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
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
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
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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