WHAT IS INVESTMENT ANALYSIS?
When a company decides to invest in a new project, it requires an outlay with the aim of generating future economic benefits. Evaluating an investment project stems from the objective of analyzing the project’s viability and effectiveness. That is, determining if the project will generate the desired return to then make the decision to accept or reject the project.
How do we decide which INVESTMENT alternative to choose?
It’s essential that before committing resources, we are sure the investment aligns with the company’s strategic objectives and will offer adequate returns. So, here is a step-by-step guide for conducting an investment analysis.
? STEPS TO ANALYZE AN INVESTMENT PROJECT
1️⃣ Define the investment objective.
2️⃣ Features of the investment.
3️⃣ Assess Financial Viability. Is the project profitable?
4️⃣ Analyze and quantify the Risks.
5️⃣ Review and Adjust.
1️⃣ DEFINE THE INVESTMENT OBJECTIVE
This involves answering questions like: Why am I undertaking this project? Am I familiar with the business? Do I like it? What do I hope to achieve with this investment? Am I looking for short-term or long-term profitability?
What kind of project is it?
✔️ cost reduction
✔️ profit increase
✔️ legal requirement
✔️ strategic
✔️ growth
Example: Need for new machinery due to high demand or launching an exclusive clothing line which requires opening a new store.
2️⃣ FEATURES OF THE INVESTMENT
Every investment depends on 4 factors: risk, initial investment, liquidity, and profitability. By briefly analyzing these variables, we can determine whether to proceed with our investment idea.
- Risk: Is there a high or low probability of significant losses?
- Initial investment: How much initial investment will we need?
- Liquidity: It’s the ability of the project to be quickly converted into cash. The less liquid an investment is, the riskier it is, as it can’t be quickly sold.
- Profitability: We can determine an initial project profitability by relating the initial investment to the net profit we expect the investment to generate.
ROI Profitability: Net Profit/ Initial Investment * 100
EXAMPLE:
Suppose you invested €1000 in a project and after one year you get back €1200.
Net profit: 1200-1000= €200
ROI/ Return on investment: (200/1000) * 100= 20%
3️⃣ ASSESS FINANCIAL VIABILITY. IS IT PROFITABLE?
Next, I’ll show you points to analyze to determine the project’s financial viability:
FORECAST PROFIT AND LOSS AND BALANCE SHEETS: Make a financial forecast taking into account overheads, the sales increase from undertaking the project.
FINANCIAL RATIOS: We analyze the profit and loss to get an approximate calculation of profitability.
Although the correct way to calculate the profitability of any project is using the IRR (Internal Rate of Return) of cash flows, which we will see later,
it’s typical for investors to use a preliminary profitability estimate that involves fewer calculations.
For this, from the profit and loss and balance sheets, we will analyze ratios like:
- RONA Economic Profitability: (EBIT/Net Asset)
- ROS Profit Margin (Return on Sales): profit/sales
- ROE Financial Profitability: (Net Profit/ Equity)
- Sales and their growth.
- Gross margin/sales and its evolution.
PROFIT ESTIMATION: How much can I earn from the project?
To evaluate any investment project, the key element to consider is the CASH-FLOW or cash flow generated by that project over time.
The operating or free cash flow is the cash flow produced by the asset, assuming it is financed only with equity, without considering bank debt, and before taxes.
The net cash flow (NCF) for each period is the difference between the inflows and outflows due to the project in each of the periods considered. Once the cash flows are determined, we can analyze the project’s profitability.
- Estimate the project’s profitability:
- INVESTMENT CONVENIENCE (NPV)
- INVESTMENT PROFITABILITY (IRR)
Use the Net Present Value (NPV) to calculate how much your investment is worth at present, and the Internal Rate of Return (IRR) to calculate the profitability you can get from your investment.
- If NPV < 0 the investment is NOT
- If NPV > 0 we accept the project.
- If IRR > K we accept the project.
- If IRR < K the project is NOT
4️⃣ HOW MUCH CAN I LOSE? RISK ANALYSIS.
Risk is the uncertainty associated with the future earnings of an investment. And it’s important to note that, generally, the longer the period during which we expect a project to generate income, the greater the uncertainty, and therefore, the associated risk.
PAYBACK OR RECOVERY PERIOD:
A key tool we use to measure risk is Payback. In essence, Payback tells us how long you need to recover your initial investment.
If you visualize it, it’s like knowing how long it would take to recover a sum you loaned.
For example, if you invest 100 and generate annual net flows of 50, you’ll need two years to recover your investment. The higher the cash flow obtained, the lower the risk since it takes less time to recover the investment.
Sensitivity Analysis: conduct a sensitivity analysis in different scenarios: pessimistic, neutral, and optimistic.
Assign different values to key variables like:
- Total sales amount and its growth.
- Gross margin (in percentage).
- Growth of operating expenses (opex).
- Level of indebtedness.
In the end, we determine the Internal Rate of Return (IRR) for each scenario. This step is crucial, as it shows us how sensitive the project is to changes in certain variables. Thus, we can identify which factors have the most impact on the project’s profitability and how much they affect it.
5️⃣ REVIEW AND ADJUST
Establish checkpoints in time to assess the project’s progress.
Are you getting the expected return? Are the set objectives being met?
Identify new associated risks, adjust estimated variables based on the results obtained, reallocate resources to areas that need more focus.
CONCLUSION:
The Importance of Analyzing Your Investments. It not only boosts your chances of success but also allows you to save money, optimize the time invested, and crucially, minimize the risks that your project doesn’t meet expected outcomes. In the realm of investments, knowledge, and preparation are your best allies.
If you need expert assistance in financial analysis and control or would like to grow and improve your business’s financial health, as a financial consultant, I’m here to help and offer the best solution for your company.
