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168 views54 pagesUnderstanding Financial
Uploaded by
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF or read online on Scribd
/ 54
SLA ed
* POCKET MENTOR
UN SANE
aA es
Budgeting + Financial Statements + Accounting Methods + Cost/Benefit Analysis Pocket Mentor Series
Understanding
Finance
Expert Solutions to
Everyday Challenges Contents
Mentors’ Message: Why Understand Finance? ix
Understanding Finance: The Basics 1
Understanding Financial Statements 3
‘An overview of the statements you need t0 assess your
Accounting methods 5
Theincome statement 6
The balance sheet 9
The cash flow statement 12
Using Financial Statements to Measure Financial Health 15,
A menu of eal
financial soundness
Profitability ratios 17
Operating ratios, 18
Liquidity ratios 19
Leverage ratios 20
Other ways to measure financial health 21
You can use fo evaluate your organization's The Budget Process 25
Four steps to developing an inforn
Understanding top-down and
Preparing a budget 29
‘Articulating your assumptions 31
Quantifying your assumptions 34
What Is Cost/Benefit Analysis? 39
invest ina particular initiative.
Nt return and payback per
Nt present value and internal rate of retun 45
Breakeven analysis 49
i Sensitivity analysis 51
Estimating unquantifable benefits and costs 53
‘Tracking Performance 55
Tactes for
‘Tracking the performance of an investment 56
‘Tracking your budget 58
Tipsand Tools 61
Tools for Understanding Finance 63
review of concepts presente in this
‘and after you've read through the guide, 1
learned.
Answers to test questions 70
Key Terms 73
Definitions of important and commonly used t
ToLearn More 89
5 of articles and books if you want to go more deeply
Purther
Sources for Understanding Finance 93
Notes 95)
For you to use as ideas come to mind. Mentors’ Message: Why
Understand Finance?
No matter where you work in your organization, understanding
basi financial concepts will help you do your job better and con-
tribute to your company’s efforts to stay in business and turn @
profit.
Understanding Finance explains the basics of this important
subj jot make you a finance expert, nor will it qualify
you to become afin lyst, controller, or chief financial of-
ficer (CFO). But it will explain what you need to know to be an in-
gent consumer of financial information, to plan, and to use
financial concepts in making business decisions.
Reduced to its essentials, busines finance is about acquiring and
allocating the resources a company needs to operate. Regarding re-
source acquisition finance is concerned with questi
Jur company acquire and finance
equipment, and other physical assets?
+ How:
+ Should we use the owners’ money, borrowed
ly generated cash for resource acquisiti
low long docs take to collect money owed to us by
customers? nance helps managers answer
And regarding resource alloca
questions like:
invest in several ventures, how might we deter-
imately generate the greatest value?
+ lewe:
mine which
+ What return must an investment produce to be worth mak-
we? And
o produce financial statements, budgets,
‘documents give you the numbers you need to
make savvy decisions for your own divi-
if you interpret and use them correctly
ask key questions
sion, departme
(Chuck Krem
Mentor
any years’ experience as an accountant,
ess consultant, He is currently the
ovations VMS. He has
executives overcome'fear off
joyable devices in Novations Finan
-and The Accounting Game seminars.
sing by the Numbers: A Conamonsense
i's Financials. Chuck
x Mentors’ Message
Karen Berman, Mentor
Kaen Berman, PAD is fu
aa ecommerce
programs, Maney Map keynote and other products and services
despa ene the creronein crpmizations endetands how
aac ena eae tate t cate Re,
tes worked wth doen of ompenic fm entrepreneur ima
Fornne 50 organizations png them creat fan
{punt hat anton employes manage ad leds ins Baines
Ferter, Shido user ong wits oe Knight of cial
teligeneA Managers Gude o Knog What th Numbers Realy
Mean Harvard Busines choo Pres 206),
ing firm offering customized tai
Mentors’ Message xi Understanding
Finance:
The Basics Understanding
Financial
Statements process data,
But the un-
to make money. As
money—preferal
the nonprofit or
and the cashflow:
4. Understanding Finance
ee
statements available to everyone—shareholders, industry analysts,
and competitors as well. Asa result, they are not as detailed as the
‘company’s internal financial statements.
Accounting methods
Financial statements follow the same general format from com-
pany to company. Depending on the nature of the company’s busi-
the statements are
ness, however, specific line
Most companies use!
‘This system relies on the matching princi-
ple, which helps companies understand the true causes and effects
‘of business activites. Accordingly:
+ Revenues are recognized during the period in which the
sales activity occurred.
+ Expenses are recognized in the same period as their associ-
ated revenues.
‘Amalgamated Hat Rack Company, which man-
the revenue for 2
ufactures hat racks from imitation moose antl the income st
shows acomy
ically, month
s—are then subtracted from the revenue. The bot-
st over—is the net income or profit. i
ample shown in the
ted Hat Rack” (Explanations for key ter
| Income statement for Amalgamated Hat Rack
| SRP SMP Se cee Sr
etal sales [220.000
[Corporate sales mn $1,000,000
Totalrevenue a $2,200,000
Cost of goods sold $11,600,000)
Gross profit ‘$1,600,000,
Operating expenses (800,000),
Depreciation expense . —[se4,00)
‘Operating income
{also called earnings before interest and taxes) $757,500
Interest expense (110,000, |
Earings before income tax 647,500 |
Income tax ba Lae la __$(900,000)_|
Net income ele _ 8a |
Source: Harvard Managaltntr® on France Escorts adared witnpemisson.
Understanding Finalal Statements 7 The balance sheet
8 Understanding Fiance ing the assets that are most eas-
ther assets that have value but
lated depreciation in this
10 Understanding Finance
a
‘Amalgamated Hat Rack balance sheet
‘as of December 31, 2004
‘Assets
‘Cash and marketable
secuties
‘Accounts receivable
Inventory i
| Prepaid expenses
Total current assets
Net property, plant,
‘and equipment | s1.631,000_| $1,888,000 _| $106,000)
|
eae Sea a oa
|
|
‘abilities and
owners’ equity |
‘Accounts payable | $440,000
Accrued expenses $08,000
Income tax payable | __$17,000
‘Short-term debt [$409,000
[total current abilities
| 1,785,000 |
3401,000
“Sauce aver Marageertor® on Feance Esser adap winpamieson. —_]
Understanding Financial Statements 12 Subtracting cur
‘company generated cash flow of $95,500 i
nations for key terms follow.)
‘Amalgamated Hat Rack statement
of cash flows, 2004
Netineome — [sir 00
Depreciation $42,500
‘Recounts o3ivable is 543.000
Inventory in $460,000)
Prepac expancos $425,000,
‘Accounts payable ‘$20,000,
| Accrued expenses $24,000
Incometaxpeyeble | $8,000 |
Cashflow from operations
Property, plant and equipment PPAE) $7500)
Cash low from investing activites | 0,800) |
‘Shor-term debt |__s191,000)
‘Long-term borrowings $90,000)
[Contributed capital a 0
[ash cividends to stockholders | Sia7.000)
{Cash low from nancing activities ___| stt08.000 | Using Financial
Statements to
Measure Financial
“a Rlealult
flow statement
| ACCOUNTS RECEIVABLE
the company for pro
be paid out of HE THREE FINAN
bottom line: it indicates
sa company generates over a period
th, a quarter, ora year,
+ The balance sheet shows a
specific poit . That
any’ financial situation—its ass
ona given day.
of time—a
npany’s financial position at a
+ The cash flow statement
‘comes from and where it
cash in, through, and out of
‘here the company’s cash
's—in other words, the low of
\e company.
Another way to understand the interrelationships is as follows:
AL statements offer three different
ympany’s financial performance.
ted stories about how well
‘gives a snapshot of the com-
By themselves, financial statements tell you quite a bit: how
‘much profit the company made, whe
large its debts are. But how do yor
's provide? For example, is the company’s profit
smal? Is the level of debt healthy or not?
Ratio analysis provides a means of digging deeper into the
formation contained
ratio is two key numbers from a company’s financial statemer
expressed in relation to each other. The ratios that follow are rele-
vant across a wide spectrum of industries but are most meaningful
‘when compared against the same measures for other companies in
the same industry.
the three financial statements. A fins
Profitability ratios
‘These measures evaluate a company’s level of profitability by ex-
pressing sales and profits as a percentage of various other items,
+ Return on assets (ROA). ROA provides a quantitative de-
scription of how well a company has invested in its assets.
‘Tocaleulate ROA, divide net income by total assets.
+ Return on equity (ROE). ROE shows the return on the por-
tion of the company’s financing that is provided by owners.
te ROE, divide net income by owners’ equity.
+ Return on sales (ROS). Also known as net profit margin, ROS
isa way to measure how sales translate into bottom
profit ‘ company makes a profit of $10 for
every $100 in sles, the ROS is 10/100, or 10 percent.
‘Tocalculate ROS, divide net income by the revenue.
Tocale
Using Financial Statements to Measure Financial Health 7 * Gross profit margin. A ratio that measures the percentage of
£8708 profit relative to even
Tocalculate gross margin,
* Earnings before interest and taxes (EBIT) margin, Many ana-
Iysts use
and balance sheet figures,
ws how efficiently a company uses
ide revenue by total
ber, the better,
icantly more working capital than one that takes four days to
collect.
‘There are different methods to calculate days receivables,
(One way isto divide ending accounts receivable by revenue
per day.
* Days payables. ‘This measure tells you how many day
takes a company to pay its suppliers. The more days it
the longer a company has the cash to work with.
(One way isto divide ending accounts payable by cost of
goods sold per day.
+ Days inventory. Thisis a measure of how long it takes a com-
pany to sell the average amount of inventory on hand during,
a given period of time. The longer it takes to sell the inventory,
the more the company’s cash gets tied up and the greater the
lihood thatthe inventory will nt be sold at
‘To calculate days inventory, divide average inve
cost of goods sold per
*+ Current ratio. ‘This isa prime measure of howw solvent a c
pany is. I's so popular with lenders th
called the banker’s ratio. Generally speaking, the higher the
Using Financial Statements to Measure Financia Health 19 "ati, the better financial condition a company is in. A com-
pany that has $3.2 mil
+ Debt to equity. This measure provides a description of how
well the compam
hhance the return’
in current assets and $1.2 million
0f 2.710 1
‘er than one with a
‘making use of borrowed money to en-
‘owners’ equity.
‘To calculate the debt-to-equity ratio, divide total liabili-
ties by owners’ equity.
Other ways to measure financial health
9s, other ways of
these measures are most
the same measures for other
refers to the process by which people
‘of a company for the purpose of selling
an uncertain science. For example, a
the quick ratio, divide current assets minus
inventory by current
Leverage ratios
1 how, and how extensi
tance, the word leverage
ympany uses
sed for debt, tech company may be valu
the acquired firm's
s other operations.
's company’s margin of
‘company can make its in-
refers to the process
to scrutinize a company’s fi
and stock performance carefully in order to arrive at what they
Using Financlal Statements to Measure Financial Health 22 believe to be a realistic estimate of that company’s value. Since a
share of stock denotes ownership of a part of the company, ana-
lysts are interested in knowing whether the market price of that
share is a good deal, relative to the
the company the share represents
Wall Street uses various means of val
j ing a company’s financial performance in relation to its stock
price.
Internet company would be significa
of growth include sales growth, profit
growth in earnings per share.
Economic Value Added. ‘This concept was introduced as a way to
profit leftover after the company has met the expectations of those
‘who provided the capital
Productivity measures. Sales-per-employee and net-income-
ppet-employee measures link revenue and profit generation infor-
mation to workforce data. Watching the trends of these numbers
adds to your understanding of what is occurring in the company.
* The earnings per share (EPS) equals net income divided
the numberof shares outstanding. sf
ly take the stock’s price down
(P/E) isthe current price of a
led by the previous twelve months’ earn-
2 common measure of how cheap or ex
toearnings.
Tips: Analyzing Financial Statements
* Consider the context—what looks lke a big (or small) number may
‘not be once you understand what’ typical fr a business in that
particular industry.
+ Compare one company/s statements with those ofa similar-sized.
‘company within the same industs
‘+ Watch for trends. How have the statements changed since last
‘year? From three years ago?
+ Use your company’s statements to write a parag
scribes how much profit it is making, how wel
rs Groh mea an
ancl Koh, company on
vide increasing ie
‘ ompany—an indus
ly has long business eycles—probably doesn
you very much. But a strong one-year growth figure for an
22 Understanding Finance
Using Financial Statements to Measure Financial Health 23 The Budget
Process A BUDGE 18 4 Buprnt for ahicvng specie goals
Your unit's budget is part of
art of your company’s overall strat-
¢8y. So you need to understand your comy
"ur company’s strategy in order
o create a useful buck eh
How can you fa
strategy?
lf with your company’s overall
* Watch the overall economic picture. A. 's
A.company's stra
during are raison
ferent than in a booming
to your manager's and col-
nnd the economy—and make your
re you deluged by résumés, ors
‘Ate price rising or falling?
* Stay on top of industry trends. Even when the economy is
b me secto
tors are going bust; your budget will need
that realty
+ Step yurstfincompany sais Every company ha vals,
some 's formalized and sometime :
very best companies kee
during every deci
+ Conduct SWOT anoiyses. Every company has strengths, weak-
‘nesses, opportunities, and threats. Keep them in mind as you
build your budget.
Understanding top-down and bottom-up budgeting
If your company does top-down budgeting, senior management
sets very specific objectives for such things as net income, profit
margins, and expenses. For instance, each department may be told
old expense increases to no more than 6 percent above last
the
parameters to ensure that the objectives are achieved. For exam-
ple, suppose Amalgamated Hat Rack decides that it wants to in-
crease overall profitability by 10 percent. That could mean, among,
es, launching a new product line to generate new
sales, or cutting overhead by upgrading technology, which would
reduce the need for part-time workers.
In addition, if your company does top-down budgeting, make
sure to look at the overall plans for sales and marketing, as well as
ind expense plans, as you prepare your budget. The com-
ys sales plan determines, to a large extent, how much money
‘budget. The marketing budget will give
he company will be emphasizing in the com-
ve to reduce expenses a8 &
IL be available for
you an idea of wh:
ing year. Further, many companies
centage of revenue every year, no matter how slightly, as @ way
improve profital
In companies tom-up budgeting, managers aren't
siven specific targets Instead, they begin by putting together budgets
The Budget Process 27 —
What Would You Do?
Was the Budget on Track?
IMONE WAS PLEASED. Rece
~ of her company’s human
Worked hard to develop the budget
Year. She had negotiated wi
ied, she would have to
udget she had worked so hard to
ils. Though she y
udget, she felt somewhat
of their respective
to.create an over-
This process ean go through mu
working closely wi
28 Understanding Finance
i 8 I’ best to be as cooperative as
against yours fr limited resources
yoo wi area agi ea
bby aggressively for your own unit’s
doesn't mean you should:
needs.
Preparing a budget
‘As a manager, you are expected to put together a budget for your
department each year. Your compens ‘ a large
to stick to that budget. So it’s in your best
tart out. But
wort do your your company any good,
ing goals. You may want to improve your division's
performance over the previous yes 1
ipany, or decrease costs—maybe even all three. How do you
think your department can accom
icrease net income foi
* Increase gross sales by 5 percent by June 30.
costs by 3 erventage of
d of the fiscal year
by the en
Be sure you know the scope of iget you're fe S
produce. Scope implies two things: the part of the company
+ Decrease adm
revenue by the
the fiscal year.
+ Reduce inventories by 2 per
The Budget Process 29 budget is supposed to cover and the level of detail it should
include.
Steps for Creating a Budget
1 Analyze your company’ overall strategy.
2. If your company does top-down budgeting, start withthe targets
‘ven to you by senior management. I your company does battom-
tip budgeting, create these targets yourself
3. Articulate your assumptions.
4, Quantify your assumptions
5. Revjew: Do the numbers add up? Can you document your assump-
tions? Is your budget defensible?
you'r focusing on, the more you
need to budget atthe detail level. If you're creating a budget
fora twelve-person sales office, you typically won't need to
worry about such capital expe
the computer equipment. But you should in-
of what kinds of office supplies you'll need
tures as major upgrades to
and larger departments in your budgeting, your
scope broadens. You can assume that the head of the
twelve-person office has thought about paper clips and
and creates projections. Let’s suppose you think sales will rise 10
percent in the coming year. If that’s true, you may have to add two,
more people to your unit. But when you get before your budget
tee, be prepared to defend your assumption that sales will
1 here. Put yourself in the position of
a division manager with limited resources and many departmental
requests for funding. How can you make your case for two addi-
aff members so that the division manager grants your fe-
1 ahead ofall the others?
xt five years?
jarterly or
ir budget need to be accompanied by an
strategic plan—for example, your plans for
Articulating your assumptions
The easiest way to get started i to take a look at your department's
recent budget. If you're the manager of Amalgamated Hat
ons for the coming year, After
takes current data, adds assumptions,
‘The Budget Process 31
30 Understanding Finance
| Rack’s Moose Head Division, you might decide to look at the 2005,
budget (shown in the table “Moose Head Division, Amalgamated
Hat Rack’) to get ideas about how to increase revenues, cut
costs—or both,
Moose Head Division, Amalgamated Hat Rack
2008 Budget Budgeted | Actual _| Variance |
Sales by model 7 a
Moose Aner Deluxe
| “$237,000
$920,225
$437,525,
[$126,000
Cost of goods sols
‘$80,000
$4,199,750
Direct labor
$575,905 | — $62,000
aston overhead ‘$5,694 $6,150 ‘$(456)
rect materials $191,100 |
Stns ee eee
‘Sales, general, and
‘administrative costs
‘Sales salaries $300,
— $300,000
‘Advertising expenses $136,000
Miscellaneous soling expenses | $3,400 |
Office expenses: $88,000
‘otal SORA '$526,400_|
Operating income ___|_ $306,751 | $45,194 | 8(51,597)
‘Sauce: Harvard Maneeterion® on Finance Essent adapted wit pemisicn,
32 Understanding Finance
Dont start off by looking at specific revenue or cos ine items,
use revenues and costs are integrally linked. Instead, begin by
1g yourself what events you want to see happen over the time
‘youll be budgeting for and what revenues and expenses are
+ example, do you expect to sell more products? How? If you
increase sales of your company’s current products, there
‘costs—maybe even new
oduct development .
1e case of the Moose Head Division, the Standard Upright
Standard exceeded sales exp.
the sales projections for
sales volume for your 2006 project
the Standard Upright is a good choice: it
2005 projection by 9 percent. Could you increase the an-
is model by 5 percent or 10 percent in 20062 In
jow much more would you need to
ted, the Electro-Revolving model is faring poorly.
¢ entirely and promote the
te $81,250 in sales, but
produce, perhaps
Ar0-Re\ is very expensive
of discontinuation would not affect the bottom line
The Budget Process 33 Other questions to ask yourself include
you keep prices the same, low
wuld have more than
llprovided that the in-
price increase of 3 percent
the budget’s 2005 gross sal
crease did not damper
kets, target new customers, or
revenue do.
+ Doyou
se new sales
you expect
change? For example, do you plan
orary help and replace these resources
you be able to reduce
so, how much will it cost
toraise or lower prices? Are you
how much will it affect your sales?
xduct have to be enhanced to keep your current
rain your staff?
cts or initiatives you are plan-
Each of your
dollar figures. If your entire staff of twelve
reds sales training, you
34 Understanding Fi
to find out how much it will cost to train each person, and
ly that number by twelve to calculate the total cost. Some
ior revenues are easier to project than others—which is why
ways a good idea not to prepare your budget alone. Coworkers
direct reports will have valuable suggestions. Trade publica-
scan often provide industry averages for a range of costs.
‘Once you've translated the assumptions into numbers, you need
ncorporate those numbers into budget line items. Because Your
iget needs to be compared and combined with others, your
company Will probably provide you with a standard set of line
ims to use, In some cases, your quantified assumptions will con
ire line item—for example, you may have listed and
ified al the product development projects youll be pursuing
car, In other cases, your assumptions will be incremental: if
to boost sales by raising prices, you'll start with last year’s
figures and then increase them by the appropriate amount.
‘As you put your budget into its required format, be
easy to lose track
your assumptions. 1
sure to docu
Jation, and you will want to be able to
»m—and revise them—when needed.
ck. Does,
2 For ex:
does
When you have compiled your budget, take a step ba
goal was to increase gross sales by 5 percent,
werlook overall goals as you
The Budget Process 35) pee ron
pee se St ou
happy with it, but not everyone else oes
eee ars
Besar
aoe
thtwo? If not, be sure you.
Tips: Bi a
+ Stay goal oriented. If y
y
to increase sales, make that the
other issues sidetrack
+ Dorrt try todo it alone. Incl
have detailed
tearm members—they may
that you dont.
ave money inthe budget”
36 Understanding Finance
Nhat You COULD Do.
Remember Simone and her need to track her
budget for the HR department?
The mentors suggest this solution:
‘simone needs to assess the performance of her budget at east
n. For example a variance might be a one-t
wouldrit need to change
should keep monitoring such variances over subsequent
nake sure they do indeed st
doesn't represent a one-time aberration, Simone will need to
rnces are occuring and develop responses to
it months
In addition to tracking and addr
erly as form senior manage-
looks as if she’s not going to make her annual budget
Js. That way, management can adjust the overall compaty
recast accordingly. Finally, Simone should also inform senior
her unit's performance is turning out better than
and esti-
‘The Budoet Process 37 What Is
Cost/Benefit
Analysis?
OMPANY REVENUE Rat Hack is considering two invest-
machinery and cre-
is a plastic extruder
ave time and money
wgsafer than the current ma-
of coutracks, will re-
ipment, and desig.
decide whether these investment op-
over the long term,
chinery. The sect
Quire a $250,000 investment in plant,
How does Amal
jing the answer is known as cost/benefit
cans evaluating whether, over a given
‘of the new investment or the new business
tweigh the associated c
want to weigh the relative
merits of each investme the negative consequent
any, of not proceeding wi
costs of doing nothing are always high: in many cases, even when
40 Understanding Finance
ificant benefits could be gained from a new investment, the
rksheet” in the Tips and Tools sect
Steps of cost/benefit analysis
.e cost/benefit analysis of a particular investment involves the
jing steps:
1. Identify all the costs of the new purchase or business
‘opportunity.
2, Identify the benefits of additional revenues.
3, Identify the cost savings to be gained.
Map out the timeline for expected costs and anticipated
Evaluate the unquantifiable benefits and costs,
srward. First, begin by
‘The fits three steps are fainy stra
dng all the costs associated with the venture—this year’s
font costs as well as the ones you anticipate in subsequent
.econd, determine additional revenue that could come from
we customers or from increased purchases from existing cus-
and the benefits ofthese revenues, make sure 0
ately this
can arise
ers. To unde
new expenses associated with them;
means you'll be looking at profit. Third, cost savings
‘What Is Cost/Benefit Analysis? 42 What Would YOU Do?
The Case of the Frustrated Fortune-Teller
But be sure not to double-count cost savings in your expenses
revenue, Many times, the in-
crease revenue or decrease expenses, but not
lo either step 2 orstep 3.
In step 4, map out these two elements—the costs and the rev-
‘enues or cost savings—over the relevant period of time. When do
yout expect the costs to be incurred? In whi
you expect to receive the benefits (additional revenues or cost sav-
In what increments?
t's done, you
using one or more ofthe’
FFétncors neauzeo owns 20 tat is empany
needed to make significant to the young-adut
to senior management
market. He made numerous pres
‘on new product concepts, market
ready to begin the evaluation phase,
lowing analytical tools:
+ Net return (sometimes referred to as ROI)
‘would beat the compar
+ Pc prod
"We need to understand the bot i
+ Breakeven analysis
ke at some future date? He wasrit a
+ Net present value (NPV)
fortune-teler
+ Sensiti
alysis
Let's take a closer look at each of these tools.
from a variety of sources; for the ones listed below it isn't hard to
‘quantify the savings.
Net return and payback period
Net return (sometimes called return on investment, or ROI) de-
+ More efficient processing
are required to dot
is could mean that fewer people
process requires
fewer steps, or even that the time spent on each step decreases.
processing, or thi
:ment from the total
yramount of return
+ More accurate processing, The time required to corecter-
compare
rors and the number of lost customers could both decrease.
by the total cost of the investment. This can help
What Is Gost/Benefit Analysis? 43
Understanding Finance ‘Amalgamated extruder savings
‘eturns on money your company spends internally with returns
available elsewhere. However, because it does not address what is
‘Savings
1e new $100,000 plastic extruder Amalga-
would en ‘company to save $18,000 a
year over the lifetime of the machine, which would be seven years.
‘The total savings would thus be $126,000, making fora net dollar
return of $26,000, 1¢ formula—$26,000 divided by
investment is a very attractive
126,000
sauce: Hanae ManageMenio® on Finance Essent, adapted wi pein,
now the payback period: how long
We already
is expected to save Amalgamated
payback period, divide the tot
annual savings expected. In t
‘There is a drawback to both methods, however: they do not
wide as accurate an economic picture as more sophisticated
nal rate of return, because
Is such as net present value an
ignore the time value of money.
Net present value and internal rate of return
1 analytical tools can be fairly complicated. Because most
Iculators and spreadsheet programs can make these calculations
truly begin to reap the benefits
ve years,
AAs analytical tools, net return and payback period have several
benefits:
+ They're easy to convey to upper management.
value of money. In effect,
today is worth more than a dollar you recei
lay. The reason: even assuming no inflat
invested somewhere, which means that you
+ They adopt
+ They help you
What Is Cost/Benefit Analysis? 45
44 Understanding Finance cent: in that case, the NPV for the extruder would be
investment to being avery poor one.
Notice something c the NPV calcu
truder: even wi liscount rate, the NPV is fr less op-
timistic than the rosy 26 percent
heres that although it's much more
plain—the NPV analysis does res
comprehensive evaluation
orecast. The point
icult to perform—and ex-
of the capital required, the investm.
be undertaken, ar
INTERNAL RATE OF RETURN
&R) 11. A means for managers
urn that all invest.
ust achiove.
ie same algebraic formula as,
NPV calculation, you know the de-
IRR, by contrast, the net pres-
set at zero, and the equation is
spreadsheet prograt
calculations for:
ved for the rate of re-
tor will perform IRR
‘What's a reasonable rate of return for a business to expect on
yestment comparable to the one under consideration? Typi-
well above what it could get on a risk-free investment,
Jn as a Treasury bond. In many instances, companies will set «
‘a minimum rate of return that all investments are re-
the IRR of the investment
\der consideration must exceed the hurdle rate in order for the
company to go forward wi
If we return to Amalgamated’s coatrack opportunity, the caleu-
of 6 percent. IF Amalgamated's hur-
-would go ahead with the new line of coat-
le rate were 10 percent, the 6.4 percent IRR
investment.
dle rate were 6 pet
racks, But if the hut
‘would mean that Amalgamated should not mab
Breakeven analysis
Breakeven analysis is useful when considering an investment that
ing
you how much (or how much more) you
the fixed investment—in other
formation in
‘What Is Cost/Benefit Analysis? 49 ‘can perform the calculation, you need to understand the compo-
nents that go into it
+ Contribution is defined as unit revenue minus variable costs
per unit it’s the money available to contribute to pay
fixed costs. i
+ Fixed costs are items such as insurance, management
salaries, rent, and product development costs—they're items
that stay pretty much the same no matter how many units of
product or service are sold,
se concepts, you can understand the calculation:
+ Subtract the variable cost per unit from the unit revenue—
‘number of units that must be sold in order for all fixed costs
to be covered.
Consider the exam
pose the new coatracks sell for $75,
$22, The table “Breakeven cale
the breakeven volume for the co:
the variable cost per unit is
” shows how to determine
‘50 Understanding Finance
Breakeven calculation
$75. (unitreverue)
|=22 (variable cost per unt)
{$58 (unt eontibtion
$250,000 total investment equred)
+58 (unitcontibution)
{4717 coatracks (breakeven volume)
sauce: Hana ManageMento® on Finance Essent, adapted win pemision
smated must decide whether the breakeven
717 additional
coatracks, and if so, how quickly? To cale breakeven vol-
tame for the extruder, you would define the unit contribution asthe
cost savings per unit.
Sensitivity analysis
‘Amalgamated would expect its new line of e0a-
1 $60,000 in annual profit beginning a year
inthe scenario changed—how
all evaluation of the investment opportu-
ty analysis enables you toask just this kind of question
the ramifications of incremental changes in the assumP-
tions that underlie a particular projection.
What Is Cost/Benefit Analysis? 52 Sherman Peaboddy is the vice
We vice president of Amalgamated’
Moose Head Division. He would exercise mane
the new product line, and: me projecting $60,000 in annual
Profit fr five yeas, Natasha Rubskaya, the company’s Ci
phlegmatic about the inv
edicts an annual profit
stream of $45,000. Then there's Theodore Bullmoose, Amalga-
‘mated's senior vice president for new
ist, he is convinced t ks will prat
icks will practically sell,
themselves, producing an annual profit stream of $75,000 a year.
Amalgamated con
't be worth the invest-
owever, the investment will
be worthvshile—marginally so, according to Peaboddy’s profit pro
ons, and very much so, accor
edb of reo mig pe
her estimate of the coatrack line’s profit potenti epee
how it would be affected by vai
Other contingencies
mapped out just ase
52 Understanding Finance
Estimating unquantifiable benefits and costs
‘The numbers don't tell the whole story, s0 your cost/benefit analy-
orporate qualitative factors as well. Examples here
pany’s mission, the ability to take on the new opportunity
c