Profitability cash flow

The measurements of net profit, cash flow, and ROI tell the manager whether a firm is making money and what its relative performance is. Obviously when managers need to make decisions in the course of daily business, they will try to increase profit, cash flow, and ROI. But, it is not always immediately obvious in many decisions which alternative will maximize this return. The break-even analysis and present value analysis do provide information about investments, but they do not provide insight into decisions about how to schedule the equipment and which orders to accept given certain capacity constraints. 

As the design progresses, more information is accumulated. The best methods of assessing the profitability of alternatives are based on projections of the cash flows during the project life. ... 

The point at which the cumulative cash flow turns positive indicates the payout time (or payback time). This is the length of time required to receive accumulated net revenues equal to the investment. This indicator says nothing about the cash flow after the payback time and does not consider the total profitability of the investment opportunity. 

Net Present Va.Iue, Each of the net annual cash flows can be discounted to the present time using a discount factor for the number of years involved. The discounted flows are then all at the same time point and can be combined. The sum of these discounted net flows is called the net present value (NPV), a popular profit criterion. Because the discounted positive flows first offset the negative investment flows in the NPV summation, the investment capital is recovered if the NPV is greater than zero. This early recovery of the investment does not correspond to typical capital recovery patterns, but gives a conservative and systematic assumption for investment recovery. 

Possible numerators include the gross income net pretax income net after-tax income gross profit, ie, gross income minus book depreciation cash flow or net income. An average return value is selected by defining a typical or mature proof year as the basis of calculation. The denominator can be the original total investment, depreciated book-value investment, lifetime averaged investment, or fixed capital investment. 

Annual Costs, Profits, and Cash Flows To a large extent, accountancy is concerned with annual costs. To avoid confusion with other costs, annual costs will be referred to by the letter A,... 

In modern methods of profitability assessment, cash flows are more meaningful than profits, which tend to be rather loosely defined. The net annual cash flow after tax is given by... 

The relationships among the various annual costs given by Eqs. (9-1) through (9-9) are illustrated diagrammaticaUy in Fig. 9-1. The top half of the diagram shows the tools of the accountant the bottom half, those of the engineer. The net annual cash flow Acp, which excludes any provision for balance-sheet depreciation Abd, is used in two of the more modern methods of profitability assessment the net-present-value (NPV) method and the discounted-cash-flow-rate-of-return (DCFRR) method. In both methods, depreciation is inherently taken care of by calculations which include capital recoveiy. 

FIG. 9-1 Relationship between annual costs, annual profits, and cash flows for a project. A d — annual depreciation allowance Acf — annual net cash flow after tax Ac/ = annual cash income Age = annual general expense Aqp = annual gross profit A/r = annual tax A e = annual manufacturing cost Avc/ = annual net cash income Avvp = annual net profit after taxes A/ p = annual net profit As = annual sales Apc = annual total cost (DCFRR) = discoiinted-cash-flow rate of return (NPV) = net present value. 

Payback Period Another traditional method of measuring profitability is the payback period or fixed-capital-return period. Actually, this is really a measure not of profitability but of the time it takes for cash flows to recoup the original fixed-capital expenditure. 

The payback-period method takes no account of cash flows or profits received after the breakeven point has been reached. The method is based on the premise that the earher the fixed capital is recovered, the better the project. However, this approach can Be misleading. 

Let us consider projects A and B, having net annual cash flows as listed in Table 9-2. Both projects have initial fixed-capital expenditures of 100,000. On the basis of payback period, project A is the more desirable since the fixed-capital expenditure is recovered in 3 years, compared with 5 years for projec t B. However, project B runs for 7 years with a cumulative net cash flow of 110,000. This is obviously more profitable than project A, which runs for only 4 years with a cumulative net cash flow of only 10,000. 

Equation (9-54) may be solved for i either graphically or by an iterative trial-and-error procedure. The value of i given by Eq. (9-54) is known as the discounted-cash-flow rate of return (DCFRR). It is also known as the profitability index, true rate of return, investor s rate of return, and interest rate of return. 

No single value for a profitability estimate should be accepted without further consideration. An inteUigent consideration of the cumula-tive-cash-flow and cumulative-discounted-cash-flow curves such as those shown in Fig. 9-10, together with experience and good judgment, is the best way of assessing the financial merit of aprojec t. 

When comparing project profitability, the ranking on the basis of net present value (NPV) may differ from that on the basis of dis-counted-cash-flow rate of return (DCFRR). Let us consider the data for two projects ... 

These (NPV) data are plotted against the cost of capital, as shown in Fig. 9-12. The discounted-cash-flow rate of return is the value of i that satisfies Eq. (9-5). From Fig. 9-12, (NPV) = 0 at a (DCFRR) of 11.8 percent for project C and 14.7 percent for project D. Thus, on the basis of (DCFRR), project D is more profitable than project C. 

Comparisons on the Basis of Capitalized Cost A machine in a process generates a positive net cash flow of 1000. Two alternatives are available machine L, costing 2000, requires replacement every 4 years, and machine M, costing 3000, requires replacement every 6 years. Neither machine has any scrap value. The cost of capital is 10 percent. Which machine is the more profitable to operate ... 

Let us consider the effect of differential inflation on the overall profitability of the project of the last example. The effect of general inflation on this project showed that the apparent profitability rises sharply, to an (NPV) of 431,269 at a general inflation rate of 20 percent. However, when the cash flows of the (NPV) are properly corrected to their purchasing power in Year 0, the (NPV) instead becomes 208,733. 

The method of allocating overheads can seriously affect the assigned costs of a project and hence the apparent cash flows for that project . Since these cash flows are used to assess profitability by the net-present-value (NPV) and discounted-cash-flow-rate-of-return (DCFRR) methods, unfair allocation of overhead costs can result in a wrong choice between alternative projec ts. 

As can be seen in Table 2 all revenues less expenses associated with selling are summed in Row 17. All expenses including noncash expenses such as depreciation, amortization, and depletion are summed in Row 30. The net profit before tax, Row 32, is obtained by subtracting Row 30 from Row 17 and making any inventory adjustment required. Row 34 is the cash taxes that are to be paid unless offset by investment or energy tax credits in Row 36. The deferred income tax is shown in Row 35. The deferred tax decreases the net profit after tax in the early years and increases the net profit after tax in later years. The impact on cash flow is just the other way around as discussed later. Row 37, profit after tax, is obtained as foliow s ... 

Because it is the goal of any business to make a profit, the costs-and-benefits cash flows for each option can be related to the basic profit equation ... 

The net profit is the total income minus operating costs minus depreciation minus tax. The ROI is often calculated for the anticipated best year of the project the year in which the profit is greatest. This criterion is also used for small investments. In general, acceptable ROT are about 20 %, but typical values are difficult to give. Both POT and ROI provide a one-moment-in-time view and do not take into account future cash flows, which may not be constant in the lifetime of the venture. 

Net cash flow is a relatively simple and easily understood concept, and forms the basis for the calculation of other, more complex, measures of profitability. 

Rate of return ROR % Measures performance of capital Takes no account of timing of cash flows Dependent on definition of income (profit) and investment... 

Economic analysis can determine the discounted profitability criteria in terms of payback period (PBP), net present value (NPV), and rate of return (ROR) from discounted cash flow diagram, in which each of the annual cash flow is discounted to time zero for the LHS system. PBP is the time required, after the construction, to recover the fixed capital investment. NPV shows the cumulative discounted cash value at the end of useful life. Positive values of NPV and shorter PBP are preferred. ROR is the interest rate at which all the cash flows must be discounted to obtain zero NPV. If ROR is greater than the internal discount rate, then the LHS system is considered feasible (Turton et al., 2003). 

Figure 27 shows the discounted cash flow diagram obtained from Table 8 using the data in Table 7. A net present value of 102,462.21 is obtained at end of 15 years of useful life operation, which shows a profitable investment. Approximate discounted payback period is about eight years. Discounted... 

As a more complete picture of the project emerges, the cash flows through the project life can be projected. This allows more detailed evaluation of project profitability on the basis of cash flows. Net present value can be used to measure the profit taking into account the time value of money. Discounted cash flow rate of return measures how efficiently the capital is being used. 

---