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Understanding the difference between IRR vs Cash-on-Cash returns. We’ve broken down the two metrics and their applicability in the long-term versus the short-term.

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IRR (Internal Rate of Return) and Cash-on-Cash (CoC) return are both financial metrics used by investors to evaluate the profitability of an investment, but they have different uses and considerations.

Internal Rate of Return (IRR)

IRR considers the timing and size of cash flows over the entire investment period.

IRR is a metric that calculates the annualised rate of return at which an investment's present value of cash inflows equals its present value of cash outflows. In simpler terms, it is the rate at which an investment breaks even or generates a zero net present value (NPV).

Long-term: IRR is best suited for evaluating the overall performance of an investment over its entire holding period. It considers all cash flows, including both initial investment and subsequent cash flows (profits or losses) generated during the investment's lifetime.

Investors can use IRR to assess the relative attractiveness of different investment opportunities and compare them against alternative investments.

Short-term: While IRR can be used to evaluate short-term investments, it is more commonly applied to long-term investments, such as real estate, infrastructure projects, or private equity deals. In short-term investments, the time horizon is limited, and other metrics like Cash-on-Cash return may provide more relevant insights.

Cash-on-Cash Return

Cash-on-Cash return is a simpler metric that measures the annual return on the actual cash invested in an asset, relative to the net cash flow generated by the investment.

It is calculated by dividing the annual net cash flow by the initial cash investment.

Long-term: Cash-on-Cash return can still be relevant for long-term investments, especially in real estate or other income-producing assets. It helps investors understand how much cash flow they are receiving each year relative to their initial cash investment. However, it does not consider the overall profitability of the investment over its lifetime.

Short-term: Cash-on-Cash return is particularly useful for short-term investments or scenarios where investors seek to quickly recoup their initial investment.

What to look for

Long-term investments

  • For long-term investments, IRR is a more comprehensive metric to consider. A positive IRR, higher than the investor's required rate of return, indicates a potentially profitable investment.
  • Investors should also consider other factors, such as market conditions, growth potential, and exit strategies to make informed decisions.
  • In long-term investments, focusing solely on short-term cash-on-cash returns might not provide an accurate picture of the investment's overall success.

Short-term investments

  • For short-term investments, like fix-and-flip real estate projects or short-term business ventures, cash-on-cash return is crucial.
  • A high cash-on-cash return indicates that the investment is generating a significant return relative to the initial cash outlay.
  • Investors should carefully evaluate the risks associated with short-term investments, as they may be more volatile and subject to market fluctuations.

Ultimately, both IRR and Cash-on-Cash return have their merits, and investors should use them in conjunction with other financial metrics and qualitative factors to make well-informed investment decisions. Each metric provides different insights into an investment's performance and should be applied based on the specific investment type and time frame.

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