Cash Flow Forecasting: Separate Investment from Financing Decisions
Imagine you are thinking about starting a new venture, perhaps opening a bakery. Before you even begin to think about borrowing money or finding investors, you first need to figure out if the bakery itself is a good idea. This is where the crucial separation of investment and financing decisions comes into play when you’re forecasting project cash flows.
Think of it this way: the investment decision is all about the project itself. It’s asking, “Is this bakery a good business opportunity, regardless of how we pay for it?” This involves figuring out what you need to invest in – ovens, mixers, display cases, ingredients, and so on. You then need to estimate how much money this bakery is expected to bring in – sales of bread, cakes, pastries – and how much it will cost to run – rent, utilities, staff salaries, ingredient costs. These are your project cash flows, the money coming in and out because of the bakery’s operations.
On the other hand, the financing decision is a completely separate question. It’s about how you will fund those initial investments and ongoing operations. Will you use your own savings? Will you take out a loan from the bank? Will you bring in partners who invest in exchange for a share of the profits? These are all financing choices. They are about securing the capital needed to get the bakery off the ground and keep it running.
The reason we must separate these decisions when forecasting cash flows is to get a clear, unbiased picture of the project’s inherent profitability. If you mix financing costs, like loan repayments or interest payments to investors, directly into your project cash flow forecast, you’re muddying the waters. You’re no longer seeing the pure performance of the bakery itself. Instead, you’re seeing a mix of the bakery’s performance and the costs of how you chose to pay for it.
Let’s say your bakery project is fantastic. It’s projected to generate a lot of sales and profit. However, imagine you take out a very expensive loan with high interest rates to finance it. If you include those high loan repayments directly in your project cash flow forecast, it might look like the bakery is barely breaking even, or even losing money. You might mistakenly conclude that the bakery is not a viable project and decide to abandon a potentially great business idea. The problem isn’t the bakery; it’s the expensive financing you chose.
Conversely, imagine a less profitable bakery project. But this time, you finance it entirely with your own savings, meaning you have no loan repayments to worry about. If you don’t separate financing, the project might appear more profitable in your cash flow forecast than it truly is operationally because you’re not accounting for the cost of capital you could have earned elsewhere by investing your savings.
By separating the investment and financing decisions, we can first evaluate the bakery project on its own merits. We can see if the core business model is sound and if it’s likely to generate positive cash flow before we even think about how to fund it. This allows for a much clearer and more objective assessment of the project’s potential. Once we’ve determined that the bakery is a worthwhile investment, we can then separately consider the best and most cost-effective way to finance it. We can compare different financing options, like loans with varying interest rates or different investor agreements, and choose the one that makes the most financial sense after knowing the project itself is strong.
In essence, separating investment and financing decisions in cash flow forecasting is about clarity and sound decision-making. It ensures that we are evaluating the project’s intrinsic value first and then making informed choices about how to fund it, rather than letting financing complexities cloud our judgment about the underlying business opportunity. It’s like judging a recipe on its flavor first, before considering the cost of the ingredients. You need to know if the dish is good before you worry about the grocery bill.