Net present value: Understanding your businesses financial health with this critical metric
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Business owners face daily financial decisions around maintaining cash flow, ensuring customers pay on time, and overseeing an adequate bank balance fit to cover payroll and expenses. But other metrics should also play a role in ensuring your company's health.
The primary metric companies use to value their worth is net present value. Net present value combines future cash flows with a discount rate, commonly determined by the cost of lending or the expected return of an investment.
Current headlines of a potential recession in the U.S. have dominated news circuits for several months. Although the timelines vary, many economists predict a recession by the end of 2022, if not earlier. It's important to understand the impact of a recession on business performance and the net present value equation.
The Biden administration has recently increased interest rates to battle inflation. As a result, borrowing money is more expensive than it was in 2021. In addition, the rising prices of goods, services, and commodities impact the cost of producing products or providing services.
Businesses must be prudent when weighing the value of their company or investing in significant capital through the net present value metric. When using the net present value equation, it's essential to choose a discount rate that adequately reflects the considerable changes in the current economy.
This article will discuss how net present value can guarantee your business is on the right financial track, especially in a rocky economic environment.
What is net present value?
In simple terms, net present value, or NPV, represents the current value of all future cash flows for given investment decisions, capital projects, or ventures. When accurately calculated, net present value can help a business owner or manager decide if a cash outlay will result in a positive or negative return.
Net present value is commonly used to evaluate the potential return from various purchasing opportunities. Consider an example of a business owner choosing between 3 pieces of equipment. All 3 pieces of equipment will be effective at making the product, but their yearly cash flows vary.
Equipment A has a net present value of $1,000, whereas Equipment B and C have negative net present values of ($500). All things being equal, Equipment A would provide the best return on the business owner's investment.
Net present value isn't only helpful for calculating the return on large purchases—it can also determine the worth of your business. If you can reliably forecast the yearly cash flows of your business for next year and beyond, you can determine the value of your business to potential buyers or investors.
Calculating net present value
If you plan to calculate net present value by hand, you will likely make mistakes. The NPV formula is complicated, especially if you have numerous cash flows to consider. Most people use financial calculators or the net present value calculator option available in Excel if they need to determine the net present value of an investment opportunity or project.
However, before breaking out your calculator or opening Excel, it's crucial to understand how the net present value formula works as well as the factors involved in its calculation. Net present value can be calculated with the following formula:
The inputs include n, which denotes the year of the cash flow discounted to today's dollars, and the discount rate, which is the cost to borrow money or the expected rate of return on investment.
Why should a business owner know their company's net present value?
Understanding the value of your business is key to making financial decisions. Here are a few reasons for calculating the NPV of your company.
Understand the viability of your business
If your business is barely staying afloat, you'll want to know early to adjust your financial footing. Calculating the net present value of your business can help you determine if the value of forecasted cash flows is in line with your expectations. If you wind up with a minimal or negative net present value, it's time to make some cuts to your business outlays or take steps to increase your revenues.
Determine how much investors should pay for your business
Sometimes businesses need the financial help of investors in order to grow. Understanding the value of your business is crucial to deciding how much an investor should pay to own a part of your organization. If you're planning to sell your company outright in the coming years, understanding its worth can help you sort out the reasonable offers from the not-so-reasonable ones.
Figure out whether you can afford expensive equipment for your business
Equipment is at the heart of many businesses. Purchasing equipment can allow you to produce more products, streamline business processes, and generate additional revenues. However, if the future cash flows of your company indicate that your organization may be struggling to meet its current debts, purchasing equipment may not be the right option. You may want to hold off until the business has increased its profits.
What net present value doesn't tell you
Net present value relies on estimates and assumptions. When valuing a business, you assume that the forecasted profits are accurate. In reality, many factors could change. You could lose customers, resulting in reduced revenue, or your costs may increase due to unexpected expenses.
The discount rate can be challenging to determine. If it's set too high, the NPV decreases. A higher discount rate can lead you to settle for lower investments in your business than are warranted. Make sure you carefully consider the discount rate when calculating the net present value.
As with all formulas, if your calculation relies on inaccurate assumptions, the results you obtain will be wrong. As the saying goes, "Garbage in, garbage out."
What do the results of your net present value calculation mean?
Even if you can calculate net present value, the results of your calculation mean nothing if you don't understand them.
Positive net present value
A positive NPV means you may earn a return on the cash outlay you make today on an investment or capital asset purchase. As long as the assumptions you used when forecasting expected cash flows and selecting an appropriate discount rate are reasonable, you can expect a return that exceeds the amount of your purchase price.
Negative net present value
A negative NPV indicates that a purchase may not be worth it. The cost you pay to obtain a capital asset or make an investment exceeds your expected returns. Essentially, you'll be paying a premium for an asset that won't meet your financial goals. In some cases, a company may choose to go ahead with the purchase if it provides other benefits that aren't financially centered, such as meeting safety regulations or enhancing employee morale.
Other financial metrics for startups to consider
There are a variety of other financial metrics that you can consider when running your business. A few of the ones that startups commonly use include cash flow, net profit margin, and cash burn rate.
There are various ways to calculate cash flow, some of which are quite complicated. Cash flow statements are used for accounting purposes. A cash flow forecast is essential for financial modeling and can give you a heads up when your organization may not have the funds available to cover its expenses. Finally, operating cash flow is the amount of cash generated by the normal operating activities during a specific period.
Most startup owners are interested in managing cash flow, wanting to ensure they have enough money to meet their expenses. To manage cash flow, you'll calculate your total cash inflows minus total cash outflows for a period. Thus, if your weekly sales are $50,000 and you have $35,000 of expenses, your net cash flow for the week is $15,000.
Keep in mind that cash float is an essential part of your cash flow calculations. Not all sales are deposited into your bank account immediately. Cash from a credit sale is not received until the customer pays their bill. Similarly, if you regularly pay a vendor via check, it may take a few days for the bank to draft the money from your account. Understanding the cash float in your business is crucial to understanding cash flow.
Net profit margin ratio
The net profit margin ratio determines how much profit an organization earns as a percentage of its revenues. Net profit is the total income earned after deducting all expenses from revenues over a given period. In general, the higher your net profit margin the better. However, certain industries have smaller net profit margins than others. Comparing your company's net profit margin to others in your industry can provide insight into your organization's performance.
So, how to calculate the net profit margin? As an example, consider a company with $100,000 in revenues. After deducting expenses, the business has a net profit of $5,000. The company's net profit margin ratio is Net Profit / Revenue or $5,000 / $100,000. Thus, for every $1 the company earns in revenue, 5% is profit.
Companies with higher profit margins are usually better positioned to navigate difficult financial periods. A business can then save its profits to cover expenses if the organization takes a sudden downturn.
Many startups don't have positive cash flows in their beginning stages. Often, they rely on funding from the business owner or investors who believe in a company's growth potential. Understanding the burn rate helps financial managers realize how much cash they are spending on overhead. When compared to the amount of money the company has in the bank, the burn rate can determine how long a company has to generate a profit before it simply runs out of cash.
To calculate burn rate, use the below formula:
If a company has $2,500,000 in the bank and $250,000 in monthly operating costs, its burn rate is 10%. In this example, the company has 10 months before it runs out of money to cover costs. A company can reduce its burn rate by cutting expenses or generating revenues.
Other important financial considerations
As a business owner, you'll want to understand how to create a balance sheet and read your financial statements. Monthly financial statements, including the balance sheet and income statement, provide essential insight into your company's economic performance. You can review your income statement and balance sheet to determine if your company has increased its revenues or reduced expenses or has essential upcoming payables due.
P&L management is another crucial factor. You should regularly examine your organization's income statement for essential changes, such as declining sales or increased costs. Understanding changes to your monthly financial position will make it easier to make the adjustments required to keep your company financially sound.
How Ramp's cash flow management features can help your company track net present value and other financial metrics
One of the most pressing problems of managing a business is the time it takes to close the monthly financials. Frequently, financial statements are outdated by the time they're released. Your corporate finance team can attempt to act as a mediator by filling in the blanks and supplying forecasted information in the meantime, but it isn't always accurate.
Ramp offers reporting solutions and seamless accounting that reduce the time your accounting and finance teams need to spend on monthly accounting. We provide real-time reporting of your cash metrics so you can make decisions quickly and efficiently. To learn more, check out Ramp today.
As your streamlined and automated accounting software, Ramp offers real-time reporting solutions that provide the financial metrics you need for your business. At Ramp, we believe that you should have access to your financial details when you need them.
Net present value is the current value of an expected series of cash flows less the investment amount at a given discount rate. Present value is simply the value of future cash flows given a discount rate. The difference is that net present value considers the value of an initial cash outlay, whereas present value does not.
Higher NPVs indicate that potential investments or purchases have higher returns than their initial cost. However, remember that net present value is only as good as the information provided. If any assumptions or estimates are inaccurate, the NPV will be as well.