When spending money on your business it's important you work out if you're spending it on the right thing. This is important because you want to make sure there's value in spending the money.
There are different ways you can assess the effects that spending money will have on your business. This is sometimes called 'capital budgeting' or 'investment appraisal'.
It's important to estimate the benefits of the investment in financial terms.
The main techniques you can use are:
- accounting rate of return
- payback period
- discounted cashflow
- investment risk and sensitivity analysis
When using these techniques you should ignore any sunk costs (costs that you've already incurred or would spend regardless). These are not part of your specific investment.
Accounting rate of return
Accounting rate of return or 'ARR' compares the profits you expect to make from an investment to the amount you need to invest.
It's normally calculated as the average annual profit you expect over the life of an investment project, compared with the average amount of capital invested.
Payback period is a simple technique for assessing an investment by the length of time it would take to repay it. It's usually the default technique for smaller businesses and focuses on cashflow, not profit.
Discounted cashflow applies a discount rate to work out the present-day equivalent of a future cashflow. There are two types of discounting methods of appraisal - the net present value (NPV) and internal rate of return (IRR).
Investment risk and sensitivity analysis
Investment risk and sensitivity analysis is a realistic assessment of risks is essential. In practice, the biggest risk for many investments is the disruption they can cause.
The benefits of investing in your business
Spending money on your business can have many benefits, including:
- greater flexibility and quality of production
- faster time-to-market, resulting in a bigger market share
- improved company image, better staff morale and job satisfaction, leading to greater productivity
- quicker decisions due to better availability of information
It can also contribute to what your business is trying to do overall, sometimes called 'strategic objectives'.
Often, one of the key benefits of spending money can be the skills your business learns and the future opportunities that may arise. A useful test is to think about your alternatives.
An accountant can give you help and advice on the value of spending money on your business.
You can find an accountant on The Institute of Chartered Accountants of Scotland website.