Financial evaluation of investment projects: some points to remember

Finance or accounting, what is the difference?

First of all, it is important to distinguish between the terms "accounting" and "finance". I often joke with my students that the "F" in the word "finance" stands for future. Simple to remember! By the word future, I mean forecasts. In financial evaluation, these forecasts are linked to the objectives or targets that you wish to achieve with the project in question. The function of finance is therefore to define financial objectives and to estimate whether an investment will be profitable or not over time. The fundamental difference with accounting is that the latter describes everything that has already been achieved. Accounting provides figures on what has happened: thanks to the financial statements, you can take stock of the cash flows (inflows and outflows) related to an investment project.

So these two functions go hand in hand, but their respective roles remain diametrically opposed.

Investment: The objective → result approach

When an investor is interested in a company (we can replace the word company with asset), he already has expectations. These expectations are often called "return" and are always in a minimal mode. In other words, the investor will ask himself what is the minimum profit he wants to obtain, what is the minimum turnover he wants to achieve, etc., in order to make an informed choice. These expectations, and all the related figures, can be put together in what will become the project budget. This budget will translate the company's orientations or strategy for the years to come. Finance is therefore the function that allows the investor to estimate whether the project is satisfactory or not, while reducing the financial risk to a minimum.

Three pillars to evaluate an asset

When analyzing an investment project, you should keep in mind these three simple pillars, which will be the foundation of a balanced, quantified reflection, devoid of any sentimental impulse that you might be tempted to give to a project. By "sentimental", I mean that we can sometimes have a tendency to be voluntarily blind, to be emotional, about certain data. For example, because we want to take over the family business at all costs, or because a project is a crush. Beware, this can play tricks on you if your analysis is not strictly based on accurate data that takes into account all the levers presented below.

First pillar: Know the asset in its environment

As simple as it may seem, it is not possible to evaluate a building if you have never seen it! It is very important to understand that a valuation requires that we know the asset. When I say "see it", I am not necessarily talking about physically seeing it (although), but rather knowing its characteristics: its location, the competitive market, its past performance, etc. I need to describe my asset in its internal and external environment: I want to understand the interactions between my asset and its peers. Some professionals even mention that the external environment is responsible for 50% of the asset's value. Think of the economic, political, epidemiological, etc. framework. It is a process that must be systemic.

Second pillar: Forecasting and free cash flow.

You will notice that I added "available" to the term "cash flow". Why? Because we tend to forget to analyze the cash flows that are actually available to the organization. As my grandmother used to say, we only spend our income! When the investor makes the choice to invest in an asset, he expects a return of money. This money is the cash flow we are talking about. In theory, the company will generate these cash flows and make them available annually. Afterwards, this investor will have the choice to withdraw these funds or reinvest them. Now, it remains to be seen how the investor plans to generate sustainable cash flows for the company: what level of return he wishes to obtain, over what period, etc. These objectives will facilitate the involvement (or not) of the investor in a project, since he will be able to foresee future cash flows.

Attention: This second pillar assumes that we have analyzed the first one very well. The study of the internal and external environment as well as all the conditions related to this project have been well taken into account.

Pillar Three: Calculating the level of risk

What is a risk in finance? I mentioned at the beginning of this article that the finance function is equal to future. Thus, the risk in finance is not to reach the financial forecasts. However, it is possible to classify risks in order to determine what represents, for the investor, an acceptable risk or, on the contrary, a scenario in which he is not ready to invest. Risks can be multiple. For example, one can miss the planned target because a major customer defaults. Another risk is the possibility of a new confinement, while you are in the hotel business. The important thing is to identify why you have not been able to reach your forecasts, over a given period. Based on this risk, the investor calculates the desired return each year (or within a selected period), which is called the investor's required return.

No matter what the project, it's always the same process!

The evaluation of an investment project is therefore a process that can be complex, but where the pillars to consider will always be the same. It is therefore essential to keep them in mind, regardless of the projects you have or the assets you wish to acquire. Never hesitate to call on an expert in the financial world to help you in this type of decision: you will reduce your personal risk and avoid potential mistakes! Until then, good luck in your investment projects!

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