Estimating Returns for a Recommendation
Definition:
When a recommendation is made for anything from purchasing a piece of equipment to adding new employees, to making an acquisition, to recommending a new company strategy; it is necessary to describe the financial impact of the recommendation.
- What it is: Each recommendation that you make has a financial impact. For completeness in your recommendation, you should always include a forecast of the financial impact of your recommendation and if possible a comparison to the financial impact of the status quo and other alternatives considered. The financial outcome is a forecast of the impact of implementing the recommendation with a number of assumptions built-in. Where possible, it is best to provide a range or a Probabilistic forecast versus a single-point forecast.
- What does it do: The forecast of returns on the recommendation allows the leadership team to decide if the returns are worth the resources deployed and the risks taken to implement the recommendation. While finances are not the sole measure of value created be a recommendation, it is a measure of success that can not be ignored. Also, the financial analysis allows a comparison to the other alternatives considered and the always present alternative of doing nothing and remaining in the status quo. It also provides a scorecard of how well the recommendation met the forecast projections.
Uses:
- How is it used: Provides a key informational point to the decision-maker of whether or not they should implement the recommendation. It provides a metric by which the success of the recommendation can be compared to after the implementation of the recommendation.
- Where: While many business leaders do not ask for a financial estimate of the impact on earnings for a recommendation, it should almost always be offered. When a market plan is presented that projects using funds for advertising, sales materials, and customer service offerings, there should be an estimation of the cost and the projected change in revenue and returns. If a new piece of equipment is purchased to increase productivity, then the financial returns are needed to determine if it is worth the resources expended.
- Why: Making decisions without understanding the impact on returns is like trying to drive a car while blindfolded.
Limitations:
- Where it shouldn't be used: Recommendations that are driven by government regulations and other activities where you have no options available do not require a financial estimation, but you still may want to be aware of the financial impact for planning purposes.
- Any restrictions: If the decision is small, and assumed to have little impact on resources or returns, it may not be worth the time and effort to complete the analysis
- Warnings: Single point forecasts are risky because they give no insight into the potential variations that are possible. Based on the assumptions made in the financial analysis the returns may be projected to be very positive, but under certain other assumptions, the forecast of returns could be very negative. If you do not have some range identified, then a single point forecast can be misleading. It is suggested that one of the 2 following approaches be considered:
- A three-point forecast of estimated returns based on worst, base and best case scenarios
- A full Probabilistic forecast using a Monte Carlo simulation like Crystal Ball or @Risk
Demonstrations:
- What is Financial Modeling ?:What is Financial Modeling ?
- Financial Model Tutorial:Financial Model Tutorial
- A 60 Minute Recipe for creating a Simple Project Finance Model - Part 1
- A 60 Minute Recipe for creating a Simple Project Finance Model - Part 2
- A 60 Minute Recipe for creating a Simple Project Finance Model - Part 3
- A 60 Minute Recipe for creating a Simple Project Finance Model - Part 4
- A 60 Minute Recipe for creating a Simple Project Finance Model - Part 5
Step-by-step process:
- Gathering data: Utilize traditional modeling practices to gather data. See the processes found in the library documents below:
- Analysis of data: Use the Data you have captured and modeled to complete specific comparative analysis ratios and other approaches like those below:
- NPV
- Cashflow Analysis
- Internal Rate of Return
- Payback Period
- Accounting Rate of Return
- See the following link for many of the formulas for these ratios and analyses
- Interpretation of results: Use comparison tables, Efficient Frontier, weighted priority tables and soft factors to determine what is the best alternative based on the Financial Analysis and common sense.
- Presentation of results: Use the charts, tables, and graphs completed in the above analyses to display the findings and highlight the decision choice.
Template for capturing data:
- Options Model:
Options Financial Model.xlsx - Simple Template: Financial Model Simple.xlsx
- What if Template:
Financial Model What-If Analysis.xls - Financial Model Full Statements: Financial_model Full Statements1.xls
Output representation and recommendations:
Use the charts, tables, and graphs completed in the above analyses to display the findings and highlight the decision choice.