Financial performance is the key underlying foundations of an organization. Some of the important financial measures that organization uses to assess or forecast the financial performance are discussed.
Net present value (NPV)
The net present value (NPV) of an amount to be received in future is given by the formula for using the time value of money to appraise the long term projects.
P = A (1 + i)-n
Where, P is net present value, A is the money that is to be received in ‘n’ years from the present time and ‘i’ is annual rate of interest depicted as a decimal like if i is 10%, then 0.10 is taken to calculate the NPV. This measure is used to select the project with the maximum Net Present Value. The time value of money is already taken into account while calculating NPV. As an example
Assume that Rs. 2400 will be available in five years. What is the NPV of that money if the annual interest rate is given as 9%. Solution – Substitute A as Rs. 2400, n as 5 and i as 0.09 in the formula. We have P = 2400(1 + 0.09) = Rs. 1559.84 Thus, Rs. 1559.84 invested at 9% for five years will be worth Rs. 2400.
Another example, there are 2 projects. Project A has as NPV of Rs. 1,000 and will be completed in 5 years. Project B has a NPV of Rs. 800 and will be completed in 1 year. Which project to select? Solution – Project A will be selected. The fact that project B has a lesser duration than project A does not matter because time is already taken into account in NPV calculations.
Return on investment (ROI)
Usually, ROI is used to estimate the organization’s potential to utilize its resources to produce revenues. It is one of the most common financial measures. It is computed as
ROI = Net income/Total investment x 100%,
Where, net income includes the money that is earned or expected to be earned by the project and money that is saved by avoiding certain costs. Investment refers to the money that is needed to carryout the project. Another ROI approach is to calculate the ‘amortization’ time, i.e., the time in which the organization can get back the money invested on the project. Thus, it is also known as ‘payback period’.
Cost-benefit analysis
Cost-Benefit Analysis is done before the project is initiated. It is conducted in the following way
- List the anticipated benefits of the project.
- State the benefits in financial terms and specify the time limits.
- List the costs involved in undertaking the project.
- Compute whether the benefits exceed costs and decide whether to implement the project or not. At times, the management may decide to implement a project even when the costs exceed the benefits, for instance, projects that provide social benefits, projects that are prestigious to the organization, etc.
Some of the indicators used in cost-benefit analysis are Present Value of benefits (PVB), Present Value of Costs (PVC), NPV (NPV = PVB – PVC), and Benefit-Cost Ratio (BCR).
Benefit- cost ratio (BCR) is calculated using the formula
Benefits (payback or revenue)/costs
BCR can be used as project selection criteria. A project with higher BCR is preferable while selecting projects, as an example
There are 2 projects. Project A has an investment of $ 500,000 and a BCR of 2.5. Project B has an investment of $ 300,000 and a BCR of 1.5. Using the Benefit Cost Ratio criterion, which project to be selected?
Solution – Project A will be selected as project B has a lower investment than project A will not impact the selection.
