Investment is needed to earn profit for the business!
Business organizations, both in the private sector as well as in the public sector, make investment decisions. But, before a decision regarding any significant investment can be formalized, detailed Investment Appraisal should be undertaken.
What is an investment?
An investment simply refers to purchasing Fixed Assets in the form of capital goods to bring financial benefits in the future. With investing, the business is risking its scarce resources hoping to gain future advantages.
The business makes an investment by spending its cash on capital goods. This capital expenditure is recorded as a one-time cash outflow. In return, the firm is expecting cash inflows to be received over the useful life of the assets purchased.
All investment decisions involve taking risk. The risk comes from uncertainty about the future. Specifically, what will happen with the investment in the future, whether the future will be as planned and whether returns from the investment in the form of cash inflows will keep coming into the business.
So, overall, the firm hopes that future returns from the investment project will compensate for the risk taken today. If the profits are higher than risks, then the investment will be a success. If the profits are lower than risks, then the investment will not be a success.
Examples of business investments
Examples of typical investments in a business organization include the purchase of land, buildings, machinery, equipment, vehicles, etc. Also, improving or upgrading existing Fixed Assets are considered investments too.
Very large investment decisions involve significant strategic issues affecting the whole firm. For example, relocation of the company to another country, changing the production method into mass production or the adoption of the newest IT system.
Other investments which are more department-specific are far less important to the overall performance of the whole business. For example, replacing out-of-date computers, repainting the office building, purchasing a single machine, etc.
Many very minor investment decisions are not thoroughly analyzed by business managers to the same degree of detail as the very large investments that will have serious impact on Final Accounts and the future of the firm.
In business management, an investment is NOT buying shares on the stock market, bonds or banking products!
Why businesses need investments?
Investment in a business is understood as the purchase of new means of production to increase productive capacity. And, increasing productivity (efficiency) means producing more products within the same period of time, or producing the same number of products within shorter period of time.
That is why an investment can be building or buying a new factory, buying a new machine, purchasing a new IT system, etc. Increasing capacity means that a business is able to produce more products to meet the growing demand generating more sales revenue.
How companies pay for investments?
The uses of cash for investments are not directly linked to a firm’s main trading activities – producing and selling products. It is because investment must happen before the products are even produced and sold.
Investment expenditure requires the use of cash for initial capital. Different investments can be financed differently – by long-term bank loans, debentures or selling shares. Large multinational conglomerates usually have multiple revenue streams to pay for their investments. This will also affect the cash flow position of a business as Net Cash Flows are likely to be negative in the short term.
Good Cash Flow is important for catching investment opportunities while poor Cash Flow will result in missed opportunities. When a firm obtains finance for a new investment, Cash Inflows improve the firm’s liquidity position. But as the business buys the investment, it experiences an increase in Cash Outflows. Later, when the business sells an investment, it experiences an increase in its cash flow position again.
What is Investment Appraisal?
Investment Appraisal refers to the quantitative techniques used to evaluate a specific investment. These quantitative techniques enable managers to assess the financial desirability, feasibility and profitability of the new project.
Managers will use Investment Appraisal to evaluate whether future profits from the project will be greater compared against the risk, and by how much. Investment Appraisal judges the investment by calculating the financial revenues and costs of an investment decision.
In more and more businesses these days, it is becoming increasingly common to conduct Investment Appraisal before any new investments are given the go-ahead or being abandoned. The managers are getting better at using available business tools to evaluate their investments.
Moving forward, in the next couple of days, we will consider the information needed to allow for both quantitative and qualitative appraisal of investment projects.
