Profit

3.5 - PROFITABILITY AND LIQUIDITY RATIO ANALYSIS

Ratio analysis is a quantitative financial analysis tool for judging the financial performance of the business based on financial statements

Types of Ratios :

Profitability ratios examine an organisation's profit-making ability. The three types of profitability ratios are gross profit margin, profit margin and return on capital employed (ROCE).

Gross profit margin shows the percentage of gross profit in relation to revenue. You will need a profit and loss account to obtain data for calculation of profit margin. The formula of gross profit margin is:

Gross profit margin = gross profit ÷ revenue ⨉ 100

The higher the gross profit margin is, the better. For example, gross profit of $150 from sales revenue of $250 is 60%. It means that for every $100 of sales, $60 is gross profit.

Strategies to improve Gross Profit margin -

Adjust Pricing

Lower Prices: May increase demand, raising revenue; however, it may negatively impact brand image as it could seem inferior.
Raise Prices: Can increase revenue if demand is inelastic (e.g., few alternatives), but risks being perceived as unethical.

Increase Promotion

Benefits: More potential customers become aware of the product, potentially increasing demand.
Drawbacks: Increased marketing costs, and awareness doesn’t guarantee sales.

Reduce Cost of Sales (Cheaper Suppliers)

Pros: Lower cost of sales could boost gross profit margin.
Cons: Risk of inferior quality, which may affect product reputation.

Reduce Cost of Sales (Lower Labor Costs)

Pros: Reduces expenses, improving margins.
Cons: May reduce employee motivation and incur severance costs for layoffs.

Profit margin shows the percentage of net profit before interest and tax in relation to revenue. You will need a profit and loss account to obtain data for calculation of profit margin. The formula of gross profit margin is:

Profit margin = profit before interest & tax ÷ revenue ⨉ 100

The higher the profit margin, the better the organisation controls its expenses. For example, the profit margin of $100 from sales revenue of $250 is 40%. It means that for every $100 of sales, $40 is profit margin.

Strategies to improve Profit margin -

Improve Working Capital by Extending Trade Credit Period

Method: Negotiate a longer trade credit period to delay payments, improving cash flow for daily operations.
Pros: Increases cash on hand, boosting working capital.
Cons: Suppliers may react negatively, potentially straining relationships or raising prices.

Negotiate Early Payment Discounts with Suppliers

Method: Agree to pay earlier than usual in exchange for discounts.
Pros: Frees up cash due to lower supply costs.
Cons: May create pressure to generate revenue quickly, potentially affecting product quality or employee motivation.

Reduce Expenses (Delayering)

Method: Remove unnecessary management levels to cut costs.
Pros: Reduces expenses, directly increasing net profit.
Cons: May reduce control over employees, potentially impacting productivity.

Cut Overhead Costs (e.g., Rent, Supplies)

Method: Lower expenses on non-essential items (e.g., rent, stationery, coffee).
Pros: Reduces overall operating expenses.
Cons: Could lower staff morale if accustomed benefits, like free coffee, are removed.

Return on capital employed (ROCE) shows how well capital employed is used in making profit. You will need both a profit and loss account and balance sheet to obtain data for calculating ROCE. The formula for ROCE is:

ROCE = profit before interest & tax ÷ capital employed ⨉ 100

Capital employed = non-current liabilities + equity

The higher the ROCE, the more profit the organisation generates from invested capital. For example, 25% ROCE shows that for every $100 invested, $25 profit is generated. ROCE benchmarks are different in different industries but usually a benchmark of an acceptable ROCE is around 20%.

Strategies to improve ROCE -

Reduce Non-Current Liabilities (e.g., Long-Term Loans)

Method: Lower reliance on long-term loans, which reduces liabilities.
Pros: Improves ROCE by decreasing the capital employed.
Cons: Limited funds for growth as long-term loans often fund asset purchases essential for expansion, potentially hindering long-term growth.

Reduce Retained Profits by Increasing Dividend Payments

Method: Pay higher dividends to reduce retained profits, thereby lowering capital employed.
Pros: Boosts ROCE by reducing the capital base without impacting profits.
Cons: Lower retained profits limit self-funding for growth, potentially increasing dependency on loans, linking back to drawbacks from reduced long-term borrowing.

Liquidity ratios examine an organisation's ability to pay for its current liabilities. Liquidity is defined as the state of being liquid. In the business world, water is cash, i.e. cash is the most liquid asset.

So, liquidity refers to the availability of liquid assets to an organisation. In the balance sheet, liquid assets are in the current assets section and are usually cash, debtors and stock.

Types of Liquidity Ratios :

Current ratio compares organisation’s current assets to current liabilities. The formula of current ratio is:

Current ratio = current assets ÷ current liabilities

Desirable ratio depends on the industry, but it is usually between 1,5:1 to 2:1. If the current ratio is lower than 1:1, it indicates that the organisation is experiencing liquidity problems. If the ratio is more than 2:1, it means too much of one or some of the following:

Cash : Cash is a depreciating asset. Its value decreases over time due to inflation, so it is not a good idea to hold too much cash.
Debtors : If an organisation holds too many debtors, it means that it sells a lot of its product on credit, i.e. it means that debtors receive products, but pay for them later. It might result in bad debt — a situation when debts cannot be repaid. This should be avoided.
Stock : (unsold goods). This indicates that there is too much unsold goods that take up storage space and do not generate any value. This situation is also undesirable.

Strategies to improve Liquidity Ratio -

Increase Current Assets by Selling Non-Current Assets for Cash

Method: Sell non-current assets to boost cash reserves.
Pros: Increases cash, directly improving the current ratio.
Cons: Holding too much cash is undesirable as it’s a depreciating asset. Balance is crucial to avoid excess cash or liquidity shortages.

Decrease Current Liabilities by Shifting to Long-Term Financing

Method: Use long-term financing instead of short-term loans to reduce current liabilities.
Pros: Improves current ratio and reduces frequent payment obligations.
Cons: Risk of liquidity issues if cash is insufficient for immediate expenses, like wages or utilities.

Acid test (quick) ratio compares organisation’s current assets less stock to current liabilities. The formula of acid test ratio is:

Acid test ratio = (current assets – stock) ÷ current liabilities

This ratio is very similar to the current ratio, but it excludes stock from calculation, which makes this ratio more strict. It is more suitable for organisations, whose stock is not very liquid and yet is very high in value.

Strategies to improve Acid Test Ratio -

Increase Cash by Selling Non-Current Assets

Improves cash reserves and the acid test ratio, though excessive cash should be avoided as it’s a depreciating asset.

Reduce Current Liabilities by Using Long-Term Financing

Enhances the acid test ratio by reducing short-term obligations but requires careful cash management to avoid liquidity issues.

Quickly Liquidate Inventory through Discount Sales

Method: Sell inventory at a discount to convert it to cash.
Pros: Increases cash, thus improving the acid test ratio.
Cons: Discounts reduce revenue, potentially impacting profitability negatively.

TERMS/IMPORTANT STUFF :

Acid Test Ratio (Quick Ratio): A liquidity ratio that measures a firm's ability to meet its short-term debts, ignoring stock, as not all inventories can be easily turned into cash in a short time frame.

Capital Employed: The value of all long-term sources of finance for a business, consisting of noncurrent liabilities plus equity.

Current Ratio: A short-term liquidity ratio that calculates the ability of a business to meet its debts within the next twelve months.

Gross Profit Margin (GPM): A profitability ratio that shows the value of a firm's gross profit as a percentage of its sales revenue.

Liquid Assets: The possessions of a business that can be quickly converted into cash without losing value, such as cash, stocks, and debtors.

Liquidity Crisis: A situation in which a firm is unable to pay its short-term debts, meaning current liabilities exceed current assets.

Liquidity Ratios: Ratios that assess a firm's ability to pay its short-term (current) liabilities, including the current ratio and the acid test (quick) ratio.

Profit Margin: A ratio showing the percentage of sales revenue that turns into profit, representing the proportion of sales revenue left after all direct and indirect costs are paid.

Profitability Ratios: Ratios that examine profit in relation to other figures, including the gross profit margin (GPM), profit margin, and return on capital employed (ROCE) ratios.

Ratio Analysis: A quantitative management tool that compares different financial figures to assess and evaluate the financial performance of a business.

Return on Capital Employed (ROCE): A profitability ratio that measures a firm’s financial performance based on the amount of capital invested.

3.6 - DEBT/EQUITY RATIO ANALYSIS

Ratio analysis is a quantitative financial analysis tool for judging the financial performance of the business based on financial statements: balance sheet and profit & loss account.

Efficiency ratios examine organisation’s performance in terms of how it uses its resources (i.e. assets and liabilities). The four types of efficiency ratios are stock turnover, debtor days, creditor days and gearing.

Stock turnover ratio shows how quickly the organisation sells and replenishes its stock. Stock here refers to stock of finished goods. There are two ways to calculate stock turnover: by number of times per year and by number of days. The corresponding formulae of stock turnover ratio are:

Stock turnover (number of times) = cost of sales ÷ average stock

Stock turnover (number of days) = average stock ÷ cost of sales ⨉ 365

Average stock = (opening stock + closing stock) ÷ 2

The lower the stock turnover ratio is, the faster organisation sells its stock and thus the more efficient it is in generating profits. For example, if COGS is $100 and average stock level is $20, then stock turnover is either 5 times a year or every 73 days, depending on whether it’s by number of times or by number of days accordingly.

Strategies to improve Stock Turnover Ratio -

Low-Risk Strategy: Hold Lower Stock Levels

Method: Reduce inventory by selling at a discount to accelerate sales.
Pros: Increases stock turnover by lowering stock levels and speeds up profit generation.
Cons: Discounting may reduce revenue and profitability, even if turnover improves.

High-Risk Strategy: Implement Just-in-Time (JIT) Production

Method: Maintain minimal or zero stock by ordering only what’s needed, when it’s needed, to meet short-term targets.
Pros: Maximises stock turnover by eliminating idle inventory.
Cons: High dependency on reliable suppliers and efficient logistics; risks inability to meet demand if there are supply or demand fluctuations.

Debtor days ratio (receivables) shows how long it takes to collect debts. This usually applies to customers who bought goods from you using trade credit, i.e. when they got their goods at the time of purchase, but they paid for them later, within the credit period. In this relationship, you are a creditor, and your customers are debtors. The formula of debtor days ratio is:

Debtor days = debtors ÷ sales revenue x 365

Strategies to improve Debtor Days Ratio -

Low-Risk Strategy: Offer Discounts for Early Payment

Method: Provide a discount incentive for customers to pay earlier.
Pros: Encourages faster payments, reducing debtor days and risk of bad debts.
Cons: Discounted revenue reduces profit margins, so balancing the discount amount is crucial to maintain profitability without affecting revenue significantly.

High-Risk Strategy: Threaten Legal Action for Late Payments

Method: Warn of potential lawsuits if payment deadlines are missed (based on agreed credit terms).
Pros: Likely to secure payments promptly, improving debtor days ratio in the short term.
Cons: Could harm long-term customer relationships and push customers to seek alternative suppliers if legal threats are used too frequently.

Creditor days ratio (payables) shows how long it takes to pay creditors. This is quite the opposite of debtor days ratio. In this relationship, you are a debtor, and your suppliers are creditors. The formula for creditor days ratio is:

Creditor days = creditors ÷ cost of sales x 365

The higher creditor days ratio is, the more time you have to pay for current liabilities, but the worse your relationship with the suppliers might be because it takes you a very long time to pay for their supplies.

Strategies to improve Debtor Days Ratio -

Low-Risk Strategy: Build Trusting Relationships with Suppliers

Method: Foster strong, reliable relationships to negotiate longer credit periods.
Pros: Suppliers are more likely to grant extensions, enhancing cash flow flexibility.
Cons: There’s a risk of taking advantage of their trust, which might lead to reluctance to offer future extensions.

High-Risk Strategy: Switch Suppliers for Better Credit Terms

Method: Seek new suppliers who offer more favourable credit terms.
Pros: Potentially improves creditor days by securing better payment terms.
Cons: Time-consuming to establish new relationships, and there’s no guarantee the new suppliers will be as reliable or beneficial as the current ones.

Gearing ratio shows the extent of organisation's reliance on loan capital. Highly geared organisations might be a high-risk investment but might have a higher growth potential. Low geared organisations are the opposite: they might be low-risk investment but have lower growth potential.

Highly geared firms are also less likely to pay dividends, because they have to pay for their long-term debt obligations first. The formula for gearing is:

Gearing = loan capital ÷ capital employed ⨉ 100

You can find all the data for gearing ratio in the balance sheet.

Loan capital is the same as non-current liabilities. Capital employed is a sum of non-current liabilities and equity. Equity in for-profit organisations consists of retained earnings and share capital, for non-profit organisations it consists of retained earnings only.

Strategies to improve Gearing Ratio -

Low-Risk Strategy: Seek Free Sources of Finance (e.g., Share Capital)

Method: Increase financing through issuing more shares instead of relying on debt.
Pros: Raises capital without incurring interest expenses, improving financial stability.
Cons: Dilutes existing shareholders' ownership and may lead to loss of control over the organisation.

High-Risk Strategy: Stop Paying Dividends

Method: Retain earnings by not distributing dividends to shareholders.
Pros: Increases capital employed, improving the gearing ratio.
Cons: May displease shareholders, leading to potential share sell-offs and a decrease in the company’s market value.

Insolvency is a situation when an organisation is not able to pay its debts on time. This is a kind of situation when current liabilities exceed current assets.

The ratios that indicate insolvency are current ratio and acid test ratio. When these two ratios are less than 1:1, it is clearly evidence of liquidity problems and insolvency.

Negotiate with Creditors

Method: Request an extension of the credit period and propose later payments, possibly at a higher rate.
Pros: Provides immediate relief from payment pressures; terms depend on the relationship with creditors.
Cons: Success of negotiation varies based on creditor willingness and relationship dynamics.

Liquidate Assets

Method: Sell off some assets to generate cash for settling current liabilities.
Pros: Provides quick access to cash to address immediate financial obligations.
Cons: Selling assets may reduce operational capacity and long-term value of the organisation.

Bankruptcy (Extreme Solution)

Method: If other solutions fail, file for bankruptcy as a legal process to address insolvency.
Pros: Provides a structured way to deal with debts and liabilities.
Cons: Significant legal and financial implications, and can severely damage the organisation’s reputation and future operations.

Bankruptcy is a process that an organisation goes through when it is not able to pay its debts at all. Similar to insolvency, the indicator of inability to pay debts is current and acid test ratios that are lower than 1:1, which means that current liabilities are greater than current assets.

Nature of Bankruptcy

Definition: Bankruptcy is a legal process that occurs when an organisation is unable to meet its debt obligations, marking a last resort for financial recovery.
Inflexibility: Unlike insolvency, which allows for negotiation and various resolutions, bankruptcy often leads to a legally enforced liquidation of assets.

Asset Liquidation

Process: Assets are sold off, and the proceeds are distributed to creditors to settle debts, either fully or partially.
Implications: The focus is on relieving creditors' debts, often at the expense of the organisation’s viability.

Potential for Unethical Practices

Fraudulent Behaviour: Some individuals exploit bankruptcy for personal gain by establishing businesses to attract investments, only to misuse funds for personal expenses before declaring bankruptcy.
Historical Context: Such scams have existed for centuries, illustrating a long-standing issue within business practices.

Reputation Damage

Consequences: Bankruptcy can severely harm the reputation of individuals and organisations, leading to loss of trust from investors, customers, and suppliers.

Scandals in History

Examples: Numerous bankruptcy scandals have been documented throughout history, highlighting the recurring nature of fraudulent activities in the business world.

TERMS/IMPORTANT STUFF :

Bankruptcy: The legal process declared by the courts when an individual or business entity is unable to repay its debts.

Credit Control: The ability of a business to collect its debts within a suitable time frame.

Creditor Days Ratio: An efficiency ratio that measures the average number of days it takes for a business to pay its creditors.

Debt and Equity Ratios: Ratios that calculate the value of a business's liabilities and debts against its equity, serving as a measure of the financial stability of the business.

Debtor Days Ratio: An efficiency ratio that measures the average number of days it takes for a business to collect the money owed from debtors.

Gearing Ratio: A measure of the percentage of an organisation's capital employed that comes from external sources (noncurrent liabilities), such as mortgages.

Insolvency: A financial state where an individual or business entity is unable to pay its debts on time; if unresolved, it can lead to bankruptcy.

Liquidity: The ease with which an asset can be turned into cash. Highly liquid assets can be quickly and easily converted into cash without losing their monetary value.

Profit Quality: The ability of a business to earn profit in the foreseeable future; a business with good profit quality can sustain profitability in the long run.

Stock Turnover Ratio (Inventory Turnover Ratio): A measure of how many times a business sells its stocks within a year, which can also be expressed as the average number of days it takes for a business to sell all of its inventory.

3.7 - CASH FLOW

Cash is the most liquid asset of the business. It is like the water of the business because it is essential and because it flows.

Cash flow refers to money coming in and going out of the business. Money coming in are cash inflows, money going out are cash outflows.

Ideally, businesses should have sufficient cash at any point in time. Cash deficiency might result in insolvency and even bankruptcy, but too much cash might mean that a business is holding too much of a depreciating asset because cash is losing its value over time due to inflation.

Profit is the positive difference between revenue and costs. If this difference is negative (i.e. if costs exceed revenues), it means that a business is experiencing loss.

Investment (in IB BM course) refers to the purchase of non-current assets that generate future earnings. It can also refer to purchase of stock/shares, M&As and many other things.

Differences Between Profit and Cash Flow -

Profit

Represents financial gain after expenses.
Can include revenue from credit sales.

Cash Flow

Measures actual cash coming in and out of the business.
Reflects liquidity and ability to cover immediate expenses.

Key Differences

Profitability with No Cash

A business can be profitable while having little or no cash (e.g., sales on credit).
Example: Customer buys on credit; profit recorded, but cash received later.

Cash without Profitability

A business can have cash inflow without being profitable (e.g., loans).
Example: Taking out a loan provides cash but doesn't contribute to profit.

Relationship to Investment

Investment : Refers to allocating resources to generate future returns.

Link to Cash Flow and Profit

Investments can impact both cash flow and profit:
New equipment may increase future profits but requires immediate cash outflow.
Cash flow from investments (like dividends) may not immediately translate to profit.

Cash flow forecast is a document that shows predicted movement of cash in and out of business per time period. Cash flow forecast is a forward-looking document, because it shows a prediction of the future cash flow.

If the same document is backwards-looking and is based on existing past data, then it is called a cash flow statement. Comparing cash flow forecasts with cash flow statement helps businesses to predict their cash flow more accurately and reflect on the performance of the business in terms of cash flow.

Opening balance is the amount of cash at the beginning of the trading period. It equals the preceding month’s closing balance. For example, the opening balance for June is the same figure as May’s closing balance.

Cash inflows come from sales revenue, debtors, loans, interest received, sale of assets, rental income, etc. Anything that refers to money going inside the business is a cash inflow.

Cash outflows are expenses, such as rent, wages, purchase of stocks, tax, creditors, advertising, interest payments, dividends, etc. Outflows are the opposite of inflows, i.e. they are money going out of the business.

Net cash flow is the difference between cash inflows and cash outflows. It needs to be positive to avoid bankruptcy. If net cash flow is negative for a few months in a row, it is a clear indicator of cash deficiency and liquidity problems. Remember that there are also liquidity ratios that serve as indicators of liquidity issues.

Closing balance is the amount of cash at the end of a trading period. In other words, closing balance equals opening balance plus net cash flow.

TERMS/IMPORTANT STUFF :

Opening Balance: The value of cash a business has at the beginning of a trading period, shown in its cash flow forecast or cash flow statement. It equals the previous period's closing balance.

Overtrading: When a business expands too quickly without sufficient resources, often by accepting too many orders, leading to cash flow issues.

Bad Debts: Occur when debtors are unable to pay their outstanding invoices, reducing the cash inflows of the business that sold goods on credit.

Cash: A current asset representing the actual money a business has, either as cash in hand (on-site) or cash at bank (held in a bank account).

Cash Flow: The movement of money into and out of an organisation.

Cash Flow Forecast: A financial tool showing the expected cash inflows and outflows for a business over a given period.

Cash Flow Statement: A financial document that records the actual cash inflows and outflows of a business over a specific period, usually 12 months.

Cash Inflows: Money entering a business during a specific period, usually from sales revenue when customers pay for their purchases.

Profit: The positive difference between a firm’s total sales revenue and its total production costs for a given time period.

Working Capital Cycle: The time between cash outflows for production costs and cash inflows from customers paying for finished goods and services.

Cash Outflows: Money leaving a business during a specific period, such as payments for invoices or bills.

Closing Balance: The amount of cash left in a business at the end of a trading period, calculated as: Closing Balance = Opening Balance + Net Cash Flow.

Credit Control: The process of monitoring and managing debtors, including setting trade credit limits and ensuring timely payments.

Net Cash Flow: The difference between a firm's cash inflows and cash outflows for a given period, usually calculated monthly.

3.8 - INVESTMENT APPRAISAL

Investment appraisal refers to quantitative techniques that are used to evaluate the pros and cons of investment opportunities.

Investment Appraisal Techniques -

Payback period (PBP) is the length of time required for an investment to recover its initial cost of investment (principal) in terms of profit. In some industries (for example, IT and hi-tech), assets become outdated in a short time, so for these industries calculating PBP is really important. If an asset becomes obsolete before the end of the payback period, then there is no point in purchasing it.

Let’s see how to calculate payback period. We’ll start off with a simple example. The formula for PBP is as follows:

PBP = initial investment cost ÷ cash flow from investment per period

If a delivery scooter for a pizza restaurant is worth $1200 and it’ll bring $600 per year (after variable costs are paid, e.g. maintenance), then PBP is 2 years ($1200 ÷ $600 = 2).

However, most of the time, it is not as straightforward as in the example above. Let’s see a more complicated example. The formula would be:

PBP = additional cash inflow needed ÷ annual cash flow in the next year ⨉ 12 months (+ no. of years)

The first thing we have to do is to outline annual net cash flows (CF) and cumulative net cash flows for each year of investment. It is really important to start counting with “year 0”, which refers to the point when the purchase is made. See the table below for annual and cumulative cash flows.

What we do next is look back at the formula and identify additional cash flow needed (in green), annual cash flow in the next year (in blue) and count the number of full years until investment pays off (in red). Again, see the table below with all the necessary figures:

Now calculating the payback period should be really simple. Let’s see the pros and cons of the payback period as an investment appraisal technique.

On the one hand, the payback period is simple, easy, and quick to calculate. It is super helpful for industries where assets quickly become outdated, for example, IT. Overall, payback period is a quick way to check the viability of the investment project or to compare several investment opportunities. If you are not sure whether to pursue investment project A, B or C, then see which one pays back sooner and go for it.

However, payback period, as an investment appraisal technique, only takes time into account. It ignores overall project profitability. In addition, annual and cumulative cash flows for the coming years are just a prediction, it is impossible to know them certainly, which makes the payback period quite unreliable. So, on the downside, PBP is too simplistic to be the only investment appraisal technique to rely on.

Average rate of return (ARR) is average profit on investment expressed as a percentage of the initial investment (capital costs).

So, if PBP shows time, then ARR shows percentage. After calculating ARR, managers usually compare it to the interest rate in the banks. Depositing money in a bank has almost no risk, but pursuing an investment project is quite a risky thing to do.

ARR = (total returns – capital costs) ÷ years of use ÷ capital costs ⨉ 100

Let’s continue the pizza theme and calculate ARR for a pizza restaurant again. Suppose pizza oven XYZ is worth $5,000. This time, the expected returns for the five years of its lifespan are estimated to be $3,000, $2,500, $2,000, $1,500 and $1,000 accordingly.

First of all, let’s calculate the total returns:

Total returns = $3,000 + $2,500 + $2,000 + $1,500 + $1,000 = $10,000

Now we have all the data we need for the formula.

ARR= (total returns – capital costs) ÷ years of use ÷ capital costs ⨉ 100 = ($10,000 – $5,000) ÷ 5 ÷ $5,000 ⨉ ⨉ 100 = 20%.

Then, ARR is compared to criterion rate and interest rate and investment decision is made. The example of the entire step-by-step calculation is summarised below:

Advantages of ARR

Simplicity: ARR is easy, quick, and straightforward to calculate.
Long-Term Insight: Unlike Payback Period (PBP), ARR considers profitability over the entire lifespan of an investment, not just until it pays off.
Comparison Tool: ARR can be used to quickly assess the viability of a project or compare multiple investment opportunities.

Disadvantages of ARR

Ignore Timing of Returns: ARR doesn’t consider when returns occur; investments with the same ARR might have different payback periods.
Reliance on Predictions: ARR relies on predictions for total returns and the lifespan of an investment, which may be inaccurate.
Over-Simplicity: ARR alone may not provide a full picture of an investment’s viability.

Net present value (NPV) is the difference between present values of future cash flows and original cost of investment (principal). As always, it might sound difficult but in fact it is not. First of all, we have to establish that cash is a depreciating asset because it loses its value over time.

100 years ago you could buy way more things for $100 than now. Why is that? Mainly because of inflation that makes cash lose its value over time. Thus, we may conclude that in the future we can afford less things for $100, compared to today.

Simply speaking, if the interest rate offered by the banks in your country is 5%, then it means that $100 today will be the same as $105 one year later. Of course, it is not as simple as that, but we’ll leave the complexities to those of you who study Business and Economics in university and we’ll focus on the basics now.

So far, we’ve established that present value is today’s value of future cash. In order to calculate present value, we need to multiply the sum by a discount factor from the table below:

NPV = Sum of present values – Original cost

In order to understand it, let’s get back to my favourite thing in this class — the pizza restaurant! So, as you remember, it’s considering purchasing a pizza oven XYZ that is worth $5,000. The expected returns for the five years of its lifespan are $3,000, $2,500, $2,000, $1,500 and $1,000. The interest rate is currently 6%. Let’s outline a simple table that will help us calculate the net present value of this investment.

NPV = Sum of present values – Original cost = 8,669.85 – 5,000 = $3,669,85.

Advantages of NPV

Comprehensive Value: NPV considers both the time value and cash value of returns, unlike Payback Period (PBP) and Average Rate of Return (ARR), which focus on just time and rate, respectively.
Flexible with Economic Changes: NPV can adapt to changes in the economy by adjusting the discount factor, making it more flexible.
Widely Used: NPV is popular because it incorporates multiple factors (profitability, economic conditions, and time).

Disadvantages of NPV

More Complex: Calculating NPV is a bit more challenging than PBP and ARR.
Inaccuracy Due to Interest Rates: NPV can be unreliable over a project’s lifespan if the interest rate fluctuates, which is likely over time.
Too Simplistic on Its Own: Like other methods (PBP and ARR), NPV is too basic to rely on exclusively.

Combined Use (PBP + ARR + NPV): Using all three methods together provides a comprehensive view of an investment’s potential, making them especially useful for more advanced analysis.

Key Differences:

PBP: Measures time until payoff.
ARR: Focuses on the rate of return (percentage).
NPV: Indicates monetary value considering time and cash value.

TERMS/IMPORTANT STUFF :

Advantages of Using the PBP

Simplicity and Speed: PBP is the simplest and quickest investment appraisal method, making it the most widely used.
Cash Flow Insight: Helps firms with liquidity issues determine how quickly they can recoup their cash investment.
Break-Even Analysis: Shows if the business can break-even on an asset before it needs replacement, valuable in fast-paced markets.
Project Comparison: Allows comparison between projects with different costs by identifying which has the quickest payback period.
Shareholder Value: Assists managers in identifying projects that provide quick returns to shareholders.

Disadvantages of Using the PBP

Inconsistent Cash Flows: Demand fluctuations (e.g., seasonal changes) may cause inconsistencies in monthly cash flow, potentially extending the PBP.
Focus on Time Over Profit: PBP prioritises time over profitability, which is a key goal for most private businesses.
Short-Term Focus: Can lead to short-term thinking, where managers prioritise immediate benefits over long-term gains.
Unsuitability for Long-Term Investments: Not ideal for industries with extended recoupment periods, such as property development or cruise liners.
Inaccuracy Risks: Difficulties in accurately predicting future cash flows make PBP calculations prone to errors.

Average Rate of Return (ARR): Calculates the average annual profit of an investment project, expressed as a percentage of the initial amount of money invested.

Investment Appraisal: A financial decision-making tool that helps managers determine whether certain investment projects should be undertaken, based mainly on quantitative techniques.

Payback Period (PEP): An investment appraisal technique that calculates the time required to recoup the initial expenditure on an investment project.

Cumulative Net Cash Flow: The sum of an investment project’s net cash flows for a particular year, plus the net cash flows of all previous years.

Discount Factor: A number used to reduce the value of a future sum of money to determine its present value.

Net Present Value (NPV): Calculates the total discounted net cash flows minus the initial cost of an investment project. A positive NPV indicates that the project is financially viable.

Discounted Cash Flow: Uses a discount factor (the inverse of compound interest) to reduce the value of money received in future years due to the time value of money.

Investment: Refers to capital expenditure or the purchase of assets with potential future financial benefits.

Principal (Capital Outlay): The original amount spent on an investment project.

Qualitative Investment Appraisal: Judging an investment project’s worthiness through non-numerical techniques, such as alignment with corporate culture.

Quantitative Investment Appraisal: Judging an investment project’s worthiness based on numerical (financial) interpretations, such as PEP, ARR, and NPV methods.