How To Evaluate A Business Investment

The idea fairy often drives the decision to make a business capital investment

. A company can improve its earnings, valuation and industry standing through the realization of dreams and goals. But the dream is only the beginning point. A solid fundamental analysis of the investment opportunity must be completed to ensure it adds tangible enterprise value. The business executive needs to be reasonably sure based on sound financial calculations that a minimum acceptable return on invested capital will be realized.

The most important part of a prospective investment is the gross income that will be generated. The top-line revenue, if it is big enough, will flow through the expenses, any debt service and eventually reach the owners in the form of distributable cash flow. The point of any investment is to make a profit and add value to the business. The primary business income, whether it is lease revenue from tenants or coins from a vending machine, is the key driver for business cash flow. Gross income can be affected by under-utilization of business resources such as vacancy at a shopping center or down time for manufacturing equipment repairs. An allowance for less than 100% revenue generating capacity is a good idea when evaluating a business investment. A portion of revenue may become noncollectable and eventually winds up as bad debt expenses. The investment pro forma should have an estimate for bad debt.

If you are making a capital infusion for an existing business asset you must evaluate only the marginal income that will be generated compared with the marginal or new investment in that asset. The original cost of the asset is irrelevant in the calculation of the return on the new capital contribution. The historical costs are considered sunk costs and do not become part of the new investment pro forma return calculation.

Ancillary sources of income can contribute to top-line revenue in certain capital investments. An office building might generate revenue from billboards on the property. A sports team generates ancillary license revenue from the sale of merchandise. The pro forma evaluation of an investment should include all sources of quantifiable ancillary revenue. Again, some discount should be applied based on the probability of realizing the ancillary revenue.

Operating expenses will usually have the largest impact on operating revenue. We would expect the primary revenue generating activity to also generate most of the expenses. Other types of expenses not related to operating the investment are classified as non-operating or management expenses. These expenses are typically incurred by management but not directly related to operations. The cost of legal and accounting services is an example of non-operating expenses. Certain accrual accounting line items for the smoothing of revenue and expenses should only be included below the net operating income line in the investment pro forma analysis.

Net operating income (NOI) is the difference between the investment operating income and operating expenses. Non-operating expenses can also be included in this calculation if they can be directly allocated to the investment. NOI is one of the most important figures used to evaluate the financing capability of an investment. The amount of debt that can be used to leverage an investment is directly dependent on NOI among other factors. However, an investment should be evaluated on an un-leveraged basis first, that is without debt, when making a capital decision.

Other expenses might come into play including federal, state and local taxes, depreciation, amortization and other accrual accounting items. Again, theses should be included below net operating income and play a less important role in determining the return on a capital investment. Capital expenditures are also below the NOI line and include items like estimates of long term improvements to an investment and capital reserve funds.

The cash flow available for debt service is the net number after subtracting operating, non-operating and capital expenditures. This is the amount of money available to pay monthly principal and interest on any loans used to finance the investment. Over-leveraging an investment can result in negative cash flow, foreclosure and or bankruptcy so this calculation is extremely important.

The owners get paid last with any remaining cash flow that can be distributed or reinvested. Some investors choose to hold distributions in favor of establishing reserves as a cushion against future expected and unexpected expenses. Your capital investment analysis should show a net profit and distribution to ownership. After all, that is the most compelling reason to write the investment check in the first place.

by: Michael Shelton

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