One of the most important parts of the project planning process is the financial analysis. The goals of this phase are to determine whether or not to take on the project, to calculate its profits and to ensure stable finances during the project. In other words, financial analysis evaluates project liquidity and profitability. Liquidity is assured by cash flow analysis, while the profitability is evaluated by the following techniques:
- Payback period analysis
- Accounting rate of return
- Net present value
- Internal rate of return
Each of these techniques will be described below.
Cash Flow Analysis
A cash flow is one of the most important parts of the financial analysis for a project or a business. It represents a listing of the project cash inflows and outflows divided into time periods. The time periods may be months, quarters or years, depending on the project needs. A cash flow can be created for either the past accounting period (it is called the cash flow statement) or the future accounting period (the cash flow budget). Apart from the cash flow projections, the cash flow budget may contain the actual cash inflows and outflows, allowing you to monitor the accuracy of your projections.
The main benefit of cash flow budgeting is that it quickly points out any liquidity problems in the future. It shows when the company would experience cash deficits and allows you to take corrective actions in advance by reducing the outflows, changing the time of certain transactions or borrowing the money. The cash flow budget can also identify the time periods when the company will have excess amounts of cash, allowing you to use this cash in order to create additional revenue.
You can download a cash flow budget Excel template from here.
Payback Period Analysis
Payback period analysis is a method that will tell you in how much time you can earn the same amount of money that you would spend on the project. Its formula is:
For example, if the project costs $100,000 and is expected to return $20,000 annually, the payback period would be five years.
When this method is used for project comparison, the projects with shorter payback period rank higher ??they are more liquid and less risky than the projects with longer payback periods. A payback period of three years or less is considered good, while the projects with payback period of one year of less should be considered very important and should be prioritized.
However, the payback period formula has two disadvantages. First, it ignores the revenues after the payback period, meaning that the project that returns $20,000 after a five year payback period ranks lower than the project that returns nothing after a three year payback period. Secondly, and more importantly, it ignores the time value of money.
Accounting Rate of Return (ARR)
Accounting rate of return is a simple method used to quickly estimate a project’s net profits. It represents yearly profits as a percentage of the initial investment:
One good thing about this method is that it considers the depreciation of assets. Depreciation is the decrease in value of assets (e.g. a used machine has less value that a new one) and is calculated by using the following formula:
Salvage value is the value you can earn by selling the asset after its useful life has passed. For the purpose of this formula, useful life of an asset is measured in years. For example, if you buy a machine for $10,000, use it for four years and then sell it for $2,000, the depreciation would be:
After calculating the depreciation, we can use its value to calculate the accounting rate of return. If the new machine would earn us $4,000 per year, the accounting rate of return would be:
Another advantage of the accounting rate of return is that the project’s entire useful life is considered, not just the payback period. On the other hand, this method does not use cash flow data and does not consider the time value of money.
Net Present Value
Unlike the previous two methods, net present value (NPV) considers the time value of money. Basically, due to its earning capacity, the same amount of money is worth more right now than at some point in the future. For example, if you deposit $100 in a savings account with a 5% interest rate, the money invested today would be worth $105 in one year. On the other hand, $100 received one year from now would be worth $95.24 today.
So, the net present value allows you to find the today’s value of the future net cash flow of a project. If the value is greater than the cost, the project will be profitable. You could also compare multiple projects, where those with greater difference between the net present value and the cost are ranked higher. The net present value is calculated by using the following formula:
- Ct– net cash inflow during the period
- Co– initial investment
- r – discount rate
- t – number of time periods
The discount rate represents the cost of borrowing the money. If you are taking a loan in order to finance your project, you can use the loan interest rate as the discount rate. Note that if the rate is variable, you may have to estimate an average interest rate over the loan period. Also, you should take tax laws into account, as business loans may be tax-deductible. If you finance the project with your own funds, the discount rate could be the interest rate you would earn by depositing the money in a savings account.
Internal Rate of Return (IRR)
The internal rate of return is another financial analysis method that allows you to calculate the time value of money. The IRR of an investment represents the discount rate at which the net present value of costs (negative cash flows) of the investment equals the net present value of the benefits (positive cash flows) of the investment. In other words, it represents the interest rate which is equivalent to the amount of money you expect to earn on the project.
Theoretically, all projects in which the internal rate of return is higher than the cost of capital are profitable. However, it is advised to only accept projects where the internal rate of return is several percentage points higher than the cost of borrowing, in order to compensate the risk and time associated with the project.
Tips and Tricks
- Create a cash flow budget
- Use realistic cash flow predictions and monitor their accuracy by including the actual cash flow as the time passes
- Identify potential liquidity problems and solve them on time
- Use at least two techniques for evaluating project profitability