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. You could be putting your company at risk by not considering all the aspects of an investment.”
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 the timing and its strategic fit.
Be sure the project aligns 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 recommended that you purchase a building that doesn’t take into account the space you're most likely require.
Take the example of an investment in property. Entrepreneurs are often very interested in real estate. They will think the best option is to acquire their own building. Questions to ask are: Is it the right time? Do you know what your required capacity will be in five years? Will the building be big enough?
If your business is in high-growth mode, it’s not recommended that you purchase a building that doesn’t take into account the space you’re most likely to require. 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 for doing this exist:
- 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 costs and revenues. 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 some assumptions. You have to make sure your numbers are realistic. People too often tend to be 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?
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 impacts on your cash flow?
Even if the investment makes sense from an economic standpoint, you also have to make sure it makes sense from a cash flow perspective. An investment could have a good return, but your operations may not generate enough cash flow to absorb the increase in outflows.
It’s important to include all expected outflows in your cash flow projections, such as acquisition costs, lease payments and interest on additional financing.
Making the investment without looking at cash flow could put you out of business. Even if it’s a good investment, in many cases companies 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 common mistake for businesses to think that just because something is a good investment, they will automatically get financing.
Projecting the cash flow impacts also lets you approach bankers about financing ahead of time, and 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? Take the example of a business that buys a large new plant to consolidate operations. The project requires relocation of all existing employees, but only a few are willing to make the move. Finding qualified employees in the new location and attaining required efficiency translates into huge costs for the business, which then contributes to serious cash flow problems.
Download our guide for entrepreneurs Build a More Profitable Business to gain a better understanding of key ratios you need to track to generate insights from your financial reports.