Evaluating Cash Flow Results

We've already explained how to put a business case together based on a cash flow analysis.  In this article we're going to be focusing on how to interpret the results of a business case by examining some of the more common financial measures associated with cash flow results / analysis.

Measures used in Cash Flow Analysis

There are four financial measures that most decision makers expect to see in a business case based on a cash flow analysis:

• Net Present Value of Cash Flows / NPV of Cash Flows
• Internal Rate of Return / IRR
• Profitability Index
• Payback / PB

This article will dedicated to examining each of these measures including how to interpret those results (including simple rules of thumb), the calculation of each measure, examples of each measure, and finally the pros and cons of each approach.

We're going to finish up by providing you with a link to a worksheet that includes all of the calculations we're about to discuss.

Net Present Value of Cash Flow

Perhaps the mostly widely used technique for analyzing a potential investment opportunity or project is the net present value of cash flow or NPV approach.  Using the NPV of cash flow technique we would discount all cash flows in our business case at the opportunity cost of capital - in most cases the weighted average cost of capital for a company.

The business rule that is applied with this analysis is to accept all projects or investments where the NPV of cash flows is greater than zero - so we're looking for positive NPVs.

Calculating Net Present Values

Most modern spreadsheet applications such as Excel allow us to calculate net present value automatically - and without much thought to what we're doing.  All you need to know is the discount rate and the range of cash flow values you're analyzing.

But what that Excel function is simply doing is applying the following rule - which calculates the present value of each cash flow in each year.

PV = Cash Flow / (1 + r)^n

Where r = discount rate, and n = the period we're examining.

The important point here is that the rate and the period need to be for the same measure of time.  So if we're looking at annual cash flows, the discount rate needs to be an annual rate.  If we're looking at monthly cash flows, then the discount rate needs to be stated on a per month basis.

NPV Example

Let's see how this calculation works using an example where we have an initial investment of $1,000 and three years of positive cash flow at $500 per year and our discount rate is 8.95%.

The convention is to state results in terms of the current year or Y0 in this example.  So applying the formula we figure out the present values of each cash flow:

PV Y1 = 500 / (1 + 0.0895) = 459
PV Y2 = 500 / (1 + 0.0895)^2 = 421
PV Y3 = 500 / (1 + 0.0895)^3 = 387

So our result for this example would be:

NPV = -1,000 + 459 + 421 + 387 = 267

And based on the NPV rule mentioned earlier, we would accept this as being a good project because the NPV of cash flows is greater than zero.

Pros and Cons of NPV

The strength of calculating NPV is that we are recognizing that the value of a dollar today is more than the value of a dollar received a year from now - that's the time value of money concept.  The other strength of this measure is that it recognizes the risk associated with future cash flow - it's less certain.

The weaknesses of the NPV approach are related to the measure's simplicity.  Our NPV rule tells us to accept all investments where the NPV is greater than zero.  However, the measure doesn't tell us when a positive NPV is achieved.  Does it happen in five years or 15?

Another limitation of the NPV approach is that the model assumes that capital is abundant - that is there is no capital rationing.  If resources are scarce, then the analyst has to look carefully at not just the NPV for each project they are evaluating, but also the size of the investment itself.  Fortunately, there is another measure that can help overcome this weakness - the calculation of internal rates of return.

Internal Rate of Return or IRR

The internal rate of return, or discounted cash flow rate of return, offers analysts a way to quantify the rate of return provided by the investment.  The rule with respect to capital budgeting or when evaluating a project is to accept all investments where the IRR is greater than the opportunity cost of capital.  Under most conditions, the opportunity cost of capital is equal to the weighed average cost of capital (WACC).

Calculating IRR

The internal rate of return is defined as the discount rate where the NPV of cash flows are equal to zero.  The IRR can be calculated using trial and error (changing the discount rate until the NPV = 0).  In the "good ole days" there were some hand calculators such as the famous HP 12C that could perform this calculation automatically.

Today's spreadsheet applications such as Microsoft's Excel or OpenOffice Calc can perform this calculation via built-in functions.  For that reason, we're not going to dwell on how this calculation is performed.  You can see an example of this calculation in the spreadsheet we provide later on.

Pros and Cons of Using IRR

There is no doubt that IRR is an extremely important measure when it comes to evaluating the financial flows of money for a project.  Its strengths consist of the wide-scale acceptance of the measure in the financial community and it's also based on discounted cash flows - so it recognizes the time value of money.  And when used properly, the measure provides excellent guidance on a project's value.

There are however, three well known pitfalls of using IRR that are worth discussing:

• Multiple Rates of Return - if you're evaluating a project that has more than one change in sign for the cash flow stream, then the project may have multiple IRRs or no IRR at all.
• Changes in Discount Rates - the IRR rule tells us to accept projects where the IRR is greater than the opportunity cost of capital or WACC.  But if this discount rate changes each year then it's impossible to make this comparison.
• IRRs Do Not Add Up - one of the strengths of the NPV approach is that if you need to add one project to an existing project you can simply add the NPVs together to evaluate the entire project.  IRRs on the other hand cannot be added together so projects must be combined or evaluated on an incremental basis.

Analyzing Profitability Index

The profitability index, also known as the benefit-cost ratio, is another measure that uses a simple rule to evaluate cash flow results for a given project.  In this case, the profitability index rule would tell managers and executives to accept all projects that have an index value that is equal to or greater than 1.

Calculating Profitability Index

The calculation of profitability index is based on a simple relationship between a project's costs and the discounted after tax cash flow it produces.  The formula for profitability index is as follows:

Profitability Index = Present Value of Cash Flows / Cost of Project

So the rule of thumb for profitability index would state that we accept all projects that produce benefits (present value) that are in excess of the project's cost.

Profitability Index Example

We'll use the following discounted cash flows to illustrate how profitability index is calculated:

Based on the above information we know:

Present Value of Cash Flows = 459 + 421 + 387 = 1,267
Cost of Project = 1,000

So the profitability index in this example would be 1,267 / 1,000 or 1.267 - which is greater than one.  Therefore we would accept this project as a good one.

Pros and Cons of Profitability Index

One of the strengths of profitability index is that it will provide us with the same result as the net present value method.  If the NPV of cash flows is positive, then Profitability Index will be greater than one.

Likewise the pitfalls of profitability index would be the same as the NPV method mentioned above.

Analyzing Payback

Payback allows us to see how rapidly a project returns the initial investment back to the company.  In practice, companies establish "rules" around payback when evaluating a project.  For example, a company might decide that all projects need to have a payback of less than five years.  This is also referred to as the cutoff period.

Calculating Payback

Payback can be calculated based on two methods - simple payback and discounted payback:

• Simple Payback - with this approach payback is calculated based on the after tax cash flows.
• Discounted Payback - when calculating discounted payback, all cash flows uses are shown on an after tax basis, then discounted using the proper discount rate - usually the weighted average cost of capital.

Unfortunately, there is no simple spreadsheet function that the analyst can use to calculate payback.  That being said we have incorporated a rather complex formula for automating the calculation of payback into the business case spreadsheet we've provided later on in this article. 

The following example illustrates how each type of payback is found.

Payback Example

The following example used a discount rate of 8.95% and applied that rate to each of the annual cash flows.

In this example our simple payback would be 2 years.  By year Y2 we would have recovered the initial investment of -1,000 that occurred in Y0.  If we look at the discounted cash flows - which are smaller - then the discounted payback is 2.3 years.

Pros and Cons of the Payback Method

Perhaps the greatest strength of the payback method is that it allows executives and managers to get a good feel for how much time will pass before they can recoup their investment.  This allows go, no-go, decisions to be made based on simple cutoff date rules.

Discounted cash flow should be the preferred way to evaluate payback since it does recognize the time value of money.  That is cash in the future is not worth as much as much as cash today.

Payback's big weakness is that it ignores all cash flows that occur after the payback period is reached.  In the example above simply knowing that the payback period is 2 years tells us absolutely nothing about what happens after year 2.

Cash Flow Example Worksheet

We're going to finish this one up by once again pointing out that we've put together a cash flow spreadsheet that performs all of these calculations.  If you're having trouble understanding each of the concepts discussed earlier then just refer to back to this worksheet for help.

If you've performed this kind of analysis before then you know that someone cannot expect to become an expert overnight - most of the time we learn via our experiences.  But you can take steps to help accelerate that process.  Assuming you've read through this article once take a look at the worksheet we've provided and then read the article again - this approach should help to reinforce the concepts.

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