In a financial analysis it is essential to calculate the cash flows of the investment. To do this, two things must be taken into account:

 

1. When evaluating an investment, we always take into account the cash flows associated with the investment. In doing so, we take into account current prices (thus we consider inflation and projected price and cost fluctuations) rather than constant prices. Cash flows can be negative (if "money leaves the company") or positive (if "money enters the company").

 

2. When evaluating an investment, only the additional cash flows resulting from the investment should be taken into account. Here, several aspects should be considered:

  

• Opportunity costs. If, for example, the company that rented business premises decides to make an investment in those same premises, the loss of the rent represents a negative cash flow deriving from the investment. Similarly, if an old investment is replaced by a new one, the cash flow that was produced by the previous investment is lost. However, the expenses associated with the investment that are prior to the investment decision are not to be considered as investment cash flows, since they would have arisen regardless of the investment.

 

• External effects of the investment. They can be positive (eg if, thanks to an investment, the company improves its market position and can therefore offer better prices on other products as well) or negative (eg due to cannibalism among the products of the same company sales of other products decrease after the investment).

 

• These effects, positive or negative, must be considered as cash flows of the investment.

 

The investment cost (WACC) is not considered in the cash flows of the investment and is implicitly considered later, when economic indicators are calculated.

To put it simply, we can say that the cash flow of every single year for the entire duration of the investment is defined as the sum:

 

1. of profits from exercising the investment after tax
2. of amortization of the investment
3. of the other effects of the investment (opportunity costs and external effects).

 

 For an example of the calculation of the cash flows of the investment, see the section "Managing cash flows over time".

 

Source: Dolenc, P. & Stubelj, I. 2011. Poslovne finance s praktičnimi primeri. Ljubljana.

In the financial analysis of an investment, we distinguish three time periods and three cash flows linked to them: 

1. at the beginning of the investment, we define the initial investment expenditure;
2. over the life cycle, we define cash flows from operating activities and
3. identify any additional cash flows at the end of the investment. 

 

For multi-year investments, the easiest way to determine cash flows is by year, regardless of when exactly they occur. This is a simplification, but it usually does not play a major role in the investment decision based on the investment criteria. 

The easiest way to do this is to prepare a customized income statement for years, calculate cash flows by year, and then apply the investment criteria. 

See a practical example.

Investments face several types of risks, but when talking about financial risks, investments can be reduced to two types of risks that cover everything: risks of changes in individual projected cash flows and risk of changes in financing cost (WACC). The first risks are the most extensive, as changes in the financial plan of the investment may occur due to changes in all assumed parameters of the investment plan, for example: changes in the sale price, changes in sales volume, changes in costs, changes in the final market values ​​of fixed assets, and also changes in the tax rate, etc. The second risk, however, may be an increase (or decrease) in the average cost of capital (WACC), as the general level of interest rates, market and specific risk, etc. change.

Risk management is very important in investment planning and implementation of the investment, and we mainly deal with the risks that can cause changes in the investment's cash flows. The risks of changing the WACC are easier to leave aside if we already consider the long-term estimate of these costs in the initial WACC assessment, i.e. exclusively current market conditions. Thus, we cannot start from the unrealistic assumption that the EURIBOR benchmark interest rate, which was at its lowest levels in 2009, will be so low over the entire investment period.

When it comes to the risks related to changes in cash flows, it is especially important that, when planning an investment, we do not start from a single cash flow forecast, but we rather:

1.  Make a sensitivity analysis, that is, see how much the result would change (see section "How to decide once the financial analysis is done?") if each of the revenue variables (selling price, expenses, costs...), should increase or decrease by 10%, 20% or 30%. In this way, the decisive variables for the outcome of the investment are identified, and they must be kept in mind during the construction phase. If the sensitivity of the investment turns out to be too high, you can also decide not to do it.
2. Perform a scenario analysis, which means defining three or more different scenarios (negative, neutral and positive) and estimating the values ​​of the variables for each scenario. This leads to three scenarios with three possible final solutions. If the result of each scenario is not very different from that of the other two, it means that the risk level is relatively low, if instead it changes a lot then the risk is relatively high. Such an operation allows the investor to carefully evaluate the minimum and maximum risk levels and to decide whether he is willing to take them.