How to evaluate a capital investment: 5 questions to ask
A capital investment can be a crucial step in growing your business and achieving your strategic goals. Or it could saddle you with soaring, unexpected costs that imperil your finances and derail your growth.
Whether it’s machinery, equipment, real estate, vehicles, software or hardware, the success of a capital expenditure often depends on whether you adequately planned the purchase and aligned it well with your business strategy.
“Many businesses make capital investments emotionally without a thorough assessment of the opportunity,” says BDC Senior Business Advisor Jorge Henao, who specializes in financial management and strategy. “Business owners often put their company at risk by not considering all the aspects of the investment.”
Henao advises entrepreneurs to ask the following five questions when evaluating a capital expenditure.
1. Is it a good strategic fit and the right timing?
A good investment isn’t necessarily the right investment for your business. You should also consider its strategic fit for your business and the timing.
Be sure the project fits with your company’s needs and overall strategy for the next several years. A nonstrategic purchase may offer a nice return, but could detract attention and resources from your core business, which may suffer.
Timing is another often-overlooked issue. Think about the current outlook for your business and industry and any potential disruptions on the horizon.
If your business is in high-growth mode, it’s not a good idea to buy a building that doesn’t take into account your most likely scenario of required space.
Henao gives the example of an investment in property. “It’s very typical for entrepreneurs to have a fixation with real estate. They think the best option is to acquire their own building. The question I always ask is, ‘Is it the right time?’ Do you know what your required capacity will be in five years? Will the building be big enough?” he asks.
“If your business is in high-growth mode, it’s not a good idea to buy a building that doesn’t take into account your most likely scenario of required space. The investment will also take cash away from growth. You’d be better off waiting until your business stabilizes.”
2. Is it a good investment?
Do a cost-benefit analysis of the investment to make sure it’s a good opportunity for your business. Various methods exist to do this, such as:
- payback period (expected time to recoup the investment)
- accounting rate of return (forecasted return from the project as a portion of total cost)
- net present value (expected cash outflows minus cash inflows)
- internal rate of return (average anticipated annual rate of return)
The results depend heavily on your estimates for the revenues and costs. It’s common for business owners to overestimate the projected revenues of an investment, while underestimating or even ignoring major expenses, such as implementation, hiring, training, downtime, transition time, maintenance, upgrades and financing.
“Any analysis requires a lot of assumptions,” Henao says. “You have to make sure your numbers are realistic. In many cases people tend to be too optimistic.”
It can be helpful to make a set of calculations for various scenarios—worst case, best case and most likely. Think about how your business would be affected in each case.
You should also weigh the investment against alternative options, such as fixing or improving existing assets, or doing nothing at all. “Is it going to bring you a competitive edge, and can you quantify that?” Henao asks.
Ask yourself what risks you could face if you don’t make the investment.
- Could you lose clients or be surpassed by competitors?
- Could it limit your ability to make other necessary investments?
3. What are the cash flow impacts?
Many business owners neglect the effect of their capital expenditures on cash flow. This can be a critical mistake. It’s important to include all expected outflows in your cash flow projections, such as acquisition costs, lease payments and interest on additional financing.
Even if the investment makes sense from the economic standpoint, you have to make sure it does so from the cash flow perspective as well. An investment could have a good return, but your operations may not generate enough cash flow to absorb the increase in outflows.
“Making the investment without looking at cash flow could put you out of business,” Henao says. “Even if it’s a good investment, in many cases businesses can’t afford it without proper financing in place.”
4. What financing will you need?
Once you project the cash flow impacts, you can more easily determine your financing needs.
Bankers will want to see up-to-date financial information, such as your company’s assets, liabilities and cash flow history, plus a solid case for the investment and your overall business plan.
“It’s a very common mistake for businesses to think that just because it’s a good investment, they’ll get financing,” Henao says.
Projecting the cash flow impacts also lets you approach bankers about financing ahead of time, not in a crisis when financial institutions may refuse the loan.
5. Have you considered all other impacts of the investment?
A major project can have implications on many aspects of your business, such as sales, procurement, production and delivery capabilities.
For example, have you thought about the impacts on your workforce? Henao gives the example of a business that bought a large new plant to consolidate operations. The project required relocation of all existing employees, but only a few were willing to make the move. Finding qualified employees in the new location and attaining required efficiency translated into huge costs for the business, which contributed to serious cash flow problems.