What Are the Best Tips for Rate of Return Analysis?

Osmand Vitez

Rate of return analysis represents an interest rate an individual or business earns when investing capital into a project. Many types of individuals or businesses use the rate of return to compare multiple opportunities on which they can earn financial returns. The best tips for rate of return analysis include focusing only on actual cash inflows or outflows, using time value of money techniques, and setting an internal rate of return for projects. These tips ensure the users select the most profitable project in a logical manner. Failure to do so can result in a company or individual losing potential rewards from poor investments.

Businessman giving a thumbs-up
Businessman giving a thumbs-up

Companies typically have multiple sources of information when evaluating their financial returns. While net income as prepared by national accounting standards is common, this is a nominal figure that does not necessarily represent true cash flows. Therefore, using only the actual cash inflows and outflows for each individual project ensures a company can measure returns in real terms during rate of return analysis. For example, a company should estimate all the cash it will take to start a project and continue its operations for the near future. Inflows represent all payments a company receives from customers and other parties looking to obtain goods or services.

Time value of money techniques are typically the best processes for measuring rate of return analysis. It requires the total cost for a project, number of years the project will last, and the total future value expected — in real dollars — as the final financial return. Individuals can then use this information to manually compute a project’s rate of return. The good thing about time value of money techniques is they allow for a dollar-to-dollar comparison, that is, it strips away inflation from future dollars to compare money in current dollars. Financial calculators often allow companies to compute this figure without the need for long mathematical formulas.

Another best tip for rate of return analysis is setting an internal rate of return for each project or available opportunity. A project’s internal rate of return often differs from its actual rate of return, sometimes by a large difference. Companies can set internal rates of return using actual figures to simulate project outcomes or simply select estimated internal rates of return. They often look for projects or opportunities with the highest rates of return. Actual rates of return that meet a company’s internal rate of return can also represent good investments.

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