Investing you hard earned profits back into you business is a decision all business owners face. There is certain IP & machinery that a business requires to operate. Over and above that is the necessity to update aging equipment. Finally , there is the need to capitalise on new ideas and the tooling that will be required to bring these ideas to market to remain ahead of the competition.

We are now talking about the asset side of the balance Sheet.

Capital Equipment is generally known as fixed assets. They are depreciated over the life of the asset as determined by the Australian Tax Office (ATO). This can be between 3 – 40yrs depending whether the asset is computer hardware, manufacturing equipment or land & buildings. IP (trade marks, patents, goodwill etc.) are also assets. These are known as intangible assets, which are amortised over the life of the asset, again as determined by the ATO. The amortisation is between 15 – 25 years depending on the intangible asset. These timeframes indicate that some of the decisions to spend the business’ money can be of significance. So how are these decisions made and priorities set to determine where the money is best invested?

Research on the topic shows that many business owners used a method called The Payback Period (PBP). In essence this determines how long it will take the investment to pay for itself. The business will have a rule of thumb that a certain PBP is acceptable and a longer payback times mean the investment will not proceed. The downside of the PBP is that it shows no concern for changing the value of a firm or the impact on cash flow. It doesn’t compare large and small investments very well and may in fact be biased towards big investments when several small projects would be financially better. Finally there is no obvious ability to determine perceived risk.

Alarmingly, a large number of businesses when faced with a large expenditure on capital, use no formal analysis at all. They use intuition or ‘Gut Feel’.

This is the market intelligence, experience and managerial knowledge that business owners pride themselves on. While this approach has its place for small investments, if the capital to be expended is likely to put the business under stress, there needs to be a more formal or financially acceptable approach. This is especially important as use of financial techniques establishes how to measure the financial success of the project, gives targets to measure the performance of the project along the way, helps reveal risks & the ways that the investment might fail, increases the confidence of third parties in the decision making process (these are the people/institutes who are likely to be lending the funds), and can be used to set priorities on which investments should be continued and those where investment should be reviewed or dumped.

So why do SME’s not devote the time in financial analysis when making important investment decisions? Some thoughts on this might be that only the owner can understand the impact of key non-financial variables on the investment after comparing it with other alternative uses of the funds. Perhaps management talent within an SME is a scarce resource. Maybe the training of the owner/managers is frequently of a technical nature, as opposed to a business or finance orientation. The perspective of these owners is influenced greatly by their backgrounds. There is no doubt that the smaller size of projects SME’s undertake may be thought to need less formal computations, but it would be hoped that these owners seek the advice of an accountant/adviser when making important financial decisions.

Business owners (and their accountants) must go through a process of assessing all their investment priorities (in line with the Business Plan), the risk associated with investing and what the overall benefit to the business will be if they do or do not invest. Further, if the investment is planned over a long period of time (eg years) the impact of the reduced value of money also needs to be factored into the decision process. The use of Discounted Cash Flow (DCF) allows comparison of projects, be that with different durations, a one-off investment or with projects that require multiple investments. The use of DCF also allows financial risk factors to be built into the analysis. In essence it answers objectively which investments will give the business the best financial outcome, be that purchase of assets or commissioning of projects..

Each business has to understand their decision process and use the tools appropriate to the size of the investment and the risk associated with that investment. If the investment is large, the risk high or both, then the use of DCF will aid the decision making process. Further the discipline of preparing cashflow forecasts is a good business practice anyway. Other simpler techniques such as PBP can be used when the decisions to be made are simpler, of less consequence and of low risk.

The key is to have a process and not rely solely on intuition or “Gut Feel”. If it doesn’t stack up financially, then either some of the assumptions are missing or the investment decision is wrong.

Please contact Robert Carter on This email address is being protected from spambots. You need JavaScript enabled to view it.  if you would like to discuss any of this or would like to undertake a review of any part of your business using my 16 Point Checklist.