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Financial Analysis — a Refresher by Steve Gutzman

All companies have budgets.  All companies spend capital.  Therefore, all companies do some form of capital budgeting.  It is a major tenet of modern finance theory that the value of a company equals the discounted present value of its expected future cash flows.  Hence, companies contemplating investments in capital projects involving IT should use the net present value, or NPV, rule: take the project if the NPV is greater than or equal to zero; reject it if the NPV is negative.  Why do we care about this?  We care because IT projects involve the expenditure of capital, and at some point in the process someone will ask to see a financial analysis.  Or more specifically, the debate becomes, “Do we buy this software package or do we buy this building?”  At some point, everything gets converted to a set of numbers that budget managers arm wrestle over for approval.

The good news is that we don’t need to have MBAs in finance to have a meaningful discussion about IT investment options.  Most of what we need to know, we already know from our own personal finances.  But just in case, here are a few helpful definitions that explain terms that are likely to come up when talking about money in IT.

First is return on investment, or ROI.  We get this number by taking the cumulative net benefit (benefits of the solution minus costs of the solution), dividing this by the cost of the solution, and multiplying that result by 100 to put it in the form of a percentage.  For example, if a project will produce $100,000 in productivity benefits and incur $50,000 in hardware costs, the ROI is 100%.  Conversely, if the benefits in this example were $50,000, the ROI would be zero.

Net present value, already mentioned above, is a key component of ROI and means that money available at the present time is worth more than the same amount in the future due to its potential earning capacity.  This core principle of finance holds that any amount of money, provided it can earn interest, is worth more the sooner it is received.  NPV can be a valuable tool in normalizing proposals with different cost structures and benefit timings such as comparing a SaaS proposal with a traditional perpetual license proposal.

<p>The discount rate is the company’s internal cost of capital.  It is also referred to as a hurdle rate – the rate that an investment ROI must “hurdle” in order to be considered.  Above the hurdle rate the investment will be considered.  Below the hurdle rate it will not.

“Payback period” is another term worth defining.  It is simply the length of time required to recover an investment, usually measured in months or years.  If a proposal will deliver $100,000 in benefits each month and costs $1,200,000, then the payback period is one year.  The payback period is one of the capital budgeting techniques most frequently used by CFOs, which is surprising because of its limitations: it ignores the time value of money and the value of cash flows beyond the cutoff date, and the cutoff is usually arbitrary.  Yet it remains a popular tool in large part because of its simplicity and in some cases because of top management’s lack of familiarity with more sophisticated techniques.  But it’s also important to recognize that the payback approach may provide useful information, especially for severely capital-constrained firms.  If an investment project does not pay positive cash flows early on, the company may go out of business before the expected future cash flows materialize.

And, finally, there’s the internal rate of return.  This is the rate required for discounted cash inflows to equal discounted cash outflows.  We don’t often come across situations in which an IRR is used, but now we know what it means.
With the increased scrutiny of IT spending, a thorough financial analysis is the lexicon in which technology geeks can talk to financial wonks.  It is important that everyone become well versed in this language.

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