One of the most important considerations business owners and investors need to agree on is the measure of short- and long-term success. A common business model for start-ups is to operate at a loss for several years in order to grow rapidly and capture market share. Professional investors not just invest in the asset, but in the expected value of the start-ups’ appreciation. Therefore, understanding the expectations of investors will become one of the most critical factors between the business owners and the investors.

This article will share with you three important financial concepts to understand the company’s financial situation.

Payback Period

The initial investment in starting a business is huge, and it must go through the payback period before the company can make profit. By accurately estimating the payback period, it can help companies allocate resources and measure the feasibility of sustainable business development.

There are many ways to calculate the payback period in finance. In simple terms, it can be calculated by monthly net profit:

Payback period (in years) = 1 ÷ Return rate (equal to monthly net profit x 12 months / total business investment)

Different industries will have different payback periods, and most companies have large capital flows in the early stage of their business and may not be able to achieve the expected net profit. This is normal. Net profit will gradually stabilize and rise only when the company is on track, so the payback period may take longer than expected.

Net Present Value

Net present value (NPV) is the difference between the discounted present value of future cash flows from an investment and the cost of the investment. The net present value (NPV) of an investment project is the present value of the expected cash inflows (expected cash inflows) from the project, minus the expected cash outflows from the project. We can easily calculate NPV using EXCEL.

If the NPV of a project is showing a positive number, it means that the project is worth investing from a financial perspective; the higher the NPV, the more expected cash flow will be coming in. On the contrary, if the NPV of a project is showing a negative number, it means that the project is NOT worth investing from a financial point of view; however, it does not mean that the project is not profitable. It can be the case that the profit is not good enough to cover the inflation or cost of capital.

Internal Rate of Return

Internal rate of return (IRR) is an investment evaluation method, that is, to find out the potential rate of return of an asset. Similarly, we can easily calculate the IRR using EXCEL.

Using a very layman way of looking at IRR: after considering all factors like inflation and cost of capital, the net return can be generated from this particular project. Of course the higher the better.

In different development stages, the IRR of the enterprise expected by investors is different. In the entrepreneurial stage, there is great uncertainty due to the immature business model. The expected IRR is usually higher than 50%.

In the cultivation stage, the business model of the enterprise has matured, but the profit has not yet been realized. During this period, the IRR reaches 30%-40% and can meet the expectations of investors.

In the growth stage, the enterprise has achieved profitability and is in the stage of scale expansion, and the security of funds is greatly improved. During this period, the investors’ expectations for the IRR can be reduced to 20%-30%.

Cost of Capital Considerations

In addition to the return on investment, the cost of capital is also an important consideration. The “cost” of capital is an opportunity cost, the price paid to invest in one project and forgo others, and the cost of capital in order to raise funds. In the current high interest rate environment, the cost of capital has increased, and investors will naturally increase their expectation for investment returns, or relatively some investment projects are no longer attractive.