Evaluate your business efficiency - Financial Aspects

 

Selecting the business, you are going to run must be based on clear factors that allows you to have a future vision of your business results. No doubt that financial aspects are of great weight in business evaluation. We shall now discuss some financial factors that should be taken into consideration while selecting the business you intend to build.

Time Value of Money

1000 $ today ≠ 1000 $ tomorrow.

If you have an amount of 1000 $ in your pocket today, after one year these 1000 $ value will decrease. In other words, you can’t buy the same items you can buy today with 1000 $ with the same amount after one year, that is because the value of money changes over time due to the below reasons:

interest lost: Interest rate is forecasted for market and differs for each country.

-      risk

-      inflation.

So, you need to have an overview of below factors to choose and run your business successfully:

Payback period

PBP is the period required for the cumulative expected cash flows from an investment project to equal the initial cash outflow, or in different words it is the time you will take to recover your initial investment. Payback period can be calculated with the formula Payback Period = Initial investment / Cash flow per year. So, if you have 2 different ideas one of them will take 5 year and the other will take 3 years to recover your investment. The second one will have an advantage.

Return on Investment (ROI)

ROI represents the return on your investment. It is equal to the return (revenue- investment) over investment. So, if you invested 1000 $ and the return is 500 $ so ROI=500/1000= 50 %. Ofourse projects with higher ROI is better.

Net Present value (NPV)

NPV is the present value of an investment project’s net cash flows minus the project’s initial cash outflow. It is used to calculate the current value of a future payments. it determines if your investment is worthy as positive NPV means that project is profitable and negative NPV means that project is not.

Example:

If I invested 1000 $ in a project that will return Profit after 1 year of 500 $ and after the second year 600 $ is that mean I gained 1100 $ in 2 years? It is not. Because if interest rate is annually10%, that means profit value of 1^st year equals (500/(1+10%))= 454 and the profit value of 2^nd year equals (600/(1+10%))^2 = 495 so the NPV = 1000 – (454+495)= -50. This is a negative NPV so this project is not profitable.

We can use Rate of Return (ROR) instead of interest rate in calculation. ROR is the percentage of value you gained over period of time to the initial investment.

Breakeven Point

Is the time at which revenue equal cost. Profit before breakeven point is negative, profit at breakeven point equal zero and you start gaining profit after breakeven point.

Cost-Volume Profit (CVP) Analysis

Cost-Volume determines the below points:

-      What level of sales is necessary to cover all expenses? (break-even point)

-      How many units should be sold to earn a planned profit?

-      How change in selling price affects the profit?

Fixed Cost: is a cost that does not change in total with respect to the changes in the level of production like building rent.

Variable Cost: is a cost that change in total with direct proportion with respect to the changes in the level of production like production materials and direct labors wages. 

So if we are selling a product at 5 $ per unit, variable cost is 1 $ per unit and the fixed cost is 20000 $ . so we need to sell 5000 pieces to reach breakeven point.

Piece profit equals piece price – cost per piece= 5-1= 4 $

To reach 20000 $ we need to sell 5000 pieces with 4 $ profit per piece.