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Manufacturing Cycle Time 


PART II. 

 

The best way to evaluate any opportunity is by using the dis­counted net cash flow method. In fact, most financial methods of measuring financial value are really indirect means of measuring discounted net cash flow. For practical reasons, the discounted net cash flow method is mostly used just for capital expenditure evaluations. Table 1 shows a simple discounted net cash flow evaluation for a proposed capital expenditure to reduce manufac­turing cycle time through implementing software.

You have probably seen similar calculations, perhaps under a different name. Central to the calculation is a reliable estimate of the cash out flows (the investment) and the cash inflows (the return). Another key factor is the discount rate. I have seen the discount rate described using such terms as the hurdle rate, the risk rate, and other terms. These really describe the same thing. The purpose of the discount rate is to discount the cash inflows to account for the time value of money and to discount them for the riskiness of the venture. The riskier the venture, the higher the discount rate needed. I have seen a discount rate of about 12% being used for well-understood investment decisions such as increasing the capacity of a bottleneck while, as a rule, a venture capitalist uses a discount rate of about 50%. The higher the discount rate, the less important the cash inflows further out become. In fact, at a 50% rate, anything after about four years becomes meaningless. This fits fine with the idea that with a very risky venture, it's impossible to project the cash flows after four years anyway. This method automatically accounts for the time value of money. Typically, a company will provide the discount rate to use internally as policy.

The discounted net cash flow concept is the basis for every single financial evaluation there is regardless of how the calculation is shortcut or adjusted. This is true whether you are making a hostile take over or you are buying a new car. Before the advent of desk top computers, discounted net cash flow calculations were cum­bersome so approximations were used. The payback period calculation is an example of just such an approximation. Notice it does take into account the time value of money. A return of investment in two years is better than a return in three years. It does not adjust for the magnitude of the cash flows or the riskiness of the investment but most people are equipped with an organic functioning CPU that can develop a feel for just such things.

Now for the good stuff. We've briefly seen how the discounted net cash flow calculation is made. This is typically the method used to evaluate a particular investment within a given company or division. Table 1 also gives some sensitivity values for given assumptions. This is a very simple example that I am giving to illustrate the effects of different discount rate assumptions. You will note that the higher the discount rate the less meaningful are the cash flows further out. This is one reason why, with a certain discount rate, the later cash flows can be ignored. The other, of course, is no one can provide a reasonably accurate market forecast four years out.

Ratio Analysis: Evaluation at a Truly Macro Level

Now we get into some of the indirect methods of financial evaluation. This is where ratio analysis comes in. Four types of ratios are used:

1. Leverage ratios that determine whether an entity can take on more debt or service the debt it already has.

2. Liquidity ratios that evaluate the danger of an entity running into short term problems such as not making the payroll (this is not recommended for those who wish to remain popular).

3. Efficiency ratios that measure how well the entity is doing.

4. Market value ratios that are commonly used to evaluate large, publicly traded companies.

We are going to assume the company has an adequate financial manager so we are going to focus only on the efficiency ratios,

which are the ratios affected most by the manufacturing process.

The various efficiency ratios are noted in Table 2. These are not all of them, nor is this the only way to calculate them. This is just a common set, commonly calculated. The first ratio is the Sales to Total Assets ratio. This is the annual sales divided by the average total assets. The textbooks will tell you a high ratio indicates a company is employing its assets to capacity and that further improvements can only come from additional investment. We will examine the textbook answers when we evaluate the sales. Obviously there are a lot of simplifying assumptions here but remember, this is at the macro level. The distinction between fixed costs and variable costs, for example, get blurred at this level. People like to use this ratio to determine whether additional investment is warranted. If the Net Profit Margin is marginal, you can guess whether top management will be excited about making an additional investment. Management also likes to compare this ratio to those of other companies in the industry to make sure management is on target. Unfortunately, this is often used as an excuse as to why management doesn't have to improve.

Inventory Turnover is a calculation made to evaluate the effi­ciency of the manufacturing process. It is derived by dividing the annual cost of goods sold by average inventory. This has some direct implications when cycle time reduction is considered.

I will throw the Average Collection Period in here to pique your interest. It is the average receivables divided by average daily sales. Believe it or not, manufacturing people have a major impact on this ratio. A complementary variation is the Average Payment Period, which is the average payables divided by average daily purchases. It is used by unenlightened financial people who apparently, are interested in increasing cycle time.

Finally there is the Return on Total Assets, which is net income with interest expense added back, quantity divided by total assets. This ratio, along with its sister ratio, the Return on Equity, is often used to calculate bonuses and raises. The interesting thing about this ratio, other than the fact that it is a very commonly used one, is that it is the product of the Sales to Total Assets and the Net Profit Margin. You maximize the Return on Total Assets by monitoring the other two.

To be Continued


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