Some business owners make major decisions by relying on gut instinct. But investments made on a “hunch” often fall short of management’s expectations.
In the broadest sense, you’re trying to answer a simple question: If my company buys a given asset, will the asset’s benefits be greater than its cost? The good news is that there are ways — using financial metrics — to obtain an answer.
Perhaps the most common and basic way to evaluate investment decisions is with a calculation called “accounting payback.” For example, a piece of equipment that costs $100,000 and generates an additional gross margin of $25,000 per year has an accounting payback period of four years ($100,000 divided by $25,000).
But this oversimplified metric ignores a key ingredient in the decision-making process: the time value of money. And accounting payback can be harder to calculate when cash flows vary over time.
“The lifeblood of a small business is healthy cash flow,” reports Frank Storniolo, CPA and Principal at LGA, who specializes in emerging businesses. “For instance, when considering an investment in a new piece of machinery, or selling of a new product or providing an additional service, you want to be certain the cash flow generated over a certain period of time is sufficient to cover its incremental costs to the business.”
Discounted cash flow metrics solve these shortcomings. These are often applied by business appraisers. But they can help you evaluate investment decisions as well. Examples include:
Net Present Value (NPV). This measures how much value a capital investment adds to the business. To estimate NPV, a financial expert forecasts how much cash inflow and outflow an asset will generate over time. Then he or she discounts each period’s expected net cash flows to its current market value, using the company’s cost of capital or a rate commensurate with the asset’s risk. In general, assets that generate an NPV greater than zero are worth pursuing.
Internal Rate of Return (IRR). Here an expert estimates a single rate of return that summarizes the investment opportunity. Most companies have a predetermined “hurdle rate” that an investment must exceed to justify pursuing it. Often the hurdle rate equals the company’s overall cost of capital — but not always.
A Mathematical Approach
Like most companies, yours probably has limited funds and can’t pursue every investment opportunity that comes along. Using financial metrics improves the chances that you’ll not only make the right decisions, but those other stakeholders will buy into the move. Please contact Frank Storniolo at email@example.com for help crunching the numbers and managing the decision-making process.