When evaluating any investment in a firm – what is the key goal that you want to examine and assess? What is the most important cash flow measure of any business? Why?
To answer this question two assumptions are made;
- In the first question investment refers to money spent on business projects or capital expenditures.
- In the second question the measures refer to cash flow ratios.
When evaluating investments in a firm the issues to consider include funds available, the time it will take for the investment to reach maturity, the value of the investment at maturity and logistical aspects of the investment. The firm will be required to prioritize the projects with regards to the cited constraints and the urgency or measure of benefits from the said projects. First priority will be on projects that the company cannot avoid, for instance, purchase of new equipment to sustain higher production.
There are a variety of methods that can be used to evaluate a firm’s investments however the best method should consider discounting the cash flows to reflect the time value of money and the profitability of the project throughout its lifetime. The key goal would be to ensure that the value of the investment reflects the accurate lifetime value which should be higher than the initial financial injection.
Free cash flow ratio has been cited as the single most important cash flow metric. It has been considered a better metric to rank investments compared to earnings. The free cash flow refers to the operating cash flow minus capital expenditures and the ratio is calculated by dividing the free cash flow by the operating cash flow. The free cash flow is important in evaluation because it shows a firms strength based on cash flows available to the company for investment. It should be noted that a higher value shows a company’s strong position.