If you’ve ever heard of the Internal Rate of Return (IRR), you may have thought it was something reserved for financial analysts or investment gurus. But in reality, any business owner, entrepreneur, or executive should understand what IRR is, how it’s calculated, and—most importantly—why it matters for decision-making.
In this post, we’ll explain IRR in a simple, didactic way—using easy examples and no scary formulas. Because understanding IRR can help you invest smarter, avoid low-yield projects, and prioritize your resources more effectively.
What is IRR?
The Internal Rate of Return (IRR) is a measure of profitability that tells you the annual rate of return you’d earn on a project or investment.
Think of it like this: if you lend someone €100 and get back €110 after one year, you’ve made a 10% return. That 10% is the IRR in a simplified case.
Now apply that logic to a business project where you invest a sum of money upfront and then recover it over several years. IRR helps you understand the average annual return across all those future cash flows.
Why does it matter?
Because it helps you answer key questions like:
- Is this project better than others I could fund?
- Does it meet the minimum return I expect?
- Am I making the best use of the company’s resources?
In the real world, resources are limited. If you have to choose between three different projects, IRR gives you an objective way to compare the return per euro invested.
IRR made simple: a fruit stand example 🍎🍐
Let’s say you own a fruit shop and are evaluating two potential investments:
- Project A: Buy a new industrial fridge for €1,000. It helps you sell more fresh fruit and brings in €400/year for 3 years.
- Project B: Install a juice machine for €1,000 that brings in €300/year for 5 years.
Which one is better?
Both generate more than the initial cost, but Project A has a higher IRR because the returns are bigger and recovered faster.
How is IRR calculated?
In reality, it’s a complex formula solved with iterations. But practically speaking, you can calculate IRR easily using Excel, Google Sheets, or financial calculators.
In Excel, list the cash flows (negative for the initial investment, positive for incoming returns), then use the =IRR(...) function.
| Year | Cash Flow |
|---|---|
| 0 | -€1,000 |
| 1 | €400 |
| 2 | €400 |
| 3 | €400 |
How to interpret the result?
- If the IRR is higher than your cost of capital or minimum required return, the project is attractive.
- If it’s equal, you barely break even.
- If the IRR is lower, you’re losing money in terms of opportunity cost.
Comparing IRR with other metrics
✅ IRR vs NPV (Net Present Value)
- IRR gives a percentage.
- NPV gives an absolute profit amount in euros.
Use both when possible. A high IRR with a low NPV may not be worth the effort—and vice versa.
✅ IRR vs ROI
- ROI is simpler but doesn’t consider time.
- IRR accounts for time, making it more accurate for long-term projects.
Limitations of IRR
IRR is powerful, but not perfect:
- It assumes reinvestment of earnings at the same IRR, which may not be realistic.
- If there are alternating positive and negative cash flows, it can yield multiple results.
- A project with a higher IRR might deliver less total value than one with lower IRR but higher NPV.
So, don’t rely on IRR alone—use it as part of a broader analysis.
When should you use IRR?
✔️ When evaluating investments (equipment, new branches, product launches)
✔️ To prioritize internal projects based on estimated profitability
✔️ To compare alternative investments
✔️ To justify decisions to stakeholders with solid financial logic
IRR isn’t just a complex financial term. It’s a decision-making tool that reveals the real profitability of your projects.
You don’t need to be a math genius to use it. You just need to understand what it means, how it works, and how to apply it.
Next time you’re thinking of investing in a project, don’t go blind—ask for the IRR first.
