KPM

Sec. 179 Tax Deduction Health Care Plan Assessing Customer Credit QBI Deduction Cash Withdrawal Small business retirement Spouse travel expenses Accounting Software Strategic Planning Process Insurance Schemes Enterprise Risk Management Program Account-Based Marketing Wrong Software For Your Organization Operational Review Internal Benchmarking Reports Sales approach Capturing Data Older Workers Pooled Employer Plans Financial Statement Options BOI Reporting Rules Privileged Users Medicare Premiums DOL Business valuation Trust Fund Recovery Penalty Value-Based Sales Fringe Benefits Green Lease Strategic Planning Financial Reporting Marketing Strategy Succession planning health care benefits Cyberinsurance PTO Buying Media Screening Pipeline Management Billing Best Practices Solo 401(k)

Do Not Make Hunches — Crunch the Numbers

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 are really 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 there are ways — using financial metrics — to obtain an answer.

Accounting payback

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).

However, 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.

Better metrics

Discounted cash flow metrics solve these shortcomings. These are often applied by business appraisers and 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 they discount 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 cannot pursue every investment opportunity that comes along. Using metrics improves the chances that you will not only make the right decisions but that other stakeholders will buy into the move. Please contact our firm for help crunching the numbers and managing the decision-making process.

Related Articles

Talk with the pros

Our CPAs and advisors are a great resource if you’re ready to learn even more.