Financial Analysis
Financial analysis weighs the financial viability of an investment option: what it costs, what it returns, over what horizon and under what risks. BABOK places it at the point where one solution is recommended over others. Six measures make up the family and form a chain: total cost of ownership puts a figure on the cost side, cost-benefit analysis draws from it a period-by-period cash-flow table, then return on investment, net present value, the internal rate of return and the payback period read that table from four angles. None of them alone answers the three questions an investment case (business case) has to settle: how much value, at what rate and how long before the outlay comes back.
Goal
Financial analysis judges an investment option on its financial viability, its stability and the realisation of the benefits it promises. It brings together the initial cost and when it is incurred, the expected benefits and their timing, the costs of use and support, as well as the risks attached to the change. Its deliverable is a costed recommendation, together with the assumptions it rests on.
BABOK makes it a continuous exercise. As the estimates sharpen, the analyst runs the analysis again; where the new figures no longer support the original recommendation, he can propose adjusting the change or stopping it. An investment case approved once and then filed away exercises no governance.
The analysis brings unrelated investments onto a common basis, where an executive team can rank them. It also forces the cost and benefit assumptions to be named, which makes them contestable or approvable. Its limits sit in the same place: some costs and benefits resist being put into figures, the exercise is forward-looking and its uncertainty never quite clears. Without a basis of estimation for the costs and the benefits, it returns a result that is precise and wrong. BABOK adds a warning: positive figures give a false sense of security, because they do not tell the whole story of the initiative.
Usage
When to use it
- Recommending among solution options: comparing several approaches on one costed basis before the spend is committed.
- Portfolio trade-off: an executive team ranks unrelated initiatives to decide which ones to fund.
- Contested cost and benefit assumptions: writing them down so they can be argued line by line.
- Stage review during an initiative: running the analysis again as the estimates sharpen, to confirm, adjust or stop.
- Solution in service for a full cycle: measuring the value realised against the value promised in the investment case.
When not to use it
- Benefits that are largely non-monetary: compliance, safety or reputation are weighed by a decision analysis with explicit criteria.
- Reversible decision of low value: the analysis costs more than what is at stake; decide by judgement and record the reason.
Three questions, six measures
Three questions sit under the name financial analysis, and an investment case has to answer all three. How much value does the option create, in francs? At what rate is the capital working? How long before the outlay comes back? Each measure answers one of them and stays silent on the others. That is what BABOK means by saying that a combination of techniques is typically used, each bringing a different perspective.
The six measures form a chain. Total cost of ownership puts a figure on the cost side. Cost-benefit analysis draws from it the period-by-period cash-flow table, benefits minus costs, with the running total. Return on investment, net present value, the internal rate of return and the payback period are four readings of that same table. Seeing the chain avoids the most common error in an investment case, four calculations built on four different sets of assumptions that contradict one another.
Two axes separate these readings. The first is discounting. Net present value and the internal rate of return bring future flows back to what they are worth today; the others work on gross amounts. BABOK's own cost-benefit table is cumulative and not discounted. The second axis is the unit of the result. An amount in francs ranks the options by the value created. A percentage gives the efficiency of the money put in but ignores size. A duration gives the speed of the return.
| Measure | Question it answers | Unit | Discounts the flows | Blind spot |
|---|---|---|---|---|
| Total Cost of Ownership (TCO) | What does owning the solution cost over its life? | Cumulative francs | No | Says nothing about the benefits, so never an investment verdict on its own. |
| Cost-Benefit Analysis | What net benefit does the option produce, period by period? | Francs per period and cumulative | No | The gross running total makes a franc in year 5 look worth as much as a franc today. |
| Return on Investment (ROI) | What return, set against the money put in? | Percentage | No | No time dimension: a return over one year and the same return over five are written alike. |
| Net Present Value | How much value does the option create, in today's francs? | Francs | Yes | Hides the rate of return and the time before the outlay comes back. |
| Internal Rate of Return | At what rate does the investment break even, against the hurdle rate? | Percentage | Yes | Blind to the size of the project, unstable on flows that change sign more than once. |
| Payback Period | How long before the outlay is recovered? | Years and months | No | Ignores everything that follows the crossing. |
Where to start depends on what is missing. When the option commits the organisation to a purchase, a subscription or several years of operation, total cost of ownership comes first: it gathers acquisition, use and support over a stated life, and it often reveals that the option that is cheapest to buy is not the cheapest to own. Cost-benefit analysis then produces the table the other four read. Return on investment serves communication, a single percentage comparable with other investments provided the period is the same. Net present value becomes the reference measure as soon as the flows spread over several years, since it alone returns an amount that takes time into account. The internal rate of return expresses the same series of flows as a rate, comparable with the organisation's hurdle rate, which makes it the go/no-go measure. The payback period answers the cash question, for almost no effort.
A defensible investment case carries at least three of them: net present value for the amount, the internal rate of return for the rate, the payback period for the cash position. The first two links of the chain come before them, since they supply the figures.
The pitfalls of comparison
A retailer in French-speaking Switzerland is comparing two warehouse-automation options: the first calls for CHF 250'000, at a rate of 28% and a net present value of CHF 180'000; the second calls for CHF 1'200'000, at a rate of 19% and a net present value of CHF 640'000. Ranking by the rate picks the first and gives up CHF 460'000 of value. Between mutually exclusive options whose rankings disagree, net present value settles the matter. The divergence here comes from scale. The two other causes, the reinvestment of intermediate flows and flows that change sign more than once, belong to the internal rate of return, which works them through in figures.
The payback period takes no account of what follows the crossing. An option repaid in eighteen months and then exhausted beats, on that criterion alone, an option repaid in three years that goes on to produce ten years of benefits. Ranking by payback favours the short term, which is the right instinct when cash is the binding constraint and a framing error when it is not.
BABOK asks that two investments be compared over the same period, and a return on investment whose period is not stated compares with nothing.
These blind spots produce the same effect in front of an executive committee: a positive figure presented on its own reads as a certainty. An investment case sets out the three readings together, with the discount rate chosen and the origin of the benefit assumptions. It says which one carries the recommendation.
AI considerations
AI serves the mechanics of the calculation. From a list of costs and benefits, an assistant builds the cash-flow table, applies the six calculations on a single set of assumptions and produces the sensitivity analysis an investment case rarely carries: which discount rate reverses the ranking, how far the benefits have to erode before net present value drops below zero, what slip in the schedule pushes the payback period past the accepted threshold. It also flags the flow profiles that change sign more than once, on which an internal rate of return has no single value.
Human judgement keeps what decides. The benefit assumptions are the very object of the analysis: a model that invents them to complete a table manufactures the false assurance BABOK warns about. The discount rate and the hurdle rate belong to the finance department. Benefits that resist quantification, compliance, reputational risk, future capability, call for a trade-off nobody delegates to a tool. The data in an investment case, supplier offers, margins, salary costs, do not go into an external service without the authorisation that permits the processing.
Cost
| Phase | Level | Justification |
|---|---|---|
| Preparation | High | Almost the whole cost of the family sits here. Gathering the acquisition, use and support costs, projecting the benefits period by period and obtaining the discount rate and the hurdle rate from the finance department take several conversations and the agreement of the budget holders. |
| Execution | Low | Net present value and the internal rate of return are spreadsheet functions; the other four are additions and ratios read off a table that is already built. Adding one measure to an existing analysis costs a few cells. |
| Documentation | Medium | The cash-flow table is kept as it stands. The effort goes into the assumptions: the source of each amount, the period chosen, the rate applied, without which the analysis can neither be re-run nor challenged. |
Tools
The spreadsheet remains the tool of the family. BABOK notes that financial software, spreadsheets included, typically provides pre-programmed functions for these calculations. The workbook carries the cash-flow table and the sensitivity to the assumptions, which is handled by varying one cell. An investment-case template belonging to the organisation, with its own cost lines, its standard period and its discount rate already entered, is worth more than a workbook passed from project to project: it fixes the comparison period BABOK asks for and stops an out-of-date rate living on after it has been revised.
Project-portfolio management tools compute these indicators across dozens of initiatives and rank them, which makes sense where tracking that many workbooks by hand becomes the source of error. Below that volume they add a licence without contributing anything the spreadsheet does not already do. An asset or contract management tool supplies the licence, support and maintenance costs that feed total cost of ownership, often the hardest data to assemble by hand.
Sources
- IIBA, A Guide to the Business Analysis Body of Knowledge (BABOK Guide) v3, §10.20 Financial Analysis: the definition of financial analysis as an assessment of the viability, the stability and the benefit realisation of an investment option, the list of elements from the cost of change to the financial calculations, the use of a combination of techniques, the continuous nature of the analysis through the initiative, as well as the strengths and limitations taken up here, among them the false sense of security that positive figures give.
- PMI, A Guide to the Project Management Body of Knowledge (PMBOK Guide), 8th edition, §2.4 (Finance performance domain): return on investment, net present value, the internal rate of return and the payback period as financial measures of a project's value, to be held together.
- PMI, Benefits Realization Management: A Practice Guide: the investment case as a living document, reassessed across the life cycle, and the measurement of value realised against value promised after deployment.
- Brealey, R. A., Myers, S. C. and Allen, F., Principles of Corporate Finance, McGraw-Hill Education: the primacy of net present value between mutually exclusive options, the scale problem of the internal rate of return and the reinvestment assumption implicit in each of the two measures.
- CFA Institute, Capital Investments and Capital Allocation: the choice of capital-budgeting methods and the treatment of ranking conflicts between them.