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Cash Flow – The Wallflower of Financial Analysis

By November 11, 2014December 26th, 2021Briefs
Cash Flow – The Wallflower of Financial Analysis, Michaels Energy

Energy efficiency is getting sophisticated these days.  It is discussed in Fortune 500 company board meetings.  It has appeared at a couple of past State of the Union addresses.  It is even being mentioned on Wall Street investor calls. With all this baby-kissing and martini sipping, energy efficiency advocates are rightly suggesting that project justification ought to be more sophisticated than the simple payback method[1].

Their recommendation is to move to something fancy like internal rate of return, life-cycle costing, or net present value. That’s all well and good for the corporate boardroom type.  For the vast majority of projects (and their decision makers) the solution to simple payback’s misleading charm is not some highfalutin calculation, but rather a classy straightforward cousin: cash flow.

Simple payback just can’t cut it

Simple payback describes the break-even point, but misses the magnitude of the project and the impact over the project’s lifetime. Using simple payback, for example, a project with a 4-year lifetime that costs $10,000 and returns $5,000 each year looks better than a $100,000 project that returns $40,000 a year for 5 years.  The first has a 2 year payback and the second’s payback is 2.5 years.  Forgive the exaggerated comparison, but the point is clear; only using simple payback to justify a project misses out on describing the full value of the project.

Cash flow can save the day.  A cash flow diagram quickly shows how much cash will be freed up either yearly or cumulatively over the project lifetime.  Sure, cash flow doesn’t adjust for the time-value of money, but a lot of decision makers don’t either. For many organizations, the chief concern is freeing up dollars in the budget this year and going forward. Check out the 5-year cumulative cash flow for each of the two example projects.

Cash flow is king

It might be time for the upwardly-mobile energy efficiency to shed connections with its childhood friend, simple payback, but the next step up does not require a finance degree. For the majority of decision makers, good ol’ fashioned cash flow is the right tool for the job. It reveals more about the project’s lifetime and overall impact, but it’s easy to read and calculate. It is a great asset in the decision-making process.

[1] Simple Payback: Project cost divided by project savings = years to pay back the investment.

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