THREE KPIS EVERY BUSINESS OWNER SHOULD KNOW BEFORE MAKING NEW INVESTMENTS
Occasionally, business owners find it necessary to make capital investments to further the purpose of their business. Capital investments are cash outflows beyond the normal day to day operations of the business. These cash outlays are usually made to increase revenue capacity or reduce cost. It is not financially savvy to make capital investments that bear no future benefits. You also should not use intuition to decide what these benefits are but logically determine estimates.
When to make capital investments
Capital investments are made when capacity needs to be increased or expenses can be decreased. Capital investments normally assist with streamlining operations and increasing efficiency. A capital investment should be made carefully. Sometimes an entrepreneur hears about a fancy new equipment, makes the investment, only to find out the equipment decreased overall profitability of the business. This is why you make capital investments knowing your required rate of return.
Required rate of return
You should go into an investment knowing how much you will like to get back in return. The required rate of return is the minimum return you wish to get from your investment. For example, if you are looking to make an investment and you are looking for a 20% return, then that is your required rate of return. Your required rate of return is normally tied to the opportunity cost of your money.
Capital investment decisions take into consideration
- Fund availability: Are there excess funds to make the investment or will the business have to take a loan. If a loan is taken, then the required rate of return must be higher than the cost of borrowing.
- Risk: The risk involved in the investment should also be considered. The higher the risk, the higher the minimum required rate of return should be.
Capital Investment KPIs
Cash payback period
The cash payback period is the time period it will take to recover the cost of your capital investment. The cash payback period is computed as follows:
Cost of capital investment/ net annual cash flow
For example: Let us say you are contemplating buying a new office equipment. Your current equipment is at full capacity. You are turning away new business because your current equipment cannot deliver the work at a reasonable time. The missed work opportunities amount to $4,000 a month.
Your initial payment for the equipment is $15,000 with a monthly payment of $1,500 and monthly maintenance cost of $100. How long will it take you to recoup your initial investment (cash payback period)?
It will take as 6.25 years to get back your original investment. This number is neither good or bad. It all depends on your investment requirements and other qualitative factors.
In general, the shorter the cash payback period, the more desirable the investment. However, you should already have in place a policy regarding what types of returns are acceptable before making an investment. For example, you can say if the cash payback period is more than 50% of the equipment life, then reject the investment. In this case, it will take more than 6 years to get back your investment. According to our investment guideline, this is not an investment we should make. The lost opportunities will have to be more to meet our guideline of 5 years. With increased income also comes increased cash outflows.
However, quantitative factors should not be evaluated without qualitative factors. If this is a business with intense competiton, letting customers go to the competition might have long term consequences. The business can choose to make the investment and increase marketing efforts to meet the investment guideline.
Net present value
The problem with the payback period, is that it does not take into consideration the time value of money. Using the net present value method, cash flow is discounted to its present value. The capital investment is subtracted from the net present value to see if there is a positive or negative return. In general, an investment is accepted if the return is positive.
Let us evaluate the same scenario mentioned above using the net present value method with a required rate of return of 5% and 12%.
The investment is acceptable at a 5% required rate of return but not at 12%. Be careful when choosing the discount rate. A discount rate should account for the associated risk. Higher risks means higher expected returns and higher discount rate. If the risk is under-estimated, then a lower than acceptable discount rate will be used. This will mean a bad investment will be made due to wrong assumptions.
While computing net present value, be careful to consider intangible benefits. For example, investment in an equipment might increase employee retention due to lower frustration. You can monetize intangible benefits by stating the benefits in dollars.
For example, on average you lose 2 employees a month at a cost of $5,000 a month including the cost of lost productivity. The cost savings from buying the equipment will be $5,000. To compute if the equipment is worth the investment, you will need to add the cost savings to the annual cash flow.
Internal rate of return
If you do not know what your required rate is, the internal rate of return could be a starting point. The internal rate of return is the point where your NPV (as discussed above) is zero. In other words it is the discount rate that will cause the capital expenditure to equal the present value of the net cash inflows. Using excel (formula =IRR(G9:G19)) we can determine the internal rate of return of the problem discussed above as follows:
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Questions for thoughts
Here are some key questions to ask before making a capital investment:
- Do you know your investment return criteria? To increase your chances of success you must invest knowing what you hope to get from the deal. Sure, life does not always work as planned but your chances of succeeding are much higher if you invest carefully.
- Do you know the opportunity cost of your money? Is there anything else you can invest your money in to bring back higher returns. To set your investment criteria, you must understand your opportunity cost.
Summary
In summary, you must go into investments knowing what you hope to get from it and then using kpis to predict if these investments are likely to meet your criteria. Some example of investment criteria are:
- Payback period of must be greater than 50% of the assets estimated useful life
- Required rate of return of 20% based on opportunity cost of cash
- Return must exceed cost of borrowing
In most instances a company uses a required rate of return equal to its cost of capital — that is, the borrowing rate. Remember to set a good required rate of return you must consider your cost of capital and risk involved. Underestimating the risks will lead to bad investments.