Banking

A brief guide to number crunching

Putting together a financial cost-benefit analysis is something that could make a grown IT manager cry. But maybe this brief guide will ease the pain.

There are costs and benefits for every business case or proposal, and no lucid decision-maker would ever make his judgment without considering them carefully. Ostensibly, all costs and benefits can be financial and non-financial. I'll talk about the financial side in this blog and follow up later with a blog about non-financial.

This far in my professional career, I have yet to meet a manager who would admit to not knowing how to put a financial cost-benefit analysis together. This process is colloquially referred to as "crunching numbers" and often makes perfectly sane people consume an inordinate amount of coffee, swear, and pull their hair out. What many don't know is that there are some well-defined methods of doing it and once you know them, it's just a question of following the process.

I'll tell you about three widely used methods--Payback, Net Present Value (NPV), and Internal Rate of Return (IRR)--and discuss their pros and cons. You don't need to have an advanced finance degree to use them, much less an accounting designation. I have taught this discipline to scores of managers and professionals, and many admitted they could have saved days, nights, and trees could had they known how to do it the right way. So, let's get started.

The notion of cash flows

As organizations earn and spend money, what results are inflows and outflows of cash that cross the imaginary boundary of the enterprise. For instance, when you buy a movie ticket for cash, an immediate cash inflow for the theater, as well as an immediate cash outflow for you, occurs. If you pay for the ticket with a credit card, the outcome is rather different: while the cinema theater may receive cash in its merchant account either instantaneously or perhaps overnight at the time of settlement, you will not experience any outflow of cash until you have to pay your credit card bill. Similarly, when companies buy and sell on credit, cash flows do not happen instantaneously, all the while these revenues and expenses get recorded in the company's books (unless they use what is known as cash basis of accounting, but this is something only a small business may do.)

If an organization buys an asset that has lasting value, such as a computer system, the cash outflow may occur almost straightaway (e.g., if they wrote a check upon placing the order, which was cashed in a couple of days). From the accounting perspective, the whole amount of purchase cannot be recognized as one expense. For example, if the system cost $50,000, the cash outflow equal to this amount will take place, while the accounting treatment necessary in this case will see this amount spread over several years (e.g., $10,000 per year for five years or something like that). This is known as depreciation. It's important to understand the difference between the real outlay of cash and an accounting treatment of it. Note that this discussion would not be applicable to a purchase of something that has no lasting value, such as stationery.

Why am I subjecting you to this exciting conversation? The financial analysis methods we're going to discuss are cash flow based; that is, they only consider cash flows, positive as negative, as inputs to calculations.

When performing financial analysis of a proposal or a project, you should follow these three rules:

  1. Be realistic in estimating future cash flows
  2. Only consider cash flows attributable to this project or proposal
  3. Think incremental. If you expect profit to go from $30,000 to $50,000 per month as a result of the project, that's an inflow of $20,000. If your maintenance expense goes down from $10,000 to $7,000 per month, that's an inflow of $3,000.

Isn't this stuff fun?

Time value of money

Suppose I told you that I'm prepared to give you $100 and you have a choice: You can get it now or, with absolute certainty, in a year from now. Which one would you prefer?

Even if we set aside your doubts about my memory, your sentiments about your current and future financial situation, and other such things, you should take the money now. You can invest the $100 in return for a risk-free interest rate (say, place it in a savings account at 3 percent per year) and in a year from now, you'll have $103, as opposed to $100 you would have otherwise gotten from me. The $100 now is more valuable than $100 later.

Now let's finally look at the first and the most popular method in our lineup - payback.

The payback method

If you've ever pitched an idea or a project, you may have been asked when it's going to break even. This is all the payback metric is about, it denotes the number of time units that will have to pass before the amount of cash outflows will be compensated by the amount of cash inflows.

For example, let's consider a project you believe will take three years to implement. Let's say that your company will have to pony up $3 million in year one, $2 million in year two and $1 million in year three. You project that there will be no cash inflows in year one, but years two and three will each see inflows of $3 million. By the end of year one, the balance of cash flow will be negative $3 million and by the end of year two it will be negative $2 million (-3 - 2 + 3). The project will have paid for itself in exactly three years (-3 -2 -1 +3 +3). I am using some nice whole numbers here but the answer can of course be a fraction.

The payback method is very simple method. For this reason, it's used widely even in most unsophisticated business environments. This is its main advantage. Come to think of it, this is its only advantage. Let me tell you about its key drawbacks.

First, payback is expressed in time units, which is OK if you merely want to compare several project alternatives. But it doesn't provide any idea how much they are going to cost.

Second, it completely ignores time value of money which we discussed earlier. Even in economies with low interest rates, this is an important consideration.

Third, the payback method ignores the scale of investment and is biased towards long-term projects.

Finally, consider this: What if there are cash flows after the payback period? Well... this method happily ignores them.

In other words, the payback method can be used is a rough screening tool but it's quite deficient otherwise. Your CFO will be quite impressed if you confidently explain to him these points next time he asks about the project payback.

Next time, we'll look into the other two more methods. I promise, it does get better, albeit not necessarily more fascinating.

Ilya Bogorad is the Principal of Bizvortex Consulting Group Inc, a management consulting company located in Toronto, Canada. Ilya can be reached at ibogorad@bizvortex.com or (905) 278 4753

About

Ilya Bogorad is the Principal of Bizvortex Consulting Group Inc, a management consulting company located in Toronto, Canada. Ilya specializes in building better IT organizations.

8 comments
admin17
admin17

Good introduction to the concepts! However, I believe the representation of NPV was a little off. While it is definitely better to have cash flows sooner rather than later, it is not directly related to investment alternatives. More to the point, earlier cash flows are preferred due to the effect of inflation. $100 today purchases more than $100 a year from now (see inflation in fuel prices over past year). And, of course, when you receive those earlier inflows, you can invest them to offset any decreases in purchasing power caused by inflation :) Also, when taken together with the payback method, one can assess the net value of the project over a period of time including the effects of inflation.

robin
robin

A main reason ROI determinations are often less persuasive and less reliable than expected is that the emphasis is only on the arithmetic (i.e., "number crunching") and fails to get the right numbers about the right things. Failing to quantify intangibles leaves a giant loophole which essentially nullifies any potential value of disciplined ROI calculations involving only tangibles. Our REAL ROI? methodology overcomes these and eight other common but seldom-recognized pitfalls in traditional uses of ROI. See www.ProveIT.net for whitepaper.

tim uk
tim uk

Can someone clarify which section refers to which re NPV/IRR. Payback is at least headed. As for the sentence "Now let?s finally look at the first and the most popular method" ... oh dear.

johnbaerg
johnbaerg

Your article was brief but valid and applicable. I especially appreciate the points you made about why not to use Payback Period (commonly called "ROI"). Personally, I calculate the NPV and IRR on all projects. These two metrics always come to the same conclusion (in fact, they're related), but show different aspects of the investment. For those who want a better understanding, I recommend "Essentials of Corporate Finance", ISBN 0-07-234052-5. It shows how to use spreadsheets to do the heavy lifting. It also contrasts the different budgeting techniques (as you touched on in your article), and how their popularity has changed over time. Thanks for a great article.

mcarr
mcarr

$1m. buys rather more property and stocks and shares today than a few months ago and may buy rather less than the same amount in another few months time. It's merely a tool to enable a like-for-like comparison with inherent dangers. For example, it is one of the lures behind short selling - works 95 times out of a 100; when it fails, ....

ibogorad
ibogorad

I have not really discussed the NPV yet (saved for the next installment). The explanation of the time value of money is a classic one and does not contradict what you are saying. Yes, you can discount future cash flows for payback as well; this is included in the sequel to this article. Thanks!

ibogorad
ibogorad

I am not sure why you felt constrained to do this. I thinkI was clear that non-economic costs and benefits will be discussed in a future article.

Jerry B
Jerry B

It looks like they will be covered in his next articles. See the last line of his article. "Next time, we?ll look into the other two more methods. I promise, it does get better, albeit not necessarily more fascinating."