Week 18 finance analysis and summary

Financial Analysis and Topic SummaryWeek 18 Business IT/Systems

Investment

• Investment is a key part of building your business.

• New assets such as machinery can:

– boost productivity

– cut costs

– give you a competitive edge.

• Product development, research and development, expertise and new markets can open up exciting growth opportunities.

Investment dangers

• Deciding where to focus your investment is an essential part of making the most of your potential.

• Avoid overstretching limited financial resources as this restricts your ability to pursue other options

• Even a project that is not designed to generate a profit should be subjected to investment appraisal to identify the best way to achieve its aims.

• Investment needs to consider key financial and non-financial factors that should be taking into account.

• What financial appraisal techniques can be use to assist with investment appraisal

Financial aspects of Investment Appraisal

• appraisal techniques let you assess the effects an investment will have on your cashflow

• compare the expected return to your cost of funding and to the returns offered by other potential investments

• should consider all the financial consequences of an investment; e.g.:

– buying more expensive machinery might be worthwhile if it is more efficient and uses cheaper supplies.

Indirect Effects

• Identifying ‘soft benefits’ is often as important as the financial evaluation and may make big differences:

– greater flexibility and quality of production

– faster time-to-market resulting in a bigger market share

– improved company image, better morale and job satisfaction, leading to greater productivity

– quicker decisions due to better availability of information

Evaluating Investment Benefits • Difficult however, benefits that contribute to

higher prices or increased sales are rated better than those cutting costs; e.g:- a manufacturer of machine parts could consider a general benefit of quality and estimated savings:

– reduced reworking means less disruption to the production

process, less manufacturing down-time and fewer design

changes, resulting in an overall saving of 25 per cent.

– the current warranty and service costs of £10,000 per

annum are likely to be halved.

– quality assurance staff will be reduced by one as fewer

need for inspections

– better quality products will increase sales by 6 per cent

– improve the company's current position of

fourth among its competitors.

Investment's Benefits

• Important to estimate what the investment's benefits are in financial terms wherever possible.

• Ignore any sunk costs (ie current incurred costs which cannot be recovered/spent regardless of whether the investment goes ahead), e.g. not part of this investment.

• Ensure any financing you need is available.

• Consider the potential risks of any investment (see later)

• Consider non-financial reasons for making an investment e.g.: updating equipment to improve health and safety standards

Strategic Issues for Investment Appraisal

• Do not consider an investment in isolation - consider how the investment could contribute to strategic objectives:

– extending your product range so that you can supply more of the products that your key customers want to strengthen your brand and your customers relationship

– Improve worker skill base e.g. trailing a new product, resulting in increased profit in full-scale production

....... again danger!• Making an investment can limit your flexibility to

respond to future changes; e.g. not investing heavily in new manufacturing equipment unless you were confident of the demand for your product

• Timescales issue; e.g. investors in your business may prefer investments that are expected to produce a quick return.

• A useful test is to think about your alternatives; e.g.

– do nothing

– do the minimum necessary to maintain your existing machinery

– achieve a similar outcome a different way, e.g. by outsourcing production to a supplier

– invest in an alternative project instead

Investment Appraisal Techniques• Accounting Rate of Return (ARR)

– calculated as the average annual profit you expect over the life of an investment project, compared with the average amount of capital invested: e.g. if a project requires an average investment of £100,000 and expectes to produce an average annual profit of £15,000, the ARR = 15%

• Disadvantages:

– based on profits rather than cashflow e.g subjective, non-cash items such as the rate of depreciation you use to calculate profits.

– fails to take into account the timing of profits. In calculating ARR, a £100,000 profit five years away is given just as much weight as a £100,000 profit next year

– different formulas can be used

Payback period

• Quick and simple technique for assessing an investment by the length of time it would take to repay it focusing on cashflow not profit e.g.

– £100,000 investment provides annual cashflow of £25,000, gives 4 year payback period

• Disadvantages

– ignores the value of any cashflows once the initial investment has been repaid e.g. benefit realisation

– it fails to take into account the time value of money

Discounting Future Cashflow

• Money has a time value. If you have money now, you can use it - for example, by putting it on deposit. Conversely, if you want money now but will only get it in the future, you would have to pay to borrow it.

• The further you look ahead, the greater the risks are. If you expect an investment to return £1,000 in a year's time, you may well be right. If you are looking ten years into the future, things might well have changed.

• Discounting cashflow takes these concerns into account. It applies a discount rate to work out the present-day equivalent of a future cashflow.

Net present value and internal rate of return• The NPV calculates the present value of all

cashflow associated with an investment: the initial investment outflow and the future cashflow returns. The higher the NPV the better.

• Alternatively, you can work out the discount rate that would give an investment an NPV of zero. This is called the IRR. The higher the IRR the better. You can compare the IRR to your own cost of capital, or the IRR on alternative projects.

• The key advantage of NPV and IRR is that they take into account the time value of money – the fact that money you expect sooner is worth more to you than money you expect further in the future.

Disadvantages

• NPV and IRR are sophisticated and relatively complicated ways of evaluating a potential investment

• Choosing the right discount rate to use to calculate NPV is difficult. The discount rate needs to take into account the riskiness of an investment project and should at least match your cost of capital.

Investment Risk and Sensitivity Analysis

• A realistic assessment of risks is essential

• the biggest risk for many investments is delay

– it can take longer than expected to implement new systems and train employees

– the disruption can also lead to a loss of business

• Clarity about your underlying assumptions and how reliable they are – e.g. Use different scenarios

• Cannot predict the future with confidence, you may prefer to choose a more flexible investment option e.g. Short term lease

• Rounded appraisal

Non-financial Factors for Investment Appraisal• non-financial factors can also be important.

– meeting the requirements of current and future legislation

– matching industry standards and good practice

– improving staff morale, making it easier to recruit and retain employees

– improving relationships with suppliers and customers

Cont:

– improving your business reputation and relationships with the local community

– developing the capabilities of your business, for example by building skills and experience in new areas or strengthening management systems

– anticipating and dealing with future threats, for example by protecting intellectual property against potential competition

• If in doubt get help – An Accountant!