The Challenges of Interpreting Internal Rate of Return (IRR)

The Internal Rate of Return (IRR) is one of the most universal return concepts, and rightly so because of its effectiveness in interpreting returns from an investment. However, it is also one of the most difficult concepts to wrap your head around. In my personal opinion, the difficulty arises primarily due to the understanding of the fundamental underpinnings of the definition. It is not my intention to turn this discussion into a technical one; since the objective is to demystify, I will break it down for simpler understanding.

Firstly, the IRR is better understood when used to compare returns from two or more investments. The decision rule is rather simple – the higher the IRR, the better. The confusion arises when investors look at the IRR in isolation i.e. an investment yields a 20% IRR so what does that mean? The answer is a complicated one and often leads to more questions.

Secondly, the IRR is a multi-period return measure. What this means is that when investors would like to compare investments that span different time periods, IRR becomes the best tool for this purpose. For instance, investment A returns 20% in X years whereas investment B returns 25% in Y years. The question as to which investment performs better is best answered by the IRR.

Thirdly, the IRR works best when investments have conventional cash flows patterns i.e. a negative cash flow followed by multiple positive cash flows. Any variations herein are bound to be detrimental to the IRR calculation. For instance, you buy a stock (negative cash flow) and receive dividends (positive cash flow) during the holding period. The IRR works well in this scenario. However, if you short a stock (positive cash flow) and buy another one (negative cash flow) with the proceeds and finally square of the transaction (positive or negative cash flow) later on, the IRR may not necessarily yield desired results.

Lastly, due to its very definition, in some instances an investment may have no IRR at all or at least one that can be determined! Obviously, in such instances, the IRR is of no use and creates confusion in the mind of the investor. Therefore, the challenges in interpreting IRR arise when investors use the IRR for purposes other than those mentioned above.

Although this list is by no means exhaustive, it captures the salient features of the IRR. Hope this piece has helped simplify the concept and gives you confidence to seamlessly compare investments using IRR.

Vinay Basavaraj

Vinay boasts of a decade of experience working in both large and small organizations. His roles have ranged from sales to operations and even a stint in academia. He currently manages affairs in capital markets in Capital Float.

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Why Fintech Lenders are the Best Option to Avail Business Finance

Many start-ups are launched, propelled by a brilliant idea, but often face tough times due to inadequate funds. The first impulse is to turn to banks, which, however, usually refuse requests for a loan for business without security. They also ask for plenty of documents to corroborate the need for the grant and the purpose that it will be used for.

A parallel source of finance for small businesses come in the form of non-banking financial companies (NBFCs). Traditional NBFCs offer loans on terms similar to banks, but they do not hold a banking license. In addition, unlike banks, they cannot accept deposits from public. Other than loans and credit facilities, they can offer retirement planning schemes, money market instruments and underwriting activities.

While small and medium enterprises (SMEs) have been turning to banks and NBFCs to get loans, the long-drawn process from application submission to disbursal of funds is still a deterrent for many. After the financial crisis of 2008, there was an even greater need for reliable sources of business finance. Interestingly, the digital technology that gave rise to online banking and e-commerce was also progressing at a fast pace in the same period. This helped to create a new segment of NBFCs in the form of financial technology, known as FinTech companies.

With the aid of complex analytic tools, FinTech companies evaluate credit risk by using an array of customer data, including their digital footprint on social media, e-commerce platforms, smartphone usage and geo-location.

How are business loans by FinTech lenders more convenient than traditional loans for borrowers?

Conventional NBFCs do not usually have a human-centric approach to lending. The lengthy and cumbersome process of applying for business finance that requires piles of physical documents tires out borrowers. Young entrepreneurs who are eager to expand their operations and are confident about returns on their investment cannot afford to wait for long. Also, delays in work can also harm their long-term business interests. They need an alternative source of funds that can cater to their needs more actively.

What draws the digitally perceptive entrepreneurs to a FinTech company is its ability to offer quick loans at competitive rates of interest. Such companies have a holistic approach towards risk assessment and do not ask for heaps of paper-based documents before they start considering an approval for the loan. The basic files needed to check the creditworthiness of the borrower can be uploaded on the encrypted portals of FinTechs.

The advanced machine learning algorithms that these lending platforms employ read through information such as the net earnings of a business, the educational and professional qualification of its owners, the location from which the business operates and the returns on investment that it drew in the past one year. In comparison to this, a traditional NBFC loan is issued to companies that have been in business for at least 3 to 4 years.

Summarily, the prime reasons for which business borrowers prefer FinTech platforms are:

Simplified application process – Instead of visiting a branch in person, they can apply for the business loans from anywhere and at anytime. As the process is digital, all they need is a reliable Internet connection and the soft copies of minimal documents.

Swift funding – Unlike conventional NBFC loans, the funds from a FinTech corporation do not take long to be approved and disbursed.

No prepayment penalties – To make up for their loss on interest due to early pay-off on the loan, banks as well as most NBFCs charge a percentage of the loan amount as penalty. This is not the case with new-age technology based lending organisations. If a borrower can afford to make complete payment on the loan earlier than its stipulated tenure, there are no extra charges.

No hidden charges – You may on occasions have felt surprised when a bank or NBFC told you that there would be a payment protection “insurance premium” charged on your business loan. In the traditional lending sector, such charges are normal. The lending institutions claim that these help in protecting the monthly loan instalments in case sudden sickness or an accident prevents you from making payments on the loan. FinTech organisations do not include such clauses in their agreements. The funds are granted for business expenses in the short term and are approved based on the ability of the borrower to pay back.

The ability of FinTech firms to trawl the online portals and gather data relevant to the borrower’s paying capacity helps in affording more growth opportunities to start-ups. Many SMEs in India have reasonably strong business models, but they still cannot manage to get funds from banks and traditional NBFCs. This shift towards technology-backed alternatives has been favourable for promising ventures.

At the same time, the conventional lending institutions should also understand that FinTech companies are not a threat to their existence. Both these sectors can collaborate with each other in areas such as customer acquisition, product innovation, analytics, sales enablement and cyber security.

The access to innovation through digital peer-to-peer lenders allows NBFCs and banks to create competitive advantages for their own business.

Customer-centric innovation triggered by FinTechs is here to stay. The possibility of getting a loan for business without security or collateral is real. Open architecture-based wealth management tools, Big Data and online financial advice will continue to help entrepreneurs.

As a digital-age lender in this domain, Capital Float uses proprietary algorithms to inspect large amounts of data and evaluate a potential business borrower’s creditworthiness. We offer timely business finance without collateral to SMEs, start-ups, and freelancers to help them bear the expenses that are crucial for their stability and growth in the business world. Our process of judging the payment capacity of businesses is automated, fast and flexible, while also being diligent. If you need loans in less than a week and do not have a very long history in your industry, do not let any refusal from traditional NBFCs discourage you. Visit www.capitalfloat.com to find the business loan best suitable to you.

Oct 24, 2018

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Practical Implications of Asset Allocation

Asset allocation, despite its importance in portfolio management, is perhaps the last thing on the mind of the novice investor. Before regaling the virtues of asset allocation, a layman’s definition of asset allocation is perhaps warranted, so here goes: asset allocation is a process by which an investor aims to enhance the risk-reward ratio of a portfolio of risky assets. It is important to stress upon two things here: (1) asset allocation is not a one-time exercise, it is an ongoing process; and (2) the use of multiple asset classes to convert a portfolio of risky assets into a benign money-making machine.

Equipped with a basic understanding of the theory behind asset allocation what is stopping the novice investor from going ahead and enhancing portfolio returns? The reason is that the effect of asset of allocation rests largely on finding asset classes whose returns are uncorrelated with one another – the lower the correlation, the better. For instance, it is popular belief that gold is a hedge against inflation i.e. gold prices and inflation rates move in tandem. Therefore, what one loses in purchasing power is compensated by an increase in gold prices. This, however, is a long term phenomenon i.e. one may witness large deviations in the short term.

The key to benefiting from asset allocation, therefore, is to periodically tweak the portfolio for changes in correlations between asset classes and include new ones with the overall objective of enhancing the risk-reward ratio of a given portfolio. Although this may seem like too onerous a task, the novice investor need not worry. A certain level of diversification via asset allocation can be achieved by following the below steps:

  1. Ascertain whether you have surplus money to invest – a simple equation of income less expenses. The figure you ascertain will comprise your overall pie available for asset allocation.
  2. Understand your needs as defined by three key parameters viz. risk appetite, return requirements and time constraints. Your needs are a function of your age, marital status, number of dependants etc.
  3. Identify avenues to invest in the broadest categories of asset classes viz. equity, debt, commodities, real estate and alternative asset classes.
  4. Steps 2 and 3 will require a bit of periodic back and forth because the asset class(es) you choose will depend on your needs. E.g. someone with a higher risk appetite may have a higher percentage of equities in the pie than someone with a lower risk appetite. The latter investor may lean towards debt investments.

In summary, the age-old adage of not putting all of one’s eggs in one’s basket applies here. A systematic approach to asset allocation with disciplined and timely execution can ensure that investors, novice and otherwise, hold well-constructed portfolios and therefore benefit from asset allocation.

Vinay Basavaraj

Vinay boasts of a decade of experience working in both large and small organizations. His roles have ranged from sales to operations and even a stint in academia. He currently manages affairs in capital markets in Capital Float.

Oct 24, 2018

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Accelerating the Growth of Ecommerce in India – BWCIO

Written by BW CIOWorld

Capital Float is a digital platform that provides capital finance to SMEs in India. They offer short-term loans that can be used to purchase inventory, service new orders or optimize cash cycles. Vaibhav Singh, Associate Vice-President, Business Development, Capital Float, in a chat with BW CIOWorld shares some insights on e-commerce in India.

The e-commerce boom has birthed young entrepreneurs with limited transactional history that directly impacts their accessibility to credit. Capital Float has identified this opportunity and has launched new debt products to serve this rapidly growing segment. Most banks continue to implement underwriting models on online sellers which were originally designed to underwrite debt of offline sellers, argues Vaibhav.

“At Capital Float, we have built our underwriting model bottom-up based on evolving data and metrics to identify creditworthiness of online sellers. The approach is tailored to be more relevant to online businesses and offers more accurate results, says Vaibhav. Explosive growth in the e-commerce segment has overwhelmed traditional banking institutions and companies like us are able to share the burden of offering credit to unserved SMEs in the market.

E-Commerce platforms are attempting to standardize processes while increasing scope and scalability of existing sellers. This effort is likely to cause a churn in the seller e-community creating a metaphoric sieve through which sellers will be filtered. Consequently, the best performers will experience geometric growth, increasing competition between sellers in the space.

Building individual brand identity would be a challenge
The nature of the business fosters competition on the basis of pricing. In the attempt to offer best prices, sellers would be challenged to build their individual brand identity. Accessibility to credit through traditional channels will continue to remain a hurdle for e-commerce sellers in the foreseeable future, as conventional sources of credit begin to adapt to the dynamic capital environment.  The fiery growth in the e-commerce segment can only be sustained if companies like us are able to share the burden of offering credit to unserved SMEs and ecommerce sellers in the market.

There will be a slow change in the mindset especially in a hitherto human-intensive space like lending.  People have to become comfortable with trusting machines to do everything a man can do; stepping in only where expressly human traits of experience and intuition are needed, even if this means that at volumes approaching statistical significance, we let a few true-positives slip through in the interest of overall productivity. It’s about slowly giving up control and trusting technology to pick up the slack.

Algorithms and big data will drive eCommerce growth
Capital Float has used technology innovatively to ensure that seller in the ecommerce domain have access to collateral free working capital loans and enable business growth in a simple and efficient manner. Leveraging analytics, algorithms, big data and other disruptive technology trends to make lending decisions quickly based on verifiable data thereby ensuring efficient and fast turn-around time is the future. Technology has also enabled Capital Float to expand business faster and reach out and support the SME and seller community across India. The acceptance of new forms of technology would only fast forward the growth of facilities needed to continue the growth of ecommerce.

– See more at: http://bwcio.com/accelerating-the-growth-of-ecommerce-in-india/#sthash.zDdwY1Q3.dpuf

News piece sourced from BW CIO World. Read the full piece here

Oct 24, 2018