Jul 12, 2018 · 2 min read

There is a difference between profits and cash flow. Failing to understand the difference can be fatal to your project.

Cash is a liquid asset, in the sense that it can be exchanged for supplies, labor, marketing, or other services. There are lots of fixed assets (e.g., real estate) that can’t be used as a medium of exchange for the things your business needs because they are not liquid like cash.

So it’s important to understand your cash flow.

Cash flow diagrams are a tool for organizing and visualizing information about an investment, business opportunity, or project that helps you keep track of the cash consequences of financial decisions. The difficulty with cash flow diagrams is that they extend over long periods of time, and it’s important to have a basis for comparing inter-temporal trade-offs.

Net present value (NPV) analysis is a way to simplify the information in a cash flow diagram into a single number that allows comparison of different investment or project alternatives. The “net” in NPV refers to the difference between all of the costs resulting from a project and all of the revenues, after each is represented in terms of present dollars. This video shows an example of a college student who is considering investing \$10K they’ve save for college in equipment for a landscaping business. They make some assumptions about the cost of the equipment, the revenues they will receive from the business, and what they can sell the used equipment for. Lastly, to complete the analysis, they need to choose a discount rate that reflects their time preference. This could be the cost of borrowing the initial \$10K investment, or it could be some other value.

This video uses Excel to show how the net present value changes with respect to changes in discount rate. Notice that Excel includes an “NPV” formula that saves the analyst the trouble of typing.

Just because an investment has positive net present value, that doesn’t mean it is preferable to alternative investments, relative to the amount invested. Another way to assess the quality of an investment opportunity is to calculate the internal rate of return (IRR).

The next video uses the same example, but instead of selecting a discount rate to calculate a net present value, we look for a discount rate that makes all the future revenues equivalent to the initial investment, which we call the IRR. Investment opportunities with higher IRR are preferable to lower.

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