Understand your cash flow
Free cash flow
This is the money left after paying expenses that maintain or expand your assets and operations.
It’s useful because:
- it gives you a good picture of your financial performance
- it shows you the money you can spend on a new project or investment.
Free cash flow is your operating cash flow minus capital expenditure. Positive free cash flow shows you have money to spend on repaying loans, paying investors, or on improving your business.
Negative free cash flow means you don’t. It’s common to have negative free cash flow when your small business is growing, as you’re spending money now so you can earn more in the future.
Present value of money (PV)
This is how much a future sum of money is worth today, based on interest rates and/or inflation.
If you have money today, it means that:
- it’s worth more now than in the future because you could invest it and earn interest
- you could spend it, buying more now than you could in the future because inflation will increase prices.
Present value of money is useful because it’s a way to compare the expected performance of projects or investments at a future point by translating it back into today’s money.
To calculate it, our modelling workbook uses a 20% discount rate to bring future money back to the present value. You can edit this figure to see what happens to your results if interest rates rise or fall.
Net present value of money (NPV)
This is also called total of present values. It shows today’s total value of your future returns, negative and positive.
It shows the expected performance of a project or investment over time. It’s never 100% accurate because it depends on so many things – for example inflation, interest rates, your estimates of future cash flows.
It’s useful because it the figure that allows you to decide if it’s worth going ahead with a project or investment.
Since you’ll put money in now, with the value of a dollar being what it is today, net present value converts your total expected return into today’s money. This gives a better sense of how your money will grow.
To calculate it, add up each year’s present value (our modelling workbook does this for you). If it’s a positive number, a project is more likely to be worth going ahead with. If it’s negative, it is safer not to go ahead.
Internal rate of return (IRR)
This is a percentage that measures how profitable a project needs to be to:
- earn you money
- pay interest on a loan, or an investor’s expected rate of return
- at least match the return you get from an existing income stream.
It’s useful because it gives you a good estimate of the percentage return on a project.
If you want investors or lenders to help pay for a project, your expected earnings should make enough profit so you both get a cut.
Your internal rate of return is the percentage that makes your NPV equal zero. Our modelling workbook calculates it for you, and includes tips on how to tell what’s good and what’s not.
Introduction to modelling concepts
It pays to be comfortable with strategic finance before you explore these concepts, which underpin our modelling workbook. These definitions are intended as an introduction only. Talk to your financial advisor or mentor to dig deeper.
Time value of money
Time value of money means what money is worth changes over time. Any amount is worth more the sooner it’s received. A dollar you invest today is worth more than a dollar you receive tomorrow, because of its potential to grow through interest — or contribute to the growth of your business.
Understanding the time value of money is useful when a business is making decisions about its future. It helps show whether one project will be more lucrative than another, or whether there’s more to gain through investing money in another opportunity.
Getting your head around this helps you work out what your money will be worth in the future — another concept known as future value of money.
Future value of money
Future value of money is the value of an asset at a specific time in the future, based on an assumed rate of growth. This asset could be money invested in a bank or a business, or it could be a piece of equipment.
Opportunity cost
Opportunity cost is used when deciding which project or investment to go ahead with.
It’s the difference in return between a chosen option and the next best alternative. Whenever you need to choose only one option, you give up any potential benefits from those you decide against, for example investing with one bank means missing out on the interest rate offered by another.
Discount rate
A discount rate is like interest in reverse. It’s a percentage that reduces future money back to the present value — that is, today’s money.
Which discount rate to use can vary, depending on the project or investment being modelled. It’s often the growth rate or expected return on another opportunity or potential project, for example the interest rate on a savings account, or profit margin on an existing product.
If you’re unsure about the accuracy of your forecast figures, use a higher discount rate. A low rate is for lower risk projects, in which projected figures are more certain.
Fastening a forecast
Clothing designer Anika wants to switch to cheaper fastenings. This will reduce her cost of goods sold and increase her profit margin. But paying for these in bulk means going into negative cash flow for much of the year. Her mentor suggests forecasting the expected costs and sales to see if it makes financial sense in the long run.
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