow) is one of my favorite metrics, highlighting a company's operational efficiency and financial stability.

For earnings analysis, Return on Invested Capital (ROCI) is often preferred, as it provides a clear indication of a business's ability to generate income from its invested capital, independent of its capital structure.

For returns analysis, IRR and MOIC are my favorite measures

In conclusion, understanding and selecting the right financial performance metrics is essential for accurate investment analysis. While each metric offers distinct advantages and insights, the choice of which to use depends on the investor's specific goals and the context of the investment.

Tweets you can use with your friends in the bar this week

Positive habits: https://tinyurl.com/post7tweet1

X (formerly Twitter) bookmark hygiene: https://tinyurl.com/post7tweet2

Why you should take a closer look at trades: https://tinyurl.com/post7tweet3

Check out a pair of my previous posts below

• SMBs as a force multiplier: https://tinyurl.com/post7previous1

• The importance of quality: https://tinyurl.com/post7previous2

Parting thoughts

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If you have any questions about this article or about financial metrics in general, shoot me an email at [email protected]. I will be happy to respond to all the notes that I can. Look out for a follow up post soon.

If you are looking for a thought partner with whom to think through the growth of your business, I’m also happy to chat. Again, I’m an email away.

Until next time, keep building!