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3 Ways to Evaluate a Capital Investment

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Small business owners often find themselves in a situation where they have to evaluate a capital investment project and decide whether or not how to expand their company, purchase new equipment or move to a new location. Availability of internal funds and the ability to borrow money are often limited.  So, making the decision on whether or not to move forward with a project or purchase is critical to the health of a business.

Let’s look at an example: Suppose an owner has an extremely popular restaurant and wants to take advantage of its esteemed reputation. Should the owner expand the existing facility or open a new location on the other side of town?

Expanding the existing restaurant will cost $75,000 and is expected to produce additional annual cash flow of $25,000. A new location will require an investment of $300,000. It is projected to have an annual cash flow of $75,000 after it is up and running for a few years.

Which of these projects should the owner choose?

Fortunately, several tools are available to evaluate a capital investment that will help small business owners determine the feasibility of each project:

  • Payback method
  • Net present value of cash flows
  • Internal rate of return

Evaluate a Capital Investment with the Payback Method

The payback method is the simplest to use. It is the time needed for cash inflows to cover the initial cost of the investment. The formula is the initial investment divided by the annual cash flow.

Take the example of the choices facing the restaurant owner. The payback period for the expansion of the existing facility is three years ($75,000 divided by $25,000). Since the restaurant is already operating, the increase in cash flow will take place fairly quickly.

Alternatively,  once there is a steady customer base, the payback period for opening a new location could be four years ($300,000 divided by $75,000). However, the cash flow for the early years after opening is uncertain, so the payback period may be longer.

The payback method has the following weaknesses:

  • The payback method won’t include cash flows beyond the payback period.
  • It does not consider the risk of receiving future cash flows.
  • This method fails to take into account the time value of money.

Evaluate a Capital Investment with Net Present Value

Unlike the payback method, the net present value calculation considers the time value of money. It includes future cash flows after the payback period and for as long as the project generates cash.

NPV takes a stream of future cash flows and discounts them back to their present value at the current interest rate on loans or the rate of return required by an investor or owner.

The amount that the present value of cash inflows exceeds the present value of the initial investment is the project’s NPV. This makes it possible to compare projects to each other by determining which one has the highest NPV. This method has a bias toward larger projects. This is because larger projects can show higher a higher NPV than smaller projects which have fewer dollars invested.

You can adjust the discount rate used to calculate the NPV so that you can compensate for the risk level of future cash flows. In the restaurant example, the discount rate used to calculate the NPV for a new location will be higher because of the greater uncertainty of future cash flows. Cash flows from expansion of the existing facility is more certain.

Evaluate a Capital Investment with Internal Rate of Return

The internal rate of return for a project is the discount rate that makes the net present value of the investment equal to zero.  You should consider accepting a project if its IRR exceeds your required hurdle rate. As the business owner, you determine your hurdle rate.

When using the IRR approach, you can compare projects with each other.  Upon comparing, you should select the project with the higher IRR, assuming the IRR exceeds the required hurtle rate.

None of these methods will provide the ultimate answer by themselves. Each approach has its advantages and shortcomings. The payback method is simple to use but does not include cash flows beyond the payback period. The net present value calculations favor large projects over small ones.  In addition, the internal rate of return gives multiple answers when cash flows are both positive and negative.

The most sensible approach is to use all three methods to get comparison figures for guidance and then apply experienced judgement and common sense.

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Key Financial Metrics for Small Business: The Numbers You Need to Track

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Just as drivers watch the instrument panel on their cars when driving, small business owners should continuously monitor the performance metrics of their company. An owner needs to know what’s working and what’s not. That’s part of managing a business. Just like it’s part of driving a car.  A water temperature gauge that goes into the red zone needs immediate attention; same with a financial metric that indicates the company is running short of cash. Key financial metrics for small business fall into four primary categories:

  • Profits
  • Liquidity
  • Leverage
  • Efficiency

Within these four categories, there are seven core metrics that act as the most important key performance indicators when it comes to cash flow:

Key Financial Metrics for Small Business

Measures of Profits

Revenue – This may seem obvious, but without revenue, nothing else happens, especially profits. And all revenue starts with sales. So, the first metric to watch is your most recent sales number; it could be daily, weekly or monthly, depending on the type of business,

Are your sales at the level they need to be? Comparisons of sales figures to the budget will help to keep everyone on course to reaching the revenue goal.

Gross profit margin– The gross profit margin is an early measure of a company’s efficiency of operations. It shows how efficiently a company uses its raw materials and direct labor to make and sell a product or service at a price that produces a gross profit.

The gross profit margin must be enough to pay all fixed overhead expenses and make a profit. In some industries, a gross profit margin of 25 to 30 percent may be enough; others need a gross profit of 50 percent or more. A calculation of a company’s profit plan or break-even revenue level will determine the required gross profit margin for your business.

EBITDA – It’s nice to know you’re making a net profit, but the real test is EBITDA. That’s earnings before deductions for interest, taxes, depreciation and amortization. EBITDA reveals the true operational profits of a business without the effects of financing costs, taxes and non-cash accounting entries.

Monitoring EBITDA is important because it is an indicator of the cash flow from operations.

Liquidity to Support Operations

Current ratio– Your current ratio is current assets divided by current liabilities. The timing of the cash flow cycle from inventory to receivables to cash is not perfect. Inventory can be slower to sell and turn over; customers can take longer to pay their bills.

On the liabilities side, expenses and bills to suppliers have specific amounts and due dates – there’s no mystery, there. For this reason, you need more current assets than current liabilities. A good, comfortable ratio is to have $2 in current assets for every $1 in current liabilities. Having less could indicate that you may begin to have problems paying bills on time.

Tracking the trend of your current ratio can provide advance warnings of upcoming cash flow problems, especially if the ratio drops below 1.5.

Financial Leverage

Debt-to-equity ratio – Some debt is good; it increases a shareholder’s return on investment. But too much debt can be dangerous. Lenders have strict schedules for principal and interest payments, and they expect to receive them, regardless of the company’s cash flow availability.

Efficiency of Operations

Accounts receivable aging – The accounts receivable aging metric keeps track of all unpaid customer invoices and/or credit memos. While most customers will pay their invoices before due dates, sometimes clients can run into problems – whether their own cash flow issues or poor record keeping – which keep them from paying you in a timely manner. You should try to track invoices in 30 day buckets (30 days overdue, 60 days overdue, 90 days overdue, etc) so that you can use this information to prioritize collections procedures.

Inventory turnover– Inventory represents a significant investment for most businesses, so turning inventory into sales quickly is important. Turnover is the number of times a company buys, sells and replaces its inventory in a year. It is calculated by dividing annual cost of goods sold by the average inventory level. Depending on the industry, inventory turnover rates can reach up to 10 to 12 times per year.

A decrease in turnover could be a signal that some products are not selling well, and prices should be marked down to move them out.

Owners who regularly monitor these key financial metrics for small business will have a good sense of the pulse of their business, while enabling them to quickly spot potential problems and take corrective actions before they become detrimental to the health of your business.

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