The aim of any kind of investment is to generate returns. These returns might take the shape of income, capital growth, or perhaps both. CAGR or compound annual growth rate and XIRR meaning Extended Internal Rate of Return are the two most used metrics for calculating mutual fund returns. The CAGR as the name implies, is the rate of growth of your investment, assuming yearly compounding, during the investment term.
XIRR meaning it can be applied for multiple cash flows while calculating the returns in mutual funds because CAGR returns are not applicable or cannot be employed in the event of many cash flows. When there are lots of transactions occurring at various periods, the XIRR formula is used to determine investment returns.
What are the different types of cash flows?
The most basic investment is a one-time purchase, sometimes known as a lump sum investment in financial jargon, and a one-time redemption, which involves selling your original investment at once after a certain amount of time. Two types of cash flows are involved here:
- One is investment termed as cash-outflow
- Two is Redemption or cash-inflow.
Numerous cash-inflows (such as SIP, further purchases, etc.) and cash-outflows, however, are frequently possible (for example, dividends, SWP, partial redemptions, and more.). Such situations exclude the use of CAGR because using this method you won’t be able to calculate the exact amount you will be receiving.
Switching is not taken into account while computing XIRR in mutual funds at the portfolio level.
How can you use XIRR to calculate return on investments?
The time-weighted rate of return on investment is known as XIRR or internal rate of return. It resembles an interest rate but gives the most importance to recent years. On a variety of cash flows across various time periods, XIRR is computed. Finding each period’s basic interest rate is the first step. Finding the total present value of the cash flows for each period comes next. For this, understanding XIRR meaning is important.
If you are aware of all the income and expenditure throughout the course of an investment, you may utilize XIRR (including the terminal value). Value analysis, portfolio management, and capital budgeting —all of these make use of XIRR. Discounted cash flow or DCF method requires all the information, whereas XIRR does not. Only the initial investment amounts and the estimated growth rate are required to compute your overall return on investment.
Step-by-Step process to calculate XIRR in Excel
- Create a separate column for each purchase you make. All inflows, such as redemptions, will be represented as a market positive, while outflows, such as investments and acquisitions, will be labeled as market negative.
- The next column should provide the specific transaction dates.
- Mention the latest row’s date as well as the current value of your investment.
- Use the XIRR function in Excel, which is shown as = XIRR (values, date, Guess).
- The date columns in the series of cash flows should indicate the dates on which the initial investment was made and the cash flows were collected. Choose values for the cash flows that match the dates in the payment schedule.
XIRR is a fantastic tool for figuring out your actual investment returns. When selecting a mutual fund, CAGR is a vital factor to take into account, but XIRR is essential when assessing your investment returns.
Why is XIRR important for mutual funds?
XIRR meaning, an IRR-modified method to provide the flexibility of assigning precise days to specific cash flows, making it a considerably more accurate method of calculating returns. More importantly, you can use the XIRR method in Excel sheets to handle irregular cash-flow times.
You only need to input the transactions (SIP/SWP installments, extra purchases, redemptions, etc.) and the relevant dates to find out the XIRR meaning for mutual funds. You can use the XIRR formula in an excel sheet to obtain these transactional facts from the statement of account that the fund firm supplied.
Things to remember while evaluating XIRR in Excel
All cash-outflows (huge purchases, SIP installments, etc.) must be recorded as negative values in order to compute XIRR in mutual funds, and all cash-inflows such as redemption, SWP, dividends, etc. must be mentioned as positive values. The investment value and the date of NAV must be supplied in order to compute the XIRR of your mutual fund investment if all of your units have not yet been redeemed.
Some operations, such as dividend reinvestment, don’t actually generate cash flows and should thus be excluded from XIRR calculations. Switches are problematic; depending on whether you are computing XIRR meaning in mutual funds for the source scheme (in the switch) or the destination scheme, the switch should be handled as a redemption, i.e., a cash out-flow, an investment, or a cash-inflow.
