Strategic financial analysis for successful investing.

An integrated approach to investment decisions includes elements of strategic manufacturing, marketing and financial planning.

Making successful investment decisions on acquisitions, plant expansions, new equipment and the like, requires an integrated approach including elements of strategic manufacturing, marketing and financial planning. Too often the financial analysis is only "window dressing"--producing numbers for bankers and the board of directors--that contributes very little to the actual decision-making process.

Strategic and marketing factors may correctly drive the final investment decisions. The analysis of these considerations could fall short, however, unless those intangibles are integrated into appropriate financial models that are being used (or should be used) to evaluate the investment opportunity.

To optimize decisions, it is essential that important strategic and marketing facts, assumptions and other project intangibles be incorporated into those financial evaluation models. The process of working toward such an integrated investment evaluation is called a strategic financial analysis (SFA). This analysis produces these benefits:

* Management will ask more and better questions regarding investment assumptions, resulting in a rigorous evaluation of the opportunity.

* Results of financial calculations will be more in line with management thinking, both of which will be improved by going through the process of SFA.

* Investment opportunity will be easier to "sell" to all stackholders, including potential sources of financing.

* The entire management team will be educated and motivated to a higher level of strategic thinking--not just regarding the investment, but in all its management activities.

Financial Models

The goal of investing in metalcasting, as in all industries, is to create value for business owners. There are many good ways of measuring whether a proposed investment will create value. Two methods used as a basis for illustrating SFA will be introduced here.

The receipt or disbursement of cash is what affects every firm. In the first example of a financial model, the incremental costs and benefits of an investment are used to estimate cash flows for its useful life. Those cash flows are then used to calculate a net present value (NPV) for the investment.

This NPV calculation is based on the time value of money, with future cash flows discounted according to carefully selected discount rates and the number of years in the future in which the cash is anticipated to be received. When the initial investment amount is subtracted from the NPV of future cash flows, it results in a very good measure of the financial value that is expected to be created for the investing owners.

The second model is a form of return on investment (ROI), which often is not a rigorously defined term. It can be used to indicate Return on Assets, Return on Equity or any number of other valid financial measurements. The broadest and best definition, however, and the second example, is return on capital employed (ROCE).

ROCE compares total net earnings to total capital employed, omitting nothing in the financial measurement. Total net earnings equal net interest cost (positive or negative) plus aftertax profits. Total capital employed equals equity capital plus any interest-bearing debt.

Evaluating an investment opportunity using ROCE involves projecting total net earnings and total capital requirements for the company or division for each year of the life of the investment, and calculating ROCE for each year. Both total net earnings and percent ROCE are then compared with a "base case"--that is, what would happen if the investment is not made.

The Myth of Financial Models

As widely accepted as NPV and ROCE models are in evaluating potential investments, these are only arithmetic in relation to the true nature of investment opportunities. Both NPV and ROCE are ultimately derived from strategic and marketing factors. To have a positive NPV or a high ROCE, a project must pass these two tests:

* Will the resulting products (castings, core adhesives, molding equipment, etc.) have enough value for enough customers for a long enough time to support prices and volumes that exceed the costs of producing and marketing them, including the cost of capital? This question goes to the heart of success through matching capabilities with marketplace needs and wants.

* Does the company have enough sources of sustainable competitive advantage to exploit, develop and defend the opportunities which the proposed investment presents? This question reflects the need to consider the competitive environment and trends, as well as the company's strengths and weaknesses relative to competitors.

Only if answers to these questions are accurately determined and correctly integrated into the financial models will the results of those financial calculations reflect the true nature and wealth-producing potential of the proposed investment. On the other hand, the thought and effort that must go into quantifying those answers and integrating them into financial models mean that strategic and marketing assumptions will be examined and new management insight will be developed in regards to the attractiveness of the project.

During this rigorous examination of key strategic and marketing assumptions, these additional questions must be addressed:

* What are the key assumptions that support sales forecasts?

* Has rigorous market research been conducted to verify those assumptions?

* How well do we know our competitors and their potential actions and reactions that could upset our plans?

* Do we really know what prices we will be able to charge?

* How will we defend our market position?

* What really is the useful life of this investment and will it have any tangible or intangible residual value?

These and similar questions will be developed through the process of integrating managerial judgment and financial models. Such questions will ensure that all significant investment assumptions are examined--including some that may have otherwise remained "hidden" from key decision-makers.

The following sections examine some examples of how SFA can be used to quantify and enhance managerial judgment and project intangibles.

Base Case

One area of managerial judgment that isn't usually quantified is the base case--or the alternative to making the proposed investment. Top management and/or marketing officials may believe that without the investment, the foundry will lose competitive position and/or profit margins that could lead to financial losses and the potential demise of their operation. Alternatively, they might believe that competitors have plans to offer additional value-adding services, such as machining. Their fear is that this will lead to an erosion of market share and profitable sales for the company unless it makes similar investments.

Financial models have a way to incorporate such managerial and marketing factors through the proper use of a base case. A base case is an analysis of what will happen to cash flows and capital requirements if the investment is not made. For the two sample models, the NPV of the investment then becomes the discounted difference between forecasted cash flows for the proposed investment and the base case.

ROCE is evaluated separately for the investment and base case, and the two are compared on percent return on capital employed, as well as absolute profit dollars generated.

Managerial and marketing judgment should be quantified in developing the best possible base case scenario. Too often the status quo is assumed as the alternative to making an investment. This is seldom so, since market and competitive dynamics will invariably change existing sales and profit levels.

If sales are eroding, or will erode due to anticipated market trends or competitive actions (pointing to the necessity of knowing and understanding markets, customers and competitors), the base case should be defined as declining sales and profits. If pricing can't be maintained without an increase in value-added service, profits may drop even if sales can be held constant. An investment that might appear unacceptable when compared to a status quo base case could become attractive if the base case is correctly defined as a decline in profitability.

Leveraging the Investment

Managerial insight should also be used to quantify every benefit that is reasonably expected to accrue from the proposed investment. Each investment should produce the maximum benefit--and multiple benefits--where possible. Top management, marketing, manufacturing and finance officials should carefully consider the nature of each proposed investment and use their best judgment to determine if, either as currently structured or through some restructuring, the investment can and will produce multiple benefits for the firm.

For example, would investment in new molding capacity increase the foundry's ability to market castings produced on current molding units? Can a proposed investment in new chemical binder production equipment be structured to improve efficiencies and/or quality in other foundry chemicals production? Will an iron castings producer make better use of current sales and distribution resources by acquiring an aluminum operation?

If such multiple benefits can be realized, they should be quantified to the extent possible and added to the analysis. Ancillary benefits will often tip the scale for a project that appears to be marginal financially.

SFA=Good Decisions

The use of good financial models to evaluate acquisitions, plant expansions, new equipment and the like is by no means universal in metalcasting. Unfortunately, multimillion-dollar investments are made regularly with only minimum financial modeling and analysis.

It is even rarer that any attempt is made to incorporate managerial judgment and project intangibles into financial models. Making such an attempt through SFA techniques, however, will dramatically enhance the likelihood of a good investment decision, as well as sharpen managerial decision-making skills.

Bibliography

P. Barwise, P. Marsh and R. Wensley, "Strategic Investment Decisions," Research in Marketing, vol 9, pp 1-57 (1987).