Impact investing has two primary goals:
- To earn a financial return as in any other conventional investment
- To make an impact on the economic, social, or environmental level
Therefore, it is essential to set up goals, against which future performance can be assessed. Care should be taken to set clear goals. In this regard, the SMART acronym is exceptionally relevant. It says that goals should be specific, measurable, achievable, realistic, and time based (SMART). So, for example, an impact goal to “elevate the quality of life” is neither specific nor measurable. Likewise, a goal to “earn 400% return on initial investment” lacks achievability and realism. Now, think about a goal which says, “Educate 40pc children of Niger.” This impact goal is specific, measurable, achievable, and realistic, but it does not take into account the time factor. In order for this goal to be viable, it should also state the time period within which 40pc of the country’s children should be educated. Below are provided few samples of SMART goals pertaining to impact investing:
- 200 tube wells will be constructed in a particular region within three years, with Return on Equity (ROE) touching 30pc by the end of third year.
- Return on initial investment will be 40pc in five years, with the provision of basic healthcare facilities to 60pc population of a particular city.
- Profit after tax will cross $1 million, while carbon emissions will be reduced by 20pc in a particular region by the end of second year of operations.
Businesses usually produce monthly management accounts (containing a statement of financial position and profit & loss statement) with more detailed financial statements on a quarterly basis (containing statement of cash-flows and other disclosures in addition to SFP and P&L). The Profit & Loss Statement is summary of a business’ financial performance, while SFP (Statement of Financial Position) is like a snapshot of business at a single moment in time. Thus, P&L contains figures for sales, cost of sales, operating costs, and taxes, whereas SFP presents the status of business in terms of the current and non-current assets it is holding, receivables, payables, long term loans, equity, etc. This section briefly presents several analytical tools that are conducive to obtaining a thorough understanding of the business affairs:
- Gross Profit Margin – Gross profit is what is left after paying for the cost of sales (which may include expenses attributable and identifiable to the production of goods or delivering a service). When the figure for gross profit is divided by that of sale revenue, it shows gross profit margin in percentage terms. The GP margin tells about the profitability of the product or service. An investigation can be executed when GP margin differs from the previous period or that of a competitor. It can either be due to a change in sales revenue or cost of sales. Reasons can then be discovered and addressed. For example, a raise in import duty or any other tax levy on raw material is likely to increase the entire sector’s Cost of Sales and reduce GP margin. Further, costly purchases or inefficient production process will hurt the margin of the effected business only.
- Net Profit Margin – Net profit is what is left after paying all the other expenses that cannot be directly attributed or adequately identified with a product or service. These expenses may include office expenses, salaries of administration and marketing personnel, research and development, depreciation of office equipment, or delivery expenses. Net profit is divided by sales revenue to express net profit margin in percentage terms. It shows the net profit available in each dollar of sales. A changing net profit margin over time can be caused by change in sales, cost of sales, or operating expenses. It is helpful in determining the operational profitability of the business and diagnosing problems. For example, a diminishing net profit margin, while the gross profit margin is stable, may be because of a non-proportional increase in delivery costs (rising fuel prices).
- Return on Capital Employed (ROCE) – ROCE is the profit available for all the providers of finance, i.e. debt and equity. It is calculated by adding the interest/finance cost figure and Profit before Tax (PBT), and then dividing it by total equity plus long term debt (as presented in SFP). ROCE, expressed in percentage terms, shows the profit made by each dollar of long-term finance. Hence, it is useful in assessing the viability of business to make profit by utilizing all the sources of finance. If PBT for the period is $1m, finance costs are $0.20m, and the business is financed by $5m equity and $1m debt, ROCE for the period will be 20pc [($1m+$0.20m)/($5m+$1m)*100].
- Return on Equity (ROE) – Profit after tax (PAT) is divided by equity to arrive at ROE figure. It is expressed as a percentage and is useful in assessing the profitability of equity finance in isolation to debt. This is essentially the return that providers of equity are making on their investment. An increase in equity or decrease in PAT will lower down the percentage. This is why a dilution (bringing in more equity from third parties) without a respective increase in profits may be problematic for original equity-holders. It will decrease the ROE, and initial equity-providers will have to settle for less than they had envisaged at the commencement of business.
- Interest Cover – Interest/Finance costs are added to PBT and then divided by finance costs to assess the interest-paying capability of the business. So, for example, if PBT of a business is $1m, while finance costs for the period are $0.20m, its interest cover will be 6 times [($1m+$0.20m)/$0.20m]. This means that the profits of the business need to fall by 6 times, before it starts experiencing difficulty in paying interest. Generally, higher interest cover figures are considered better, as they serve as psychological cushions against interest defaults.
- Earnings per Share (EPS) – Expressed in currency terms, it is the profit after tax (PAT) attributable to each share. If the PAT is $0.80m, and there are ten thousand shares in issue, EPS will be $0.16 or 16 cents.
- EBITDA – Abbreviated for Earnings before Interest, Tax, Depreciation, and Amortization, EBITDA excludes all the non-operational and non-cash based expenses to express both the operational profitability of the business and (to some extent) its cash-generation capability. PAT and EBITDA are used in conjunction to assess the quality of profits. The higher the EBITDA as compared to PAT, the more quality is associated with the generated profits. This is because majority expenses, in this case, will be in the form of interest (a charge for using funds, not an operational expense), tax (a levy on profits, not an operational expense), depreciation (an assumed and non-cash expense), and amortisation (an assumed and non-cash expense).
- Cash-flows from Operations to Sales – The Statement of Cash-flows is divided into three sections, namely cash-flows from “Operating Activities,” “Investing Activities,” and “Financing Activities.” Each section summarizes cash-flows from respective activities. Net cash-flows from operations (as mentioned in the first section of Statement of Cash-Flows), are divided by the sales figure to assess the cash-quality of sales. Generally, a higher ratio is considered better, since it represents sales with cash-generation capability. This ratio can be compared from period to period or with other companies of the same business sector. It will also identify if the receivables of a company are gradually increasing, and the company is not able to collect cash despite high sales.
- Compound Annual Growth Rate (CAGR) – It can be used for assessing growth in different figures from sales to expenses and from profit to returns. CAGR is useful when multiple years are under review. Suppose that sales of a business increased by 11pc in the first year, 19pc in the second, and 9pc in the third; sales CAGR will be a single percentage figure and will show how much sales increased each year. So, for example, an EBITDA CAGR of 18pc for the previous five years will mean that EBITDA increased by 18pc each year during the last five years.
- Internal/Economic Rate of Return (I/ERR) – Internal Rate of Return or Economic Rate of Return is different from the above-discussed tools of interpretation and analysis, since it is not based on simple accounting information. Rather, IRR considers cash-flows and is used primarily in DFC valuation (see sub-section 3.3). Further, another difference arises from the fact that IRR, unlike the above mentioned tools, is forward looking in nature. It has been discussed in sub-section 3.3 that to arrive at a business value, all the expected net cash-flows of future years are discounted to a present value by using a WACC (Weighted Average Cost of Capital). IRR is a percentage by discounting the net cash-flows at which, the Net Present Value (NPV) or post-discounting arithmetic sum of these cash-flows is zero. In effect, IRR measures the return that equity investment is going to earn on a particular project or in a particular business. Hence, it can be considered a contemporary of ROE, with focus on cash rather than accounting profits.
Once financial information is interpreted, impact information may be fairly straight-forward to comprehend; however, the authenticity and uniformity of such information can be questioned. If an investor had aimed to make an impact by providing clean drinking water to 75pc of a city’s population within five years, the business owner may claim by the end of fifth year that this goal has been achieved. Even the use of KPIs (see sub-section 4.3) is highly subjective as they are designed, measured, and reported by internal sources. The only reliable or neutral source then available is the reporting of relevant stats by governmental or non-governmental organisations. Investors should plan in advance how to measure the impact aspect of their investment by choosing reliable sources. In this respect, reports of the World Bank, International Monetary Fund (IMF), national department of statistics, or NGOs can be useful. In order to deal with the issues of credibility, uniformity, and transparency related with non-financial or impact reporting, several organisations have developed tools to aid decision making:
OECD Guidelines – The Development Assistance Committee (DAC) of Organisation for Economic Cooperation and Development (OECD) has issued a valuable set of evaluative criteria for assessing development projects, which are as follows:
- Relevance – To what extent the aid activity is suited to the needs of the target group?
- Effectiveness – To what extent the objectives are achieved?
- Efficiency – Were the objectives achieved in the least costly fashion?
- Impact – What have been the positive & negative, direct & indirect, and intended & unintended effects of the executed activity/programme/project?
- Sustainability – To what extent the benefits of a programme are likely to continue if funding is ceased?
- IRIS – Managed by the Global Impact Investing Network (GIIN), Impact Reporting and Investment Standards (IRIS) system is a catalogue of generally accepted performance metrics to promote credibility, objectivity, and transparency in impact and financial reporting throughout the impact investing industry. It offers several metrics from which entrepreneurs can select the most relevant ones. Users of IRIS catalogue are usually registered and appropriately quote the applicable metric/s in their periodic (such as annual) reports. Consequently, investors can compare the information and select the prospective investee on the basis of their impact preferences. It is important to view IRIS metrics as quantitative or qualitative guidelines for measuring and reporting financial and impact performance indicators. Some of the widely used IRIS performance metrics are Social Impact Objectives, Permanent Employees, Environmental Impact Objectives, Target Beneficiary Demographic, Net Income Before Donations, Target Beneficiary Socioeconomics, Greenhouse Gas Emissions, Female Ownership, Community Service Hours Contributed, Environmental Management System, ROE, EBITDA, Charitable Donations, Energy Saves/Conserved etc. For each performance metric, IRIS guides how to measure and report the metric, in order to promote uniformity for the sake of comparison.
- GIIRS – Designed by B Lab, Global Impact Investing Rating System (GIIRS) is a comprehensive system to assess the social and environmental impact of different businesses with a ratings approach. It was put together by the leading social investment funds, accountancy consultancies, and rating agencies, led by Rockefeller Foundation, and including J.P. Morgan Chase Foundation, Kellogg Foundation, Deloitte, Acumen Fund, etc. Unlike the IRIS system of performance metrics, GIIRS converts a company’s positive social and environmental information into impact ratings to be used by investors. This assists in comparison, as investors can select from a wide range of high and low impact investments. Thus, GIIRS can be viewed as a certification system to verify the credibility of the reported impact information.