Entrepreneurs and managers have to make sure that scarce resources are employed to best accomplish their vision.
When making moves, entrepreneurs carry out decision analysis for new investments aimed to meet the objectives of:
- Net Present Value (NPV) and Internal Rate of Return (IRR)
- Payback Period;
- Break-even Point;
What is Investment Decision Analysis?
Investment Decision Analysis is the evaluation process to determine whether an investment in a project or a company is worthy to be implemented. Is it worth the money? Will it help achieve your goals?
The company must survive in the long term by having good levels of liquidity (availability of cash) and being profitable. Otherwise, the investment should not be undertaken.
How can you make informed investment decisions?
Understanding the fundamentals of accounting, the recording of financial transactions, the preparation of financial statements, ratio analysis, cash flow management, changes in equity are a must for entrepreneurs and investors before taking the plunge.
The Power of “What If” Analysis
For a running business, it’s useful to perform “What if” analysis to help visualize the effect of management actions. The main actions which can be looked at in relation to achieving the targets of liquidity and profitability (ROIC, ROE) are as such:
- Increase in market share;
- Increase in unit prices;
- Decrease in purchase costs;
- Increase in Supplier’s Credits.
For a future business, or a new investment, quantitative techniques are used to assess the investment quality by looking into the “future” streams of costs and benefits. The aim is to ascertain whether the investment is worthy to be carried forward or not.
These future streams of costs and benefits happen in the planning horizon of a financial plan, say, one, two, three, four years, or more. The time horizon depends on each type of investment. For an infrastructure project as a road, or an airport, or a dam, the time horizon could be as long as 10 years or even more as the recovery of the investment and the profitability of the project will take those many years to be realized.
If we look at the case of a bakery that is set to spread in more locations, then four years is an appropriate time horizon to judge the quality of the investment. Has it been worth 4 years of work? Should it be dropped?
The financial plans, consisting of cash flows and financial statements, are the basis on which to obtain the yearly information on revenue and costs that are used in the application of quantitative techniques in investment appraisal.
Investment decision analysis can be mastered by making extensive use of cash flows for several years of operations, of the theory and practice of time value of money, net present value (NPV), internal rate of return (IRR), break-even point (B/E) and payback period.
Can you learn that from scratch by just reading some articles? Probably yes, but you can do it 100% more confidently with simulations or ‘what if scenarios,’ after having grasped the basics of financial statement analysis.
It will allow a clear understanding of the effect of changes in unit prices, or increase in market share, or decrease in expenses, or increase in borrowing on the main financial indicators of the quality of an investment.
Will be continued…..
Stay tuned for our next post!