|
|
 |
|
June 2008 The Value of Value-Based Management Tools NPV and IRR assess financial health by looking at true cash flow in dollars and timing In measuring a company’s financial health, traditional accounting methods work fine – to a point. But value-based methods provide alternative performance indicators and, ultimately, tools for enhancing your company’s value. Traditional Accounting. The limitations of traditional accounting measures are as numerous as they are significant. Traditional measures, such as an investment’s payback period, generally assume no difference in value from one period to another. Similarly, they don’t compare a company’s investment returns to its capital costs. And they are short-term focused, thereby ignoring a company’s long-term outlook. For instance, return on equity (ROE), a traditional financial performance measure, examines one year’s net income. And ROE, which is calculated by dividing annual net income by the book value of equity, has another problem: Net income differs from true cash flow. It includes non-cash items, such as depreciation and amortization, without considering many other cash items, such as debt service, capital expenditures and working capital changes. The book value of equity – the difference between a company’s assets and liabilities – is one more ROE problem. Although the values of most liabilities usually parallel their market values, asset book value is recorded at cost or market value, whichever is lower. In other words, book value typically rests on an asset’s acquisition cost, which ignores an asset’s current value and ability to generate cash flow. Value-Based Tools. Value-based management tools assess a business’s financial condition by looking at true cash flow in terms of dollars and timing. They also compare a company’s returns to its cost of capital. Two value-based measures directly show changes in shareholder value: net present value and internal rate of return. Net present value (NPV) is an indicator of how much value an investment or project adds to the value of the business. It measures the excess or shortfall of cash flows, in present value terms, once financing charges are met. To measure performance using NPV, an analyst converts future cash inflows and outflows into their present values and then totals these present values into one number, the NPV. If the NPV is positive, an investment will earn more than the cost of capital. The higher the NPV, the greater is the shareholder value. Internal rate of return (IRR) differs from NPV in that IRR is an indicator of the efficiency of an investment, while NPV indicates value or magnitude. Further, while NPV is expressed in dollars, IRR is the true interest yield, expressed as a percentage, that is expected from an investment. In general, if the IRR is greater than the project's cost of capital, or “hurdle rate,” the project will add value for the company. These value-based tools look at returns from the investor’s viewpoint. Their use involves calculations that factor in cost of capital and time value of money. These calculations are complicated, requiring intimate knowledge of the business’s cash flow. And, like any other tools, they’re best employed by people who know how to use them. You Get What You Reward. Incentive programs that reward managers who improve short-term accounting indicators often achieve their goals to the detriment of long-term financial performance and value. In your company, you may find significant benefits in incentive programs that reward employees for improving value-based indicators. For assistance in integrating value-based management analysis in your company, contact your Schmidt Westergard & Company audit professional. Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market. |
