Anderson ZurMuehlen Blog

Look Beyond EBITDA

 

Earnings before interest, taxes, depreciation and amortization (EBITDA) is commonly used to assess financial health and evaluate investment decisions. But sometimes this metric overstates a company’s true performance, ability to service debt, and value. That’s why internal and external stakeholders should exercise caution when reviewing EBITDA.

History of EBITDA

The market’s preoccupation with EBITDA started during the leveraged buyout craze of the 1980s. The metric was especially popular among public companies in capital-intensive industries, such as steel, wireless communications and cable television. Many EBITDA proponents claim it provides a clearer view of long-term financial performance, because EBITDA generally excludes nonrecurring events and one-time capital expenditures.

Today, EBITDA is the third most quoted performance metric — behind earnings per share and operating cash flow — in the “management discussion and analysis” section of public companies’ annual financial statements. The corporate obsession with EBITDA has also infiltrated smaller, private entities that tend to use oversimplified EBITDA pricing multiples in mergers and acquisitions. And it’s provided technology and telecommunication companies with a convenient way to dress up lackluster performance.

Inconsistent definitions

EBITDA isn’t recognized under U.S. Generally Accepted Accounting Principles (GAAP) or by the Securities and Exchange Commission (SEC) as a measure of profitability or cash flow. Without formal guidance, companies have been free to define EBITDA any way they choose — which can make it difficult to assess company performance.

For example, some analysts when calculating EBITDA subtract nonrecurring and extraordinary business charges, such as goodwill impairment, restructuring expenses, and the cost of long-term incentive compensation and stock option plans. Others, however, subtract none or only some of those charges. Therefore, comparing EBITDA between companies can be like comparing apples and oranges.

Moreover, the metric fails to consider changes in working capital requirements, income taxes, principal repayments and capital expenditures. When used in mergers and acquisitions, EBITDA pricing multiples generally fail to address the company’s asset management efficiency, the condition and use of its fixed assets, or the existence of nonoperating assets and unrecorded liabilities. In fact, many high profile accounting scandals and bankruptcies have been linked to the misuse of EBITDA, including those involving WorldCom, Cablevision, Vivendi, Enron and Sunbeam.

Balancing act

Despite these shortcomings, EBITDA isn’t all bad. It can provide insight when used in conjunction with more traditional metrics, such as cash flow, net income and return on investment. For help performing comprehensive due diligence that looks beyond EBITDA, contact us.

©2017

Read more from Anderson ZurMuehlen Blog

5 Recent Supreme Court Decisions that Could Affect Your Business

At the end of June, the U.S. Supreme Court adjourned for its summer recess. Here are five recent cases from its 2016 term that may be of interest to business owners and managers.

1. Advocate Health Care Network v. Stapleton (S. Ct. No. 16-74, June 5, 2017)

Under the Employee Retirement Income Security Act of 1974 (ERISA), employees are generally protected from unexpected losses in their retirement plans through various safeguards. However, church plans are specifically exempted from ERISA requirements, in order to avoid any entanglement of government and religion.

In this case, a group of employees work for a health care network that operates hospitals and in-patient and out-patient treatment centers in Illinois. The employees are covered under the network’s retirement plan. The network was formed through a merger of two religiously affiliated hospital systems. Although neither system was owned or financially operated by a church, the network remains affiliated with a church.

The employees sued the network. They argued that the retirement plan is subject to ERISA and failing to meet the ERISA requirements is a violation of federal law. The network countered that its plan falls under the exception for church plans. The Seventh Circuit Court affirmed a lower court’s ruling that a church-affiliated organization isn’t a church plan within the meaning of the law.

In a June ruling, the U.S. Supreme Court unanimously agreed that the ERISA exemption for church plans applies to plans maintained by a church-affiliated organization, even if that organization didn’t originally establish the plan.

2. TC Heartland LLC v. Kraft Food Brands Group LLC (S. Ct. No. 16-341, May 22, 2017)

A company organized under Indiana law and headquartered in Indiana sold liquid water-enhancing products that it shipped to Delaware in accordance with two of its contracts. But a major retailer, organized in Delaware with its primary place of business in Illinois, claimed that these products infringed on its patents for similar products.

The company selling the water-enhancing products argued that Delaware lacked jurisdiction over the lawsuit because the retailer isn’t registered to do business in the state, has no business there and doesn’t solicit any business there. A district court ruled that the subsection of the general venue statute allowing a defendant to reside in multiple jurisdictions for purposes of establishing jurisdiction applies to the patent venue statute.

This precedent conflicts with a previous Supreme Court case, Fourco Glass Co. v. Transmirra Products Corp. (353 U.S. 222, 1957). Fourco Glass holds that corporate jurisdiction is limited to the state of incorporation. The Fifth Circuit decided that the Congressional amendments to the general venue statute post-dated Fourco Glass and, therefore, superseded it.

However, in May, the Supreme Court unanimously ruled that the subsection of the general venue statute doesn’t apply to the patent venue statute. Thus, the Fourco Glass case still prevails. In his opinion, Justice Thomas stated that the patent venue statute hasn’t been amended, and it wasn’t meant to dovetail with other venue statutes.

3. Star Athletica, LLC v. Varsity Brands, Inc. (S. Ct. No. 15-866, March 22, 2017)

In the Star Athletica case, the plaintiff is a company that designs and manufactures clothing and accessories used in various athletic activities, including cheerleading. The design concepts for the clothing incorporate several elements — such as colors, shapes and lines — but they don’t consider the functionality of the final clothing. The plaintiff received copyright registration for two-dimensional artwork of designs that were similar to the ones that the defendant company began using.

In its lawsuit, the plaintiff alleged, among other claims, that the defendant had violated the Copyright Act of 1976. The defendant counter-claimed, asserting that the plaintiff had made fraudulent representations to the Copyright Office because the designs at issue couldn’t be copyrighted.

Significantly, the defendant argued that the plaintiff didn’t have valid copyrights because the designs were for “useful articles,” which can’t be copyrighted. Moreover, because the designs can’t be separated from the uniforms, the designs are impossible to copyright. In response, the plaintiff claimed that the designs were separable and non-functional.

The Sixth Circuit ruled that the Copyright Act allows companies to copyright graphic features of a design, even if the design isn’t separable from a “useful article.” Then the matter was brought before the U.S. Supreme Court.

In a 6-2 vote, the Court decided that copyright protection is allowed if a feature incorporated into the design of a useful article:

  • Can be perceived as a two- or three-dimensional work of art separate from the useful article, and
  • Would qualify as a protectable pictorial, graphic or sculptural work — either on its own or fixed in some other tangible medium of expression — if it were imagined separately from the useful article into which it’s incorporated.

Based on this interpretation, the plaintiff prevailed.

4. Czyzewski v. Jevic Holding Corp. (S. Ct. 15-649, March 22, 2017)

In 2008, a trucking company that was headquartered in New Jersey filed for bankruptcy under Chapter 11 of the U. S. Bankruptcy Code. At that point, it owed about $53 million to its first-priority secured creditors and about $20 million to its tax and general unsecured creditors.

Two lawsuits were initiated in U.S. Bankruptcy Court against the trucking company:

  • The truck drivers alleged that the trucking company violated federal and state Worker Adjustment and Retraining Notification (WARN) laws. Those rules require companies to provide workers with at least 60 days notice before layoffs.
  • A fraudulent conveyance action was made on behalf of the unsecured creditors. In 2012, the parties to the fraudulent conveyance action negotiated a settlement that dismissed many of the claims. But the settlement left out the drivers. The drivers objected to the settlement because it distributed property to creditors of lower priority under the Bankruptcy Code.

The Third Circuit affirmed the district court’s decision that the Bankruptcy Court had the discretion to approve a settlement scheme outside the Chapter 11 proceedings, even if it didn’t comply with distribution priority scheme under the Bankruptcy Code.

In a 6-2 decision, the U.S. Supreme Court sided with the truck drivers. The Court held that bankruptcy courts may not approve structured dismissals that don’t follow the priority order established in the Bankruptcy Code. While courts have flexibility, settlements must be viewed in light of the claims of affected creditors.

5. Kokesh v. Securities and Exchange Commission (S. Ct. No. 16-529, June 5, 2017)

The Securities and Exchange Commission (SEC) sued a New Mexico-based investment advisor for misappropriating funds from four business development companies. The district court found in favor of the SEC and ordered the advisor to pay $34.9 million for “the ill-gotten gains” connected to the violations. But the advisor argued this “disgorgement” remedy is barred by a five-year statute of limitations.

What is disgorgement? Funds received through illegal or unethical business transactions are disgorged, or paid back, with interest to those affected by the action. Companies that violate SEC regulations are typically required to pay both civil money penalties and disgorgement. In general, civil money penalties are considered punitive, while disgorgement is about paying back profits made from those actions that violated the SEC’s regulations.

The Tenth Circuit held that the usual five-year statute of limitations didn’t apply to this case because the ordered payment was remedial rather than punitive in nature. Therefore, a disgorgement payment may be allowed.

However, the Supreme Court has unanimously reversed the Tenth Circuit ruling. The Court decided that SEC disgorgement functions as a penalty, so it is subject to the five-year statute of limitations. This case is being widely viewed by commentators as a further erosion of the enforcement powers of the SEC.

©2017

Read more from Anderson ZurMuehlen Blog

Less Than 6 Months Until the New Contract Revenue Guidance Goes Live

The sweeping new revenue recognition standard goes into effect soon. But many companies are behind on implementing it. Whether your company is public or private, you can’t afford to delay the implementation process any longer.

5 steps

Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers, requires companies following U.S. Generally Accepted Accounting Principles (GAAP) to use a principles-based approach for recognizing revenues from long-term contracts. Under the new guidance, companies must follow five steps when deciding how and when to recognize revenues:

1. Identify a contract with a customer.

2. Separate the contract’s commitments.

3. Determine the transaction price.

4. Allocate a price to each promise.

5. Recognize revenue when or as the company transfers the promised good or service to the customer, depending on the type of contract.

In some cases, the new guidance will result in earlier revenue recognition than in current practice. This is because the new standard will require companies to estimate the effects of sales incentives, discounts and warranties.

Changes coming

The new standard goes into effect for public companies next year. Private companies have a one-year reprieve.

The breadth of change that will be experienced from the new standard depends on the industry. Companies that currently follow specific industry-based guidance, such as software, real estate, asset management and wireless carrier companies, will feel the biggest changes. Nearly all companies will be affected by the expanded disclosure requirements.

Some companies that have already started the implementation process have found that it’s more challenging than they initially expected, especially if the company issues comparative statements. Reporting comparative results in accordance with the new standard requires a two-year head start to ensure all of the relevant data is accurately collected.

Reasons for procrastination

Why are so many companies dragging their feet? Reasons may include:

  • Lack of funding or staff,
  • Challenges interpreting the standard’s technical requirements, and
  • Difficulty collecting data.

Many companies remain uncertain how to prepare their accounting systems and recordkeeping to accommodate the changes, even though the FASB has issued several amendments to help clarify the guidance. In addition, the AICPA’s FinREC has published industry-specific interpretive guidance to address specific implementation issues related to the revenue recognition standard.

Got contracts?

We’ve already helped other companies start the implementation process — and we’re ready to help get you up to speed, too. Contact us for questions on how the new revenue recognition standard will impact your financial statements and accounting systems.

© 2017

 

©2017

Read more from Anderson ZurMuehlen Blog

Why Financial Restatements Happen … and How to Prevent Them

 

When companies reissue prior financial statements, it raises a red flag to investors and lenders. But not all restatements are bad news. Some result from an honest mistake or misinterpretation of an accounting standard, rather than from incompetence or fraud. Here’s a closer look at restatements and how external auditors can help a company’s management get it right.

Avoid knee-jerk responses

The Financial Accounting Standards Board (FASB) defines a restatement as “a revision of a previously issued financial statement to correct an error.” Accountants decide whether to restate a prior period based on whether the error is material to the company’s financial results. Unfortunately, there aren’t any bright-line percentages to determine materiality.

When you hear the word “restatement,” don’t automatically think of the frauds that occurred at Xerox, Enron or WorldCom. Some unscrupulous executives do use questionable accounting practices to meet quarterly earnings projections, maintain stock prices and achieve executive compensation incentives. But many restatements result from unintentional errors.

Spot error-prone accounts

Accounting rules can be complex. Recognition errors are one of the most common causes of financial restatements. They sometimes happen when companies implement a change to the accounting rules (such as the updated guidance on leases or revenue recognition) or engage in a complex transaction (such as reporting compensation expense from backdated stock options, hedge accounting, the use of special purpose or variable interest entities, and consolidating with related parties).

Income statement and balance sheet misclassifications also cause a large number of restatements. For instance, a borrower may need to shift cash flows between investing, financing and operating on the statement of cash flows.

Equity transaction errors, such as improper accounting for business combinations and convertible securities, can also be problematic. Other leading causes of restatements are valuation errors related to common stock issuances, preferred stock errors, and the complex rules related to acquisitions, investments and tax accounting.

Want more accurate results?

Restatements also happen when a company upgrades to a higher level of assurance (say, when transitioning from reviewed statements to audited statements). That’s because audits are more likely than compilation or review procedures to catch reporting errors from prior periods. An external auditor is required to “plan and perform an audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud.”

But after the initial transition period, audits typically catch errors before financial statements are published, minimizing the need for restatements. Auditors are trained experts on U.S. Generally Accepted Accounting Principles (GAAP) — and they must take continuing professional education courses to stay atop the latest changes to the rules.

In addition to auditing financial statements, we can help implement cost-effective internal control procedures to prevent errors and accurately report error-prone accounts and transactions. Contact us for help correcting a previous error, remedying the source of an error or upgrading to a higher level of assurance.

©2017

Read more from Anderson ZurMuehlen Blog

Put Your Income Statement to Good Use

By midyear, most businesses that follow U.S. Generally Accepted Accounting Principles (GAAP) have issued their year-end financial statements. But how many have actually used them to improve their business operations in the future? Producing financial statements is more than a matter of compliance — owners and managers can use them to analyze performance and find ways to remedy inefficiencies and anomalies. How? Let’s start by looking at the income statement.

Benchmarking performance

Ratio analysis facilitates comparisons over time and against industry norms. Here are four ratios you can compute from income statement data:

1. Gross profit. This is profit after cost of goods sold divided by sales. This critical ratio indicates whether the company can operate profitably. It’s a good ratio to compare to industry statistics because it tends to be calculated on a consistent basis.

2. Net profit margin. This is calculated by dividing net income by sales and is the ultimate scorecard for management. If the margin is rising, the company must be doing something right. Often, this ratio is computed on a pretax basis to accommodate for differences in tax rates between pass-through entities and C corporations.

3. Return on assets. This is calculated by dividing net income by the company’s total assets. The return shows how efficiently management is using its assets.

4. Return on equity. This is calculated by dividing net profits by shareholders’ equity. The resulting figure tells how well the shareholders’ investment is performing compared to competing investment vehicles.

For all four profitability ratios, look at two key elements: changes between accounting periods and differences from industry averages.

Plugging profit drains

What if your company’s profitability ratios have deteriorated compared to last year or industry norms? Rather than overreacting to a decline, it’s important to find the cause. If the whole industry is suffering, the decline is likely part of a macroeconomic trend.

If the industry is healthy, yet a company’s margins are falling, management may need to take corrective measures, such as:

  • Reining in costs,
  • Investing in technology, and/or
  • Looking for signs of fraud.

For example, if an employee is colluding with a supplier in a kickback scam, direct materials costs may skyrocket, causing the company’s gross profit to fall.

Playing detective

For clues into what’s happening, study the main components of the income statement: gross sales, cost of sales, and selling and administrative costs. Determine if line items have fallen due to company-specific or industrywide trends by comparing them to public companies in the same industry. Also, monitor trade publications, trade associations and the Internet for information. Contact us to discuss possible causes and brainstorm ways to fix any problems.

©2017

Read more from Anderson ZurMuehlen Blog

Seasonal business? Optimize your operating cycle

Every business has some degree of ups and downs during the year. But cash flow fluctuation OKs are much more intense for seasonal businesses. So, if your company defines itself as such, it’s important to optimize your operating cycle to anticipate and minimize shortfalls.

A high-growth example

To illustrate: Consider a manufacturer and distributor of lawn-and-garden products such as topsoil, potting soil and ground cover. Its customers are lawn-and-garden retailers, hardware stores and mass merchants.

The company’s operating cycle starts when customers place orders in the fall — nine months ahead of its peak selling season. So the business begins amassing product in the fall, but curtails operations in the winter. In late February, product accumulation continues, with most shipments going out in April.

At this point, a lot of cash has flowed out of the company to pay operating expenses, such as utilities, salaries, raw materials costs and shipping expenses. But cash doesn’t start flowing into the company until customers pay their bills around June. Then, the company counts inventory, pays remaining expenses and starts preparing for the next year. Its strategic selling window — which will determine whether the business succeeds or fails — lasts a mere eight weeks.

The power of projections

Sound familiar? Ideally, a seasonal business such as this should stockpile cash received at the end of its operating cycle, and then use those cash reserves to finance the next operating cycle. But cash reserves may not be enough — especially for high-growth companies.

So, like many seasonal businesses, you might want to apply for a line of credit to avert potential shortfalls. To increase the chances of loan approval, compile a comprehensive loan package, including historical financial statements and tax returns, as well as marketing materials and supplier affidavits (if available).

More important, draft a formal business plan that includes financial projections for next year. Some companies even project financial results for three to five years into the future. Seasonal business owners can’t rely on gut instinct. You need to develop budgets, systems, processes and procedures ahead of the peak season to effectively manage your operating cycle.

Distinctive challenges

Seasonal businesses face many distinctive challenges. Please contact our firm for assistance overcoming these obstacles and strengthening your bottom line.

Contact us for more information.

©2017

Read more from Anderson ZurMuehlen Blog

How to Shape Up Your Working Capital

Working capital — current assets minus current liabilities — is a common measure of liquidity. High liquidity generally equates with low risk, but excessive amounts of cash tied up in working capital may detract from growth opportunities and other spending options, such as expanding to new markets, buying equipment and paying down debt. Here are some recent working capital trends and tips for keeping your working capital in shape.

Survey says

Working capital management among U.S. companies has been relatively flat over the last four years, excluding the performance of oil and gas companies, according to the 2016 U.S. Working Capital Survey published by consulting firm REL and CFO magazine. The overall results were skewed somewhat because oil and gas companies increased their inventory reserves to take advantage of low oil prices, thereby driving up working capital balances for that industry.

The study estimates that, if all of the 1,000 companies surveyed managed working capital as efficiently as do the companies in the top quartile of their respective industries, more than $1 trillion of cash would be freed up from receivables, inventory and payables.

Rather than improve working capital efficiency, however, many companies have chosen to raise cash with low interest rate debt. Companies in the survey currently carry roughly $4.86 trillion in debt, more than double the level in 2008. As the Federal Reserve Bank increases rates, companies will likely look for ways to manage working capital better.

Efficiency initiatives

How can your company decrease the amount of cash that’s tied up in working capital? Best practices vary from industry to industry. Here are three effective exercises for improving working capital:

Expedite collections. Possible solutions for converting receivables into cash include: tighter credit policies, early bird discounts, collection-based sales compensation and in-house collection personnel. Companies also can evaluate administrative processes — including invoice preparation, dispute resolution and deposits — to eliminate inefficiencies in the collection cycle.

Trim inventory. This account carries many hidden costs, including storage, obsolescence, insurance and security. Consider using computerized inventory systems to help predict demand, enable data-sharing up and down the supply chain, and more quickly reveal variability from theft.

Postpone payables. By deferring vendor payments, your company can increase cash on hand. But be careful: Delaying payments for too long can compromise a firm’s credit standing or result in forgone early bird discounts.

From analysis to action

No magic formula exists for reducing working capital, but continuous improvement is essential. We can help train you on how to evaluate working capital accounts, identify strengths and weaknesses, and find ways to minimize working capital without compromising supply chain relationships.

 

Contact us for more information.

©2017

Read more from Anderson ZurMuehlen Blog

Create a Strong System of Checks and Balances

 

The Securities and Exchange Commission (SEC) requires public companies to evaluate and report on internal controls over financial reporting using a recognized control framework. Private companies generally aren’t required to use a framework for the oversight of internal controls, unless they’re audited, but a strong system of checks and balances is essential for them as well.

A critical process

Reporting on internal controls is an ongoing process, not a one-time assessment, that’s affected by an entity’s board of directors or owners, management, and other personnel. It’s designed to provide reasonable assurance regarding the effectiveness and efficiency of operations, the reliability of financial reporting, compliance with applicable laws and regulations, and safeguarding of assets.

A strong system of internal controls helps a company achieve its strategic and financial goals, in addition to minimizing the risk of fraud. At the most basic level, auditors routinely monitor the following three control features. These serve as a system of checks and balances that help ensure management directives are carried out:

1. Physical restrictions. Employees should have access to only those assets necessary to perform their jobs. Locks and alarms are examples of ways to protect valuable tangible assets, including petty cash, inventory and equipment. But intangible assets — such as customer lists, lease agreements, patents and financial data — also require protection using passwords, access logs and appropriate legal paperwork.

2. Account reconciliation. Management should confirm and analyze account balances on a regular basis. For example, management should reconcile bank statements and count inventory regularly.

Interim financial reports, such as weekly operating scorecards and quarterly financial statements, also keep management informed. But reports are useful only if management finds time to analyze them and investigate anomalies. Supervisory review takes on many forms, including observation, test counts, inquiry and task replication.

3. Job descriptions. Another basic control is detailed job descriptions. Company policies also should call for job segregation, job duplication and mandatory vacations. For example, the person who receives customer payments should not also approve write-offs (job segregation). And two signatures should be required for checks above a prescribed dollar amount (job duplication).

Controls assessment

Is your company’s internal control system strong enough? Even if you’re not required to follow the SEC’s rules on assessing internal controls, a thorough system of checks and balances will help your company achieve its goals. Company insiders sometimes lack the experience or objectivity to assess internal controls. But our auditors have seen the best — and worst — internal control systems and can help evaluate whether your controls are effective.

Contact us for more information.

©2017

Read more from Anderson ZurMuehlen Blog

3 Financial Statements You Should Know

Successful business people have a solid understanding of the three financial statements prepared under U.S. Generally Accepted Accounting Principles (GAAP). A complete set of financial statements helps stakeholders — including managers, investors and lenders — evaluate a company’s financial condition and results. Here’s an overview of each report.

1. Income statement

The income statement (also known as the profit and loss statement) shows sales, expenses and the income earned after expenses over a given period. A common term used when discussing income statements is “gross profit,” or the income earned after subtracting the cost of goods sold from revenue. Cost of goods sold includes the cost of labor, materials and overhead required to make a product.

Another important term is “net income.” This is the income remaining after all expenses (including taxes) have been paid.

2. Balance sheet

This report tallies the company’s assets, liabilities and net worth to create a snapshot of its financial health. Current assets (such as accounts receivable or inventory) are reasonably expected to be converted to cash within a year, while long-term assets (such as plant and equipment) have longer lives. Similarly, current liabilities (such as accounts payable) come due within a year, while long-term liabilities are payment obligations that extend beyond the current year or operating cycle.

Net worth or owners’ equity is the extent to which the book value of assets exceeds liabilities. Because the balance sheet must balance, assets must equal liabilities plus net worth. If the value of your liabilities exceeds the value of the assets, your net worth will be negative.

Public companies may provide the details of shareholders’ equity in a separate statement called the statement of retained earnings. It details sales or repurchases of stock, dividend payments and changes caused by reported profits or losses.

3. Cash flow statement

This statement shows all the cash flowing into and out of your company. For example, your company may have cash inflows from selling products or services, borrowing money and selling stock. Outflows may result from paying expenses, investing in capital equipment and repaying debt.

Although this report may seem similar to an income statement, it focuses solely on cash. It’s possible for an otherwise profitable business to suffer from cash flow shortages, especially if it’s growing quickly.

Typically, cash flows are organized in three categories: operating, investing and financing activities. The bottom of the statement shows the net change in cash during the period. To remain in business, companies must continually generate cash to pay creditors, vendors and employees. So watch your statement of cash flows closely.

Ratios and trends

Are you monitoring ratios and trends from your financial statements? Owners and managers who pay regular attention to these three key reports stand a better chance of catching potential trouble before it gets out of hand and pivoting, when needed, to maximize the company’s value.

Contact us for more information.

©2017

Read more from Anderson ZurMuehlen Blog

Don’t Make Hunches – Crunch the Numbers

 

Some business owners make major decisions by relying on gut instinct. But investments made on a “hunch” often fall short of management’s expectations.

In the broadest sense, you’re really trying to answer a simple question: If my company buys a given asset, will the asset’s benefits be greater than its cost? The good news is that there are ways — using financial metrics — to obtain an answer.

Accounting payback

Perhaps the most common and basic way to evaluate investment decisions is with a calculation called “accounting payback.” For example, a piece of equipment that costs $100,000 and generates an additional gross margin of $25,000 per year has an accounting payback period of four years ($100,000 divided by $25,000).

But this oversimplified metric ignores a key ingredient in the decision-making process: the time value of money. And accounting payback can be harder to calculate when cash flows vary over time.

Better metrics

Discounted cash flow metrics solve these shortcomings. These are often applied by business appraisers. But they can help you evaluate investment decisions as well. Examples include:

Net present value (NPV). This measures how much value a capital investment adds to the business. To estimate NPV, a financial expert forecasts how much cash inflow and outflow an asset will generate over time. Then he or she discounts each period’s expected net cash flows to its current market value, using the company’s cost of capital or a rate commensurate with the asset’s risk. In general, assets that generate an NPV greater than zero are worth pursuing.

Internal rate of return (IRR). Here an expert estimates a single rate of return that summarizes the investment opportunity. Most companies have a predetermined “hurdle rate” that an investment must exceed to justify pursuing it. Often the hurdle rate equals the company’s overall cost of capital — but not always.

A mathematical approach

Like most companies, yours probably has limited funds and can’t pursue every investment opportunity that comes along. Using metrics improves the chances that you’ll not only make the right decisions, but that other stakeholders will buy into the move. Please contact our firm for help crunching the numbers and managing the decision-making process.

©2017

Read more from Anderson ZurMuehlen Blog