Do you find yourself dithering for lack of information when making the money side of decisions?
Whether it’s a business or personal issue the key is to focus on what matters – future cash-flows. And by simply adopting a routine method to summarise these over time a small business owner can improve the quality of important decisions. Use it consistently across all options, including personal spending.
Here’s how to put one together.
Two different types of information
First consider that there are at least 2 categories to consider for each revenue and cost:
What really matters is the dollar estimate of future streams arising as a result of decisions taken now. Ignore past events which are relevant only in that further cash-flows might “follow-on” from them.
Opportunity costs are revenues lost, and opportunity benefits are costs avoided, which are associated with the next best choice among mutually exclusive options.
When taking a vacation for example, consider the opportunity cost of interest on investments which you will not be making if the planned holiday goes ahead.
List specific cash-flows
Future cash-flows and opportunity costs should be collected in 5 buckets:
1. Revenues – here focus on the collection and timing of receipts
2. Costs – dig them all out with estimated payment dates
3. Interest – what would happen if interest rates hit 18% within 5 years?
4. Taxes – the attractiveness of any opportunity may be tinged, positively or negatively, by taxes but tax should usually not be the principle reason for going ahead with a deal
5. Inflation – not so much these days but always be conscious of escalating costs and your ability to raise prices
Time the in-goings and out-goings
Although it’s all crystal ball gazing, consider that events in the medium term are less certain than those in the near term. This is closely tied to the idea of payback – how long will you have to wait to get the benefits. The further out the event, the higher the risk.
When reviewing and deciding, put additional weight on the early periods.
Consider a range of values
Most of the elements in your decisions will be subject to estimation in both amount and timing. Unless contractual, all items are very uncertain. If nothing else this will be brought home as a result of the analysis.
Sensitivity is the key. How is the financial outcome affected by changes to critical inputs? Make decisions based on a range rather than single values.
Identify all risks
In any decision risk is inherent, but more so in business.
As an example in July 2013 a high-profile company in Australia worth $1.1 billion lost 40% of its value overnight on a change in government policy.
The idea here is that raw cash-flows may be misleading, so they could be improved by adjusting them for perceived risk. We can do this by applying a discount rate.
A discount rate has a number of elements which are built up to a final rate to use in the summary table. (Using the rate is outside the scope of this article, but the idea is that future revenues and costs are reduced, and the further out, the greater the reduction). All inputs are a matter of judgement and they should reflect the risk you attach to a cash-flow – the higher the discount, the higher the risk and the lower the value of the cash-flow. Build a rate with these elements:
· A risk free opportunity cost (for example US treasury bond rates), say 2%; then add
· A General economic environment risk (example – Europe) plus
· A Sector / industry risk (example – mining in Australia) plus
· The specific company or deal risk
The final rate, anything up to 40% or even more, is applied directly to the numbers so the impact is significant.
Develop a format
This by itself can improve the quality of important decisions taken as you will have a platform to compare the outcomes of various options. Summarise the results by constructing a table.
Tabulating numbers remove confusion. If the numbers cannot be tabulated, there is a problem. The information is summarised in grid format on a spread-sheet and while the format is complex, the assumptions underlying each number need to be thought out carefully:
Take a new spread-sheet and insert:
o Years or months (top)
o Relevant cash-flows (side)
o Totals (bottom)
A further line can be added to discount the net cashflow in each year before summing it all up to arrive at a final net cash flow.
Assign weighting to non-financial considerations
Separately assign qualitative ranking and weighting to the various other factors influencing your decision.
The result is an easy to read summary of the next 3 to 5 years’ financial outcome affected by the decision on the table plus a list of qualitative factors in the decision.
If the net of all the future estimated streams is positive at a point in time, subject to any overriding non-financial input, go ahead and write the cheques