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on Steroids

Crystal Reports and Financials: NPV, #01

 

We all know that money has a value and that money in the bank now is worth more than the same amount at some point in the future.

The NPV function takes a rate and series of cash payments and receipts to calculate what that cash flow is worth at the current point of time. Suppose your project has annual cash flows of $1000, $2000, $1500 and $1200 over the life of the project and your cost of capital is 5%. Then the cash flow function

NPV (0.05, [1000, 2000, 1500, 1200])

This will calculate a value of $5049.44. This is less than the sum of the individual values as you have to wait for the payments.

The rate is a decimal number and a 5% investment rate is entered as 0.05. The cash flows can be positive or negative numbers. Most projects have a large negative value at the start, and a series of positive returns over the life of the project.

And:

Because NPV tells you the time value of money and allows you to balance investment against cash flow, it's the basis for financial decisions in corporations.

Many people submit spending proposals or capital requests using irrelevant measurements, such as:

  • Payback. This is great for a general idea approach. But you can't finance based on it, because it doesn't address cash flow, ROI, or the cost of capital.
     

  • ROI. The Return on Investment helps managers evaluate projects based on how well their efforts pay off. But 5% of 1 million dollars is quite a bit more money than 20% of 100 dollars. Which is one reason you can't finance based on ROI.
     

  • IRR. This is a variation of ROI, and fails as a project financing metric for the same reason. However, IRR takes into account the cost of capital--something a simple ROI calculation does not. And this can be a huge factor. You can use IRR to compare projects that are roughly the same cost.

In a report, you could show these figures as supplemental information. But generally, it's better to leave them out entirely. Why? Because they could improperly influence a decision that needs to be made on a cash flow basis.

 

A close relative: IRR

NPV (Net Present Value) is the financial tool that senior managers use to make financial decisions. (And they do that because NPV allows them to work in terms of cash flow).

Another common financial tool, used primarily by lower-level managers, is IRR (Internal Rate of Return). In Crystal Reports, the IRR function takes a list of values and calculates the rate of return of that cash flow. There must be at least one negative (payment) value and one positive (receipt) value in the list.

Suppose your project has an initial cost of $30,000 and receipts of $8000, $15,000 and $25,000 over the life of the project then the formula would read

IRR ([-30000, 8000, 15000,25000])

This will calculate a value of 0.227 indicating a 22.7% return on the initial investment.

IRR and NPV are related. Combine them in the formula and you will calculate a zero value.

NPV (IRR (values), values)

 

 

This article is copyrighted by Crystalkeen, Mindconnection, and Chelsea Technologies Ltd. It may be freely copied and distributed as long as the original copyright is displayed and no modifications are made to this material. Extracts are permitted. The names Crystal Reports and Seagate Info are trademarks owned by Business Objects.

 

Businesses run on cash flow. Business decisions are, for the most part, monetary. If you want managers to decide things a particular way, you have to show them the money.

But how can you monetize the fact that you don't like sacrificing your weekends when a moderate investment in a software tool can make doing so completely unnecessary?

You have to look outside your own perspective. If the problem is important enough that you are spending weekends working on it, that means someone else is suffering also. For example, maybe the accounting department has incurred costs due to billing errors resulting from this problem. Check with the sales department and see what pain they have had due to this problem. Maybe the purchasing department has lost discounts or has paid premiums. Perhaps the customer service department can give you horror stories on support issues, product returns, service callbacks, or whatever.

To properly monetize a project, you have to find out what the costs of not doing it are. These costs will be:

  • Negative cash outflows now incurred, due to problems the project would ameliorate or solve outright.

  • Positive cash flows not now realized, due to not implementing the project.

In other words, you need to show how lack of this project is either causing your company to spend money or how doing this project will allow your company to have money it presently leaves on the table.

As you collect information on what these cash outflows and inflows are, keep in mind it's very important to have reliable backing for every number you come up with. Track each number to its source (a spreadsheet is a good tool for this). For example, you are going to include the $1,100 per month cost of rebilling customers. Who gave you this number, and how did that person come up with it?

Be able to show the validation of the data or don't use the data. With actual costs, this is pretty easy advice to follow. With positive cash flows not now realized, it is much harder and you will have to be especially diligent. Don't grab at big numbers just because they help you make your case. Remember, the bean counters are obligated to try to shoot holes in what you give them. If it's not solid, don't use it.

Once you have all of the cash flow (positive and negative) information, crunch the numbers to show the following information:

  • Cash flows in spreadsheet format.

  • Net Present Value (NPV).

This is what financial managers live by. Excel can calculate the NPV from the cashflows. From the CFO's viewpoint, this is the information that matters.

If you also need the backing of managers who don't have much input on the company's budget, you may also need to provide ROI figures in percentage format. That would be the Internal Rate of Return (IRR) or Modified Internal Rate of Return (MIRR). Let Excel calculate IRR from the cash flows.

Some managers want to see the payback figure, as well. This is completely irrational from a business management standpoint as anyone two weeks into a business finance course can tell you. But when in Rome....

Now you can present a very different picture to management than you did earlier. Now you are showing the costs to the company. You are not asking for any favors, you are not asking for a bigger slice of the budget pie for your department. You are not complaining that your job is too hard or that you would like to drop down to 65 hour work weeks because you can't remember the names of your kids anymore.

The decision to back your project is no longer about you. It's about the company. You have monetized the project based on costs to the company rather than any personal costs to you or even your department.

In addition to getting your projects approved, this approach shows you can think in larger terms. That can't be bad for your career. Along those lines, here's another tip. After project implementation, collect data again to see what the actual cash flow changes are. Run the ROI calculations again. Send these to your boss two weeks before your next performance appraisal, along with a note that this information is critical to that appraisal. Bosses can argue arcane things to deny you a raise or promotion, but it's impossible to argue against documented success when that documentation includes strong financials.

Look at it this way. If you send your boss financials showing that you added $567,824.63 to the company's bottom line in the last year, it's going to seem awfully petty to argue whether your raise should be $3,000 or only $2400.

Any project worth doing is worth monetizing, and vice-versa. If you can't monetize it, then use your time to go after projects you can monetize.

 

This article is copyrighted by Crystalkeen, Mindconnection, and Chelsea Technologies Ltd. It may be freely copied and distributed as long as the original copyright is displayed and no modifications are made to this material. Extracts are permitted. The names Crystal Reports and Seagate Info are trademarks owned by Business Objects.