Business profitability assessment methodologies for investment decisions

JWI 531 Financial Management II, week4 summary, 5/5/13

A practical approach to assessing business development opportunities would include:

I. Business development - assess the return and profitability of projects/opportunities. 
Real world Methodology (courtesy CH):
Go out five to seven years and map out the following:
    1. Determine Assumptions (pricing, market size, competitive positioning, etc.)
    2. Year by Year Revenue stream - this in itself can be fairly complicated
        product/s and/or services
        pricing
        volume
    3. Year by Year Costs at a high level
        Margin
        Sales Channel costs  (distributor margins, direct sales costs, whatever)
        Marketing costs
        Development costs
    The above allow you to figure year by year revenue and gross margin
    4. Determine the payback/breakeven
    5. Compare against other opportunities/scenarios if there are any
    6. Determine market impact (market share gained/taken, available market (size in dollars), market potential (in dollars), etc.)
    7. Highlight key risks / barriers
    8. Highlight additional opportunities that may be achieved
    9. What-If Scenarios - e.g., what if sales are lower than expected... what % off can you be before your calculation goes negative (you lose money)
    10. Highlight key dates (start by, must finish by, etc.)

II. Use 10K 10Q reports of competitors and figure out for the following for the firm:
    Revenue by Market
    Equipment pricing
    Disposable pricing
    Num salespeople (fixed costs)
    Num clinical support people (fixed costs)
    Ratio sales:clinical support
    Revenue per sales person
    Product sold per sales person
    # of accounts
    Avg Revenue per Account
    Avg Equipment/Rev per Account
    Avg Accounts/(Salesperson & Support)
    COGS
    Margin
    Avg. Margin per Salesperson

III.Leaders checklist for investment decisions
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As leaders, we needs to make sound investment decisions based on several factors including:
(i) strategic goal of the organization and the fit of the project vs the goal
This is the single most important factor.
If a project deviates from the strategic direction, success may be short lived and the firm may get in deep trouble sooner or later.
(ii) opportunity cost of investment
Every project needs to be measured with the next best alternative.
(iii) risk/reward of a project
Potential for higher reward means higher risk needs to be embraced.
Distribute the risk by betting on parallel projects with:
Higher risk - longer payback, higher potential upside
Modest risk - push the boundary
Bedrock - protect the business with minimum returns
(iv) profitability of the project vs cost of capital and hurdle rate
The higher the profit potential over the hurdle rate, the more attractive the projec
(v) time it takes to get to profitability ie break even and pay back period
The shorter the time, greater the incentive
(vi) liquidity to meet working capital needs ie cash-needs in short and medium term
investing in the project should not cause a hole in the firm's cash flow management

IV. Break-even Analysis
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Break-even analysis is a financial tool that allows an estimation of number of units of a product a company needs to sell in order to break even (hbsp.harvard.edu).

Pros
+ Captures the moment in time when an investment becomes profitable and therefore self-sustaining (JWI 531, W4 L1)
+ Helps working capital allocation decisions
+ Firms with irregular cash flows can plan ahead and benefit

Cons
- It assumes price and cost structure for the product are constant which may not hold true
- Gets more complex to calculate for multiple-product multiple-cost situation

V. Payback period analysis
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It is the length of time taken for investors to recoup all of the costs incurred to make the project happen (JWI 531, W4 L1).

Pros
+ Helps assess Liquidity and Risk ie shorter the payback greater the liquidity and lower the risk (Brigham & Enhrhardt, 2009)

Cons
- Hidden Costs need to be accurately captured
- Cash earned beyond the payback period is ignored
- May not correlate to stakeholder's wealth

When used carefully, break-even and payback analysis can help make informed decisions,
especially when used as a complement to other project valuation and analysis methods.



Dr DP