What Do Financial Metrics Say About Business Case Results?
The financial business case may use any of the following, or all of the following financial metricss to summarize business case results::
• Net Cash Flow
• Net Present Value (NPV) / Discounted Cash Flow (DCF)
• Internal Rate of Return
• Payback Period
• Return on Investment (ROI)
Financial Metrics Interpreted and Compared
Business case results are often summarized with several well defined financial metrics, such as net cash flow, discounted cash flow (net present value), internal rate of return, and payback. Another, less well defined term "Return on Investment" (ROI) is also used frequently. Each says something about the overall pattern of costs and benefits, each carries a different message. Here are some factors to consider when deciding which metrics to use.
Net Cash Flow
Net cash flow is the heart of the financial business case and the basis for deriving other financial metrics. Cash flow, like income, focuses on the difference between money coming in and money going out over a time period:
Net Cash Flow = Cash Inflows - Cash Outflows
When net cash flow is summarized across a time line (across the time period analyzed), the "bottom line" net cash flow results for a business case scenario may look like this:
This, by the way, is a typical "Investment Curve" result. Each bar represents the net of inflows and outflows for one period (here, a quarter year). The negative bars at the outset, and the positive bars in later years, mean that initially the investment incurs costs exceeding incoming benefits, but if things go as hoped, the incoming benefits will soon outweigh the costs.
Another scenario in the same business case might have a quite different cash flow profile. The question is: Referring to the net cash flow projected for each scenario, which scenario is the better business decision?
One financial metric that address that question is the simply the Total Net Cash Flow for each scenario. Other Financial metrics such as Net Present Value (NPV), Payback Period, Internal Rate of Return, and Return on Investment can also be applied to the same cash flow streams, however, to extract information about the cash flow stream that might not be apparent from simply viewing the net cash flow results (see below). For a complete introduction and in-depth review of business case financial metrics, see Financial Metrics Pro.
By the way, business case cash flow results do not, however, include some items found in the income statement, such as depreciation expense. Depreciation expense, for example, does not represent an actual cash payment during the reporting period, but rather an accounting charge against earnings. As a result, depreciation expense is not a "cash outflow" in the above equation. The income statement tells stockholders and taxing authorities what the company is credited with earning during a period; the cash flow statement tells management how much cash they have to work with (or how much they gained or lost).
Lining up the cash flow results of several time periods creates a cash flow stream such as this Business Case example:
| Business Case Results | |||
| Timing | Total Cash Inflows | Total Cash Outflows | Net Cash Flow |
| Now | $0 | $100 | -$100 |
| Year 1 | $40 | $20 | +20 |
| Year 2 | $50 | $30 | +20 |
| Year 3 | $75 | $35 | +40 |
| Year 4 | $90 | $30 | +60 |
| Year 5 | $100 | $40 | +60 |
| Total | $355 | $255 | +$100 |
The action or acquisition under consideration is expected to bring a net cash flow of $100 over five years. But does this represent a good business decision? Can the returns be improved? Where are the risks? The level of detail in this table is the minimum data needed to begin answering such questions.
Note Each column and row tells a story: Inflows continue to rise throughout the 5-year period, but so do total outflows. Management will want to use this understanding and the data behind it, for instance, to apply the financial tactics mentioned in the Return on Investment web page: above: reduce costs, increase gains, accelerate gains.
In a nutshell, a business case summary should always include a net cash flow stream because it
- Shows actual inflow and outflow figures, which are important for budgeting and business planning
- Provides the basis for calculating other financial metrics, such as DCF / NPV, IRR, and payback
- Is the beginning point for management actions to manage and optimize overall results
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Discounted Cash Flow (DCF) / Net Present Value (NPV)
The DCF is a cash flow summary that has been adjusted to reflect the time value of money. It is an important criterion in evaluating or comparing investments or purchases; other things being equal, the purchase or investment associated with the larger DCF is the better decision. Almost every professional trained in finance will ask to see cash flows on a discounted and non-discounted basis.
DCF makes use of the Present Value concept, the idea that money you have now should be valued more than an identical amount you would receive in the future Why? The money you have now you could (in principle) invest now, and gain return or interest, between now and the future time. Money you will not have until some future time cannot be used now. Therefore, the future money’s value is Discounted in financial evaluation, to reflect its lesser value.
What that future money is worth today is called its Present Value, and what it will be worth when it finally arrives in the future is called not surprisingly its Future Value. Just how much present value should be discounted from future value is determined by two things: the amount of time between now and future payment, and an interest rate. (For rough estimates, think of the interest rate as the return rate we would expect if we had the money now and invested it). For a future payment coming in one year:
Present Value = (Future Value) / (1.0 + Interest Rate)
What is the present value of $100 we will not have for a full year? If we use an annual interest rate of, say, 10%, then
Present Value = ($100)/(1.0 +0.10) = $90.91
What is the present value if the payment were not coming for 3 years? For multiple periods, the present value calculation becomes:
Present Value = (Future Value) / (1.0 + Interest rate)n
The exponent "n" is simply the number of periods, or years, in this case 3. The present value of $100 to be received in 3 years, using a 10% interest rate is thus:
Present Value = $100 / (1.0 +0.10)3 = $100 / (1.1) 3 = $75.13
"Periods" for these calculations can actually be years, months, or any other time. In any case, be sure that the interest rate represents interest for that period. (When calculating DCF on a monthly basis, for instance, use the annual interest rate divided by 12).
As the payment gets further into the future, its present value drops. Also, as you can see, increasing the interest rate would further reduce the present value. Only where interest rates were assumed to be 0 (an economy with no investment possibility and no inflation) would present value always equal future value.
Now consider two competing investments in computer equipment. Each calls for an initial cash outlay of $100, and each returns a total a $200 over the next 5 years making net gain of $100. But the timing of the returns is different, as shown in the table below (Case A and Case B), and therefore the present value of each year’s return is different. The sum of each investment’s present values is called the Discounted Cash flow, or DCF. Using a 10% interest rate again, we find:
Timing | Case A Net Cash Flow | Case A Present Value | Case B Net Cash Flow | Case B Present Value |
| Now | -$100.00 | -$100.00 | -$100.00 | -$100.00 |
| Year 1 | +$60.00 | +$54.54 | +$20.00 | +$18.18 |
| Year 2 | +$60.00 | +$49.59 | +$20.00 | +$16.52 |
| Year 3 | +$40.00 | +$30.05 | +$40.00 | +$30.05 |
| Year 4 | +$20.00 | +$13.70 | +$60.00 | +$41.10 |
| Year 5 | +$20.00 | +$12.42 | +$60.00 | +$37.27 |
| Total | $100.00 | NPV=$60.30 | $100.00 | NPV=$43.12 |
Comparing the two investments, you can see that the early large returns in Case A lead to a better total net present value (NPV) than the later large returns in Case B. Note especially the Total line for each present value column in the table. This total is the net present value (NPV) of each "cash flow stream." When choosing alternative investments or actions, other things being equal, the one with the higher NPV is the better investment.
In brief, a DCF / NPV view of the cash flow stream should probably appear with a business case summary when ...
- The business case deals with an "investment" scenario of any kind, in which different uses for money are being compared.
- The business case covers long periods of time (two or more years).
- Inflows and outflows change differently over time (e.g., the largest inflows come at a different time from the largest outflows).
- Two or more alternative cases are being compared and they differ with respect to cash flow timing within the analysis period.
For more on discounted cash flow and net present value, see the online Encyclopedia entry for net present value.
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Internal Rate of Return (IRR)
Like DCF, the IRR is a cash flow summary that has been adjusted to reflect the time value of money, but its meaning is a little less obvious than DCF. Nevertheless, IRR is a widely used concept, and it is frequently an important criterion in evaluating or comparing investments or purchases. As the word "Return" indicates, the IRR view of the cash flow stream is essentially an investment view: money will be paid out in order to bring in gains. The higher an investment’s IRR, the better the investment’s return relative to its cost.
IRR has a simply stated definition: "The IRR for an investment is the discount rate for which the total present value of future cash flows equals the cost of the investment." It is the interest rate, that is that produces a 0 NPV. You may still wonder just how to evaluate that, or how to apply it to a specific "investment" or purchase. Probably the best way to grasp IRR quickly is with the help of the graph below.
These curves are based on the same Case A and Case B cash flow scenarios presented under "Discounted cash flow" (above). Here, however, we have used nine different interest rates, including 0 and 0.10, on up through 0.80. As you would expect, as the interest rate used for calculating Net Present Value of the cash flow stream increases, the resulting NPV decreases. For Case A, an interest rate of 38% produces NPV or DCF = 0, whereas Case B hits 0 with an interest rate of 22%. Case A therefore has an IRR of 38%, Case B an IRR of 22%. Which is the better Investment? Other things being equal, the one with the higher IRR.
Now, would an investment with an IRR of, say 75% be a better investment? The answer is YES. Another way to think of IRR is this: IRR tells you just how high interest rates would have to go in order to "wipe out" the value of this investment. For the Case A cash flow, the prevailing interest rate would have to rise all the way to 38% to make this investment worthless. The Case B investment would become worthless if interest rates rose to 22%.
In deciding whether or not to include an IRR in a business case summary, here are some points to remember:
- Other things being equal, the action or investment alternative with the highest IRR is the better investment. Generally, the higher the IRR, the better the returns relative to cost, and the lower the risk.
- IRR says nothing about the magnitude of the return. A tiny investment or expenditure may lead to a magnificent IRR. An alternative action with a smaller IRR might still be preferred if it brings in a much larger net cash flow, or DCF.
- IRR has the most meaning when there is an initial net cash outflow, followed at least one period with a net positive cash inflow. IRR cannot be calculated with outflows only, or inflows only; IRR is thus not applicable to "cost only" analyses (such as the typical cost of ownership analysis).
- IRR can be quite misleading if there is no large initial cash outflow. For instance, when comparing a "Lease" scenario with a "Buy" scenario for new computing equipment, the "Buy" alternative may show an IRR of, say 30%-70%, whereas the "Lease" approach may have an IRR in the thousands. This is because leasing may not involve much of an initial cash outlay. IRR is more appropriate for comparing alternatives that have roughly similar patterns of inflows and outflows.
For more on internal rate of return (IRR), see the online encyclopedia Entry for internal rate of return.
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Payback Period
Like IRR, the Payback period metric takes essentially an "Investment" view of the action, plan, or scenario, and its estimated cash flow stream. Payback period is the length of time required to recover the cost of an investment (e.g. purchase of computer Software or hardware), usually measured in years. Other things being equal, the better investment is the one with the shorter payback period.
Also, payback periods are sometimes used as a way of comparing alternative investments with respect to risk: other things being equal, the investment with the shorter payback period is considered less risky.
As an example, consider a $240 software purchase that is expected to improve productivity valued at $100 per year for the next three years:
Cash | Cash | Cumulative Cash Flow | |
Year 1 | - $240 | $100 | - $140 |
Year 2 | $0 | $100 | - $40 |
Year3 | $0 | $100 | $60 |
Payback obviously occurs in Year 3, but where, precisely? The "formula" for payback period is simple (but surprisingly cumbersome to implement in a spreadsheet). In the example, note that Year 3 is the final Payback Year).
Payback Period = A + ( B / C ) where
A = Years before final payback year
B = Total to be paid back - Total paid back at start of final payback year
C = Total paid back in the entire payback year
For the example,
Payback Period = 2 + (240 - 200) / (100)
Payback Period = 2 + 40/100 = 2.4 Years
Payback period is an appealing metric because its interpretation is easily understood. Nevertheless, here are some points to keep in mind when using it:
- Payback cannot be calculated if the positive cash inflows do not eventually outweigh the cash outflows. That is why payback (like IRR) is of little use when used with a pure "costs only" business case.
- Payback calculation ordinarily does not recognize the time value of money (in a discounting sense) nor does it reflect money coming in after payback (contrast with discounted cash flow and internal rate of return, above)
- Other things being equal, the action or investment with the shortest payback period is the better investment because it is less risky. It is usually assumed that the longer the payback period, the more uncertain are the positive returns. For this reason, payback period is often used as a measure of risk, or a risk-related criterion that must be met before funds are spent. A company might decide, for instance, to undertake no major investments or expenditures that have a payback period over, say, 3 years..
For more on payback period, see the online Encyclopedia entry on payback period.
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Return on Investment (ROI)
Return on Investment (ROI) analysis is one of several approaches to evaluating and comparing investments. With ROI, decision makers evaluate investments by comparing the magnitude and timing of expected gains to the magnitude and timing of investment costs. A good ROI means that investment returns compare favorably to investment costs.
ROI compares returns and costs by constructing a ratio, or percentage. In most ROI methods, an ROI ratio greater than 0.00 (or an ROI percentage greater than 0%) means the investment returns more than its cost. Other things being equal, the investment—or action, or business case scenario—with the higher ROI is considered the better choice, or the better business decision.
One serious problem with using ROI as the sole basis for decision making, is that ROI by itself says nothing about the likelihood that expected returns and costs will appear as predicted. ROI by itself, that is, says nothing about the risk of an investment. ROI simply shows how returns compare to costs if the action or investment brings the results hoped for. (The same is also true of other financial metrics, such as Net Present Value, or Internal Rate of Return). For that reason, a good business case or a good investment analysis will also measure the probabilities of different ROI outcomes, and wise decision makers will consider both the ROI magnitude and the risks that go with it.
Decision makers will also expect practical suggestions from the ROI analyst, on ways to improve ROI by reducing costs, increasing gains, or accelerating gains (see the figure above).
In the last few decades, this approach has been applied to asset purchase decisions (computer systems or a fleet of vehicles, for example), "go/no-go" decisions for projects and programs of all kinds (including marketing programs, recruiting programs, and training programs), and to more traditional investment decisions (such as the management of stock portfolios or the use of venture capital).
For more on return on investment (ROI), see the online Encyclopedia entry for return on investment.
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Comparing Financial Metrics
Which of these financial metrics should you use to summarize a business case? The best general approach is to develop and present all of them–if their values have meaning. The real issue then is to decide which of them should become primary decision criteria, or which should carry the most weight in comparing alternatives. There is no universal answer to that question, but here some factors to consider.
- The cash flow stream must have a positive net total in order for payback or internal rate of return to have meaning (or for "Return on Investment" in any sense to have meaning). If you are producing a "costs only" business case, using cost totals as your data, then PB, IRR, and ROI will not be appropriate, You may, however, create positive cost impacts such as cost savings, by building the case from cost changes relative to another scenario or "business as usual" baseline. That is the only way that a "cost only" business case can approach PB, IRR, or any form of ROI.
- Discounted cash flow (DCF) totals are sensitive to the interest rate (discounting rate) used in the calculation, and choice of rate is arbitrary. When using DCF, be sure to use a rate that matches your audience's common practices and expectations. (The other financial metrics–net cash flow, payback period, and internal rate of return–do not depend on arbitrarily chosen values).
- When the positive returns are uncertain or risky, give relatively more consideration to discounted cash flow. DCF will give relatively more weight to projected near-future returns, which are probably more certain, and relatively less weight to distant-future returns, which are probably less certain.
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