Your company is ready to make a big purchase — a fleet of cars, a piece of manufacturing equipment, or a new computer system.
But before anyone writes a check, you need to calculate the return on investment (ROI) by comparing the expected benefits with the costs. Analyzing ROI isn’t always as simple as it sounds and there’s one mistake that many managers make: confusing cash and profit.
This is an important distinction because if you mistake profit for cash in your ROI calculations, you’re likely to show a far better return that you can expect in reality. So keep in mind: Profit is not the same thing as cash.
True ROI analysis has to convert revenue to profit, and profit to cash.
Here are the four steps to live by when calculating ROI:
- Determine the initial cash outlay (cost of the investment). Add up the costs of the investment – everything that goes into the project. If you are dealing with tangible assets, don’t forget: equipment costs, shipping costs, installation costs, startup costs, and training.
- Forecast the cash flows from the investment. Estimate the net cash generated by the investment, allow for increased working capital, changes in taxes, non-cash expenses, and put it on a calendar to model each month over the duration of the project.
- Determine the minimum return required by your company. Determine the cost of capital, relative risks, and opportunity costs. What standards does your finance department use?
- Evaluate the investment. Four ROI calculation methods: Payback, NPV, IRR, and profitability index. Which method you use will depend on the nature of the investment.
While these are the basic steps, there is a lot more to getting it right. You have to account for the time value of money. You have to estimate returns based on cash flow rather than on profit. You must know your company’s hurdle rates, and you must determine which method of calculating ROI is the best one for your project.
Smart question: Why is NPV the tool of choice by most finance managers? Because an investment that passes the NPV test will add shareholder value, and an investment that will destroy value.