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Countertops Magazine ArchiveInvestment & Financial Modeling – A Leadership Mindset…“Great leaders are almost always great simplifiers, who can cut through argument, debate and doubt, to offer a solution everybody can understand.” -- Collin Powell
Financial models were developed to serve as objective ways to evaluate pricing, risk, returns and more. Understanding these written models, however, can equate to deciphering hieroglyphics. Although intimidating, there is a way to grasp their essence without needing advanced mathematics to help make businesses more successful, systematic and profitable.
My goal is to translate some key economic/investment models into more understandable terms to help you make the best financial/investment decisions. I’m convinced the mindset and ability to think critically are among a leader’s most valuable gifts. By conceptualizing the underlying fundamentals of financial theory, we can avoid gut-wrenching math and overly mechanical procedures, which are arguably ineffective in small businesses.
Five concepts I’ve demystified here should help you think more critically when faced with having to expand, borrow, invest, divest, hire, leverage, price, etc. Obviously there are many more concepts, but I’ve selected those most applicable to the surfacing audience. Here I can only summarize the essenceof the model to strengthen the strategic resolve in making some of the most important decisions.
Capital Budgeting and Project Assessment Capital Investment decisions typically involve the purchase of land, machinery, buildings, trucks, etc., and are among a company’s most important strategic decisions. They are harrowing because they require large sums of money up front with the benefit coming years into the future. So how do we keep it simple, non-mathematical and hedge as much as we can against walking into the land of no-return?
First, understand this: to commit large sums of money, time and other resources on a hunch or “strong belief,” without analysis that weighs incremental costs and benefits, estimates cash flows, time value, cost of capital, etc., is tantamount to gambling! Small business owners may be adept at finding ad hoc solutions and be blessed with gut instincts that guide them in uncertain waters, but, all too often, poorly evaluated capital investment decisions lead to the downfall of a business.
That said, an appetite for growth will invariably make potential large-scale investments necessary. Financing of the project is one set of decisions required; i.e., do I borrow money or use retained earnings (cash in bank)? Every time you invest money, there is a cost of capital - always! - even if you use your own cash. Why? Using your cash carries an “opportunity cost of capital” – that is, the lost return you could have used for a more pressing need, e.g., invested it in marketable securities, hired another salesperson, etc.
The decision to use cash versus borrowed funds can also be a function of your aversion to risk – solvency risk, specifically. This is very personal in small business and not as clear-cut as the investment optimization protocol used by larger companies.
So how can we feel more secure about making large investments or selecting among various alternatives? As in any analysis, the quality of your inputs (assumptions, returns, incremental costs, timing, etc.) is directly linked to the quality of your output, (the answer telling you if and to what extent the investment creates positive value).
The three most commonly used project assessment tools are Pay Back Period (PBP), Net Present Value (NPV), which is also called the Discounted Cash Flow model, and Internal Rate of Return (IRR). There are formulas for each and yet, ironically, that’s the easy part! Let’s identify the key drivers of each so we can utilize their essence.
Pay Back Period PBP is just that; it’s the time it takes for the benefit to equal the investment – presumably the point you start getting a positive ROI. PBP is expressed in “time,” which is useful when the PBP is defined and compared to projected significant changes in the economic and political environment, family life, key personnel tenure, etc. Typically, PBP is the least scientific and effective as a stand-alone measure; however, its value emerges when computed in tandem with its more sophisticated partners of NPV and IRR.
Net Present Value NPV,
What is important to grasp from this financial model is this: time is money. So, a dollar today is worth more than a dollar tomorrow. A dollar today is certain and a dollar in the future carries uncertainty risk and therefore is slightly less valuable from an “expected value” standpoint. Additionally, a dollar in the future may need to be allocated to the cost of capital to secure that future dollar.
The cost of capital is a significant cost. The higher the cost, the more it reduces the extent to which your NPV could be positive. Also, incremental expenses incurred as a result of the investment - key factors that play a huge role in the quality of your ROI assessment - are often underestimated. You have relative control over these two areas. Remember, the more complete and accurate your input, the more dependable your assessment.
One thing that can help you is to get on a first name basis with your local bank general manager or president. Consider taking a small bridge loan once or twice and pay it back on time flawlessly so you establish a “credit rapport.” If ever you need a favor, this history will be vital to your banker’s extending him/herself for you.
Essentially, this model requires one to identify, estimate and quantify the projected benefits from the investment – along with the time frame of these benefits (increased sales, liberated cash, etc.). Then, these benefits are weighed against the outflows (costs) as a direct result of making that investment (headcount, additional truck, increase in utilities, etc.); the cost of capital (financial leverage); and the timing of these outflows. The result is a time-adjusted net value of the investment. When positive, it adds value to the business.
NPV’s one main drawback is it doesn’t consider the ROI percentage. Positive returns on investments are wonderful, but you must also consider those with the highest percentage return to optimize your investment portfolio.
Internal Rate of Return IRR, aka Intrinsic Rate of Return, is effectively your break-even rate or the rate of return achieved when you set your NPV to zero. The math here is the proof to assure that an investment should be selected only where the weighted average cost of capital (WACC) is lower than the IRR. Non-math applied theory can help you this way: if the NPV yields a dollar amount, IRR yields a percentage. Positive net income is wonderful, but it’s the percentage that is the relative indicator of how your money is working for you.
The more complete and accurate the input, the better the assessment. Carefully think through all the incremental expenses you will incur, including labor, machinery, overhead, utilities, etc. Sales may increase by entering a new product line or region, but yield percentage makes it worth your time, money and heartache to invest in? In rationing resources, drilling down into these fine details is indispensable to success.
Touching on opportunity cost again, it’s important to remember there is a cost to every decision, including the decision to do nothing. By doing nothing, you have foregone the opportunity to do something, therefore, that gain has been lost. Opportunity cost plays a role in capital rationing when resources are finite and you really need to make the wisest decisions.
Opportunity cost can be expressed financially, or in terms of leisure or family time lost. Here are three very real examples to put into perspective:
Full Absorption Versus Contribution Margin Theory These theories relate to price/costing methodologies. I believe pricing decisions may be the hardest business decisions. Do you price what the market can bear and your actual costs to fabricate a top? Theoretically, everything you sell should have a component of overhead allocated to it, but what’s fair and reasonable?
Essentially, most fabricators are not piece-mealing work or making only one ultra-custom item. When production is very limited and specialized, you can effectively argue for full-absorption costing - that is, every bit of fixed and variable cost in your business gets allocated as product cost and sets the cost basis for your pricing. Ideally, the more custom and unique a product is, the more cost-absorbed your item can be.
A contribution margin approach to pricing appears to be much more applicable to fabricators’ work. This methodology states, as long as your price covers your variable costs, then anything you charge over and above goes toward your fixed expenses.
The degree to which you are financially and operationally leveraged, i.e., the degree to which you utilize fixed expenses as your slingshot to profit, is also a necessary element in pricing design. However, that is a subject for a future article.
Sensitivity or “Swing Analysis” Sometimes the desire to have one tell-all answer can be misleading. For example, what happens to ROI calculations when assumptions are over or underestimated? In these cases, your best hedge is to perform a swing analysis, which is a measure of elasticity in your ROI.
Critical input variables such as increased sales or volume throughput should be evaluated over a range of estimates to determine the marginal effect on ROI. You can also hold constant your sales and volume estimates, but toggle some costs to see how sensitive your ROI responds to assumption changes.
If your ROI remains relatively stable given reasonable changes in your inputs, then you gain a higher degree of resolve about your decision.
Financial modeling is essential to investment decisions. The model drivers center around costs and benefits weighed against time and cost of capital. Understanding the value of opportunities discarded (opportunity cost) and the sensitivity of project assessments to changes in input variables will facilitate more critically and analytically based investment decisions, ultimately optimizing companies’ values and strategic positions.
About the author P. Max Le Pera is principal partner of Global Surfacing Alliance, LLC with 20 years’ experience in business and marketing strategy for the building materials industry. He can be reached at (908) 358-5252 or by email at [email protected]. |
, is a formula (and theory) that evaluates the differences of the sums of the discounted cash inflows and outflows of a project. Simply put, if the calculation yields a positive integer, then the project returns more than it costs.
