There is an eternal doubt about the criteria to evaluate an investment project and whether they are considered reliable, in addition to agile and precise management to make decisions to undertake or improve production processes.
In this article, an analysis generates five financial indicators considered the most recurrent that evaluate investment projects for their practicality in the calculation and the financial information they provide in their study and interpretation.
Some methods propose to generate an evaluation and plan as correct and precise as possible, estimating the return on investment in a given time, but above all, the level of profitability that the proposed business alternative can present.
The following methods to evaluate projects are the most common in financial analysis. It is worth mentioning that they have their limitations, pros, and cons, so it suggests carrying out at least three so that the decision happens on the results or more constant trends.
The five financial profitability indicators that are most frequent to evaluate investment projects are:
- Net present value.
- Internal rate of return.
- Cost-benefit ratio.
- Profitability index and the method of investment payback period.
Each project’s cash flows or net profits must be calculated as the first analysis element. All the numerical elements for the calculations must be at the present value.
Below are the indicators and what we can expect from each of them:
- The net present value (NPV) is the difference between the market value of an investment and its cost; it essentially measures how much value is created or added by making a particular investment.
- NPV> 0, accepted
- NPV = 0, investor’s decision
- NPV <0, not accepted
When evaluating an investment project based on the NPV, it must consider the analysis criteria of the indicator.
- The internal rate of return (IRR) is the second most used indicator in addition to the NPV. The IRR is about finding a single rate of return on the project. It must take investment into account if the IRR exceeds the required return. Otherwise, it must be rejected. The IRR is the return required for calculating the NPV with that rate equal to zero.
An analysis is generated between two rates, with which a calculation was made of two NPVs to include both amounts (rates and NPVs) in the formula.
- The benefit-cost ratio (B / C) is the indicator that helps us compare income and costs at present value to obtain a result that tells us how much it costs and thus has good results.
The income and costs are updated and adding the investment, and after making the calculation that marks the formula, a return greater than unity is expected.
- In most cases, the profitability index (IR), if the IR is greater than 1, the NPV is positive, and if it is less than 1, the NPV is negative. IR measures the value created per unit invested.
- For each unit invested, the same unit and a surplus are expected.
Annual cash flows or earnings are updated and divided by investment.
- The investment recovery period determines the time it takes to regain the investment.
A project is accepted if the time to recover the investment is less than the established period.
After knowing the five profitability indicators most used to evaluate investment projects and thus manage to make decisions to invest or improve processes, the question arises, which method is better to use?
Most of the investors managing in the corporate and financial world mention that the NPV is the most reliable measure; it can decide if a project is a good investment or convenient to grow a business.
When an analysis of profitability indicators happens, the results take a trend. If some mark an acceptance posture, the other indicators will take the same path. If they do not, it could say that it is poorly calculated.About Complete Controller® – America’s Bookkeeping Experts Complete Controller is the Nation’s Leader in virtual bookkeeping, providing service to businesses and households alike. Utilizing Complete Controller’s technology, clients gain access to a cloud platform where their QuickBooks™️ file, critical financial documents, and back-office tools are hosted in an efficient SSO environment. Complete Controller’s team of certified US-based accounting professionals provide bookkeeping, record storage, performance reporting, and controller services including training, cash-flow management, budgeting and forecasting, process and controls advisement, and bill-pay. With flat-rate service plans, Complete Controller is the most cost-effective expert accounting solution for business, family-office, trusts, and households of any size or complexity.