Predicting Financial Performance: Critical Data Sources

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Please see response attached, which is also presented below. I hope this helps and take care.

RESPONSE:

Tools for Evaluating Business Initiatives

Some of the tools used for evaluating the potential benefits of various courses of action include internal rate of return (IRR), net present value (NPV), payback period and return on investment (ROI). Ideally, by using such tools thoughtfully and methodically, management can compare a number of possible initiatives in terms of their potential benefit to the organization, so that the organization can choose those with the greatest likelihood of helping it achieve its objectives.
IRR compares potential benefits to a company's cost of capital. NPV and payback period analyses are somewhat different tools used in evaluating potential "investments" of resources. ROI, expressed as a percentage and typically including
calculation of NPV, has become perhaps the most popular metric for this purpose, the formula being:

ROI = Investment Cost - NPV of Savings Investment Cost

As with most things, the devil is in the details. When comparing proposed initiatives, management must be sure that all costs and benefits are included in the evaluation process. This means not only the initial investment but also recurring costs required to maintain the initiative over its intended lifespan. Similarly, when considering potential benefits, the direct, immediate benefits must be included, and also those that may occur as a secondary result of the implementation. And, of course, a specific time horizon must be established. This may be as brief as several months, or as long as several years.

With experience, an organization may be able to arrive at a fairly accurate view of costs, benefits and time frames. Even so, a variety of assumptions must be made. And when evaluating proposals dealing with BI, organizations face additional
challenges. Because it typically supports an organization's operations in numerous areas, the impact of implementing a BI solution ? or of extending or modifying an existing one ? often affects the organization in many different ways. Some of these lend themselves fairly easily to quantifiable measurement, but others may not.

As mentioned in my response to your last posting, critical data sources are used to predict financial performance.

1. Metrics

ROI is the most used metric when you need to compare the attractiveness of a particular investment to another. The results of an ROI calculation are expressed in percentage terms and qualified by a time period. The time period can be a three-year time period or five-year period. However, a three-year period is the standard in software purchasing, since technology becomes effectively obsolete in that time period. Simply speaking, a three-year ROI of 200 percent means that the benefits you accrue over three years are two times greater than the cost necessary to implement the purchase. While ROI tells you what percentage return you will get over a specified period of time, it does not tell you anything about the magnitude of the project. That is why you will often want to know the Net Present Value.

The equation for a three-year ROI is:

[net benefit year 1 /(1+discount rate) + net benefit year 2 /(1+discount rate)^2 + net benefit year 3 / (1+discount rate)^3] / initial cost

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Example1: If the initial cost for your manufacturing company's small new software roll-out was $10,000, your annual benefits minus annual costs are constant at $5,000 for the next three years, and the discount rate is 10 percent, your three-year ROI would be:

[$5,000 / (1 +.1) + $5,000 / (1 + .1)^2 + $5,000 / (1 +.1)^3 ] /$10,000
= $12,434.26 / $10000
= 124%

While ROI tells you what percentage return you will get over a specified period of time, it does not tell you anything about the magnitude of the project. So while a 124 percent return may seem initially attractive would you rather have a 124 percent return on a $10,000 project or a 60 percent return on a $300,000 investment? That is why some companies will often want to know the Net Present Value.

Net Present Value
The Net Present Value (NPV) gives you a dollar value of your expected return and is useful to determine the magnitude of your results. It is calculated by summing the present value of the net benefits for each year over a specified period of time and then subtracting the initial costs of the project. A positive NPV means that the project generates a profit, while a negative NPV means that the project generates a loss.

The great thing about NPV is that it tells you about the dollar value of your savings; the downside is that it doesn't tell you when savings will occur.

The equation for a three-year NPV is:
[net benefit year 1 /(1+discount rate) + net benefit year 2 /(1+discount rate)^2 + net benefit year 3 / (1+discount rate)^3] - initial costs

If we take the hypothetical manufacturing company's new software roll-out example, the NPV would equal:

[$5,000 / (1 +.1) + $5,000 / (1 + .1)^2 + $5,000 / (1 +.1)^3] - $10,000
= $12,434.26 - $10000
= $2,434

The great thing about NPV is that it tells you ...