Making better investment decisions

The first step toward making any investment is to budget effectively, allocating appropriate levels of capital specifically for key investments in line with your growth strategy, rather than trying to fund investments out of cashflow. This includes using forecasting models based on cash-flows and on zero-based budgeting to justify and approve every expense, instead of basing it on the previous year’s spending. The investment opportunity study focuses on the value creation for the company specific to the investment project itself.

Starting from a zero base at the beginning of each budget allows you to create a much more effective and efficient process for analysing and deciding where to allocate your funds, in line with your strategic plan. It also facilitates close analysis of future spend and opens the door to transformational opportunities.

With a strategic plan and zero-based budgets in place, the next step is to implement a process of centralised investment decision-making that avoids silos, including management silos.

In a private business, particularly in its early years, the founder or owner will often be accustomed to making investment decisions themselves however, as the business grows, this approach becomes less effective. Instead, investment decision-making needs to be controlled by a centralised process, rather than a person. This process should involve a wider group of people from across the business who can bring a more subjective point of view to investment decisions.

Making centralised, process-driven investment decisions makes it easier – and more transparent – to determine the costs required and identify the most appropriate KPIs for measuring return on investment. Usually, the key indicators used to assess the opportunity of an investment are the net present value or the internal rate of return. The discount rate applied to calculate the net present value takes into account the expected profitability and risk of the project.

Traditionally, the default approach for evaluating an investment decision is to focus on the impact of the investment on the business, based largely on financial metrics, such as growth, profit, capacity.

In many situations, however, this approach does not paint a true picture of the impact of the investment on the business. Many investment decisions are not about fixed assets, for example, but about investing in new capabilities, in innovation or in people. These kinds of investments are likely to have a high initial cost that is explicitly visible on the balance sheet, but the payback period is likely to be much longer term and much less visible, in terms of direct financial returns.

For example, data is an increasing focus of investment for many businesses as part of a broader transformation or digitalisation process. In fact, Mazars’ data maturity study found that most businesses see big data as their most important source of growth for the next 10 years, and the majority are planning significant investments in data in 2022 and 2023.

Similarly, ESG-related investments may show very little short-term ROI in cash terms, but over the longer term are essential for the sustainability of the business and perceptions of its brand. Evaluating the performance or profitability of these investments in purely financial terms, therefore, is very problematic.

This links into the need to allocate a specific execution or project management team to manage the investment and oversee its progress, which can also monitor and measure its impact. This can help to ensure the operational team is not distracted by the investment project and that any internal bias is avoided when evaluating the performance of the investment.

Making sound, reasoned investment decisions should be a core capability for every business. Without making effective and efficient investment decisions, the organisation is at risk of drifting away from its strategic priorities and wasting money on the wrong investments.

On the other hand, effective investment decision making that is connected to strategy, transparently budgeted, accurately evaluated and effectively implemented ensures capital is invested in the right areas and puts the business on the strongest footing to drive long term value and growth.

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Author: Olivier Gramling, Partner, Mazars in France

Published: 07/12/2022

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