Investment Analysis is simply the process of evaluating an investment in each attribute of investments. Evaluation of investment involves evaluating the attributes of investments. Return, risk, liquidity, tax benefits, and convenience are the key attributes considered before investing in any particular type of investment. This evaluation of investment takes place to decide or choose a suitable investment.

Investments are an integral part of any business. Every company has investments in many forms, whether in projects or assets. Income from investments directly impacts the company’s profitability. One of the primary responsibilities of a finance manager is to invest the company’s funds in optimizing its profits effectively.

Funds are invested for the short term or long term, depending on the availability or idleness of funds. To explain further, sometimes a company’s concern is to do the expansion. Therefore, it looks out for both acquisition and investment of funds in profitable projects. It uses idle cash to invest in other assets or other companies through equity shareholding, etc. On the contrary, sometimes, in seasonal businesses, the excess of working capital is invested in short-term investment options mainly consisting of money market instruments.

## Investment Attributes

In essence, investment alternatives need to be analyzed or evaluated for effective investment. The following attributes of investments to consider for evaluating the investments.

### Return

A reasonable rate of return on an investment is the first and foremost condition for effective investment. The rate of return is the ratio of the sum of annual income and price appreciation for the purchasing price of the asset or investment.

Rate of Return = {Annual Income + (Ending Price – Purchasing Price)} / Purchasing Price

Let us illustrate it with an example. Suppose a person has invested in equity shares of company A at the price of Rs. 100. During the year, company A pays a dividend to its shareholders of Rs. 10, and the share price at the end of the year is Rs. 115.

Rate of Return = {10 + (115 – 100)}/ 100 = 0.25 or 25%.

For more in-depth analysis, the rate of return can be broken into two parts: Current Yield and Capital Gain/Loss. In the current example,

Rate of Return = 10% + 15% = 25%

Here, the current yield is 10%, and capital gain is 15%. The current yield is more stable compared to capital gains. Capital appreciation may not always be there. In bad markets, it is quite possible to have a capital loss.

Annual Income | (Ending Price – Purchasing Price) | |||

Rate of Return | = | —————– | + | ————————————– |

Purchasing Price | Purchasing Price | |||

(Current Yield) | (Capital Gain or Loss) |

### Risk

The rate of return on different investment options varies a lot. Remember the famous quote, ‘More the risk and more the profits.’ It is a general phenomenon that more return is expected from a high-risk investment. Risk means the uncertainty of returns. Statistically, the risk is judged based on variance, standard deviation, and beta parameters. More security deviates from its expected outcomes, a risk is considered to be high. The challenge for a finance manager while investing funds is to achieve high returns on investments while keeping the risk at the lowest possible levels.

### Liquidity

Liquidity means the marketability of an investment. For example, equity shares of a big company can be easily liquidated in the stock markets. On the other hand, money invested in an asset (machinery) cannot be liquidated as easily as the equity share. An investment is considered highly marketable or liquid. It can be easily transacted with low transaction costs and low price variations. A finance manager looks for more liquid investments when the funds are available for a short period. Liquidity always has a preference because it helps the managers remain flexible.

### Tax Benefits

It is valid for some investments and not for all. Most of the countries have tax incentives for particular investments except tax-free countries. So, it is an important consideration for investments that have tax benefits because taxes form a major part of their expenses.

### Convenience

Convenience means ease of investment. When an investment can be made and looked after easily, we consider it convenient investing. For example, it is easy to invest in equity shares compared to real estate because it involves a lot of documentation and legal requirements.

So, the analysis of investment attributes viz. Return, Risk, Liquidity, Tax Benefits, and Convenience answer the central question – Which investment alternative should opt for?

## How to Evaluate and Analyze Investments to Check Viability?

Investment analysis and appraisal are one of the primary jobs of finance managers. It evaluates new investment opportunities for their physical and financial viability. Most important is financial viability because financial survival has to be the first goal for any firm to achieve any other purpose.

Investment analysis and appraisal is a stepwise decision-making process to assist managers in deciding about the acceptance or rejection of a project. Essentially, it analyzes the cash flows and other factors of the project to evaluate the financial feasibility. We can follow the step by step process as mentioned below:

### Estimate the Cash Flows

After coming across an investment project, the first thing that a manager should do is estimate the project’s cash flows. It is like the base of the building, which should be very strong. Estimation of cash flow should be as accurate as possible as they become the foundation for all the further steps of this process.

For example, let’s assume we will have the following cash flows in a project with an initial investment of $30,000.

Year | 1 | 2 | 3 | 4 | 5 |

Cash Flows | 10000 | 11000 | 13000 | 15000 | 15500 |

### Appropriate Opportunity Cost of Capital

The next most important thing is to discover an appropriate opportunity cost of capital. Why should the opportunity cost of capital be found? It is simply because we will compare the current investment returns based on the returns on the next best alternative investment opportunity.

The opportunity cost of capital is the rate of return that the investor can earn if he does not invest in this investment. This evaluation is also equally important, just like estimating cash flows. To achieve wealth maximization for the investors, it is vital to take projects that earn better returns than what they are currently earning. Here we are in the race to find the correct current returns of the investors.

Continuing the same example, let’s assume that the investors are ordinary public. If the cash is distributed to them as a dividend, they will invest in fixed deposits at the rate of 12% per annum. So, this rate becomes the opportunity cost for the investors.

### Calculate Discounted Cash Flows

This step will not have to do any more market research. This step will use the opportunity cost of capital and discount the cash flows estimated in step 1.

Years | 1 | 2 | 3 | 4 | 5 |

Cash Flows | 10,000 | 11,000 | 13,000 | 15,000 | 15,500 |

*Discounted Cash Flows @ 12% | 8,929 | 8,769 | 9,253 | 9,533 | 8,795 |

### Present Value

In this step, we will add all the discounted cash flows to find the present value of all future cash flows. The current value in our example is coming to be $ 45,279.

### Net Present Value

When we know the present value of the future cash flows, we can compare them with the current investment we have to make, i.e., $40,000. The present value of all the estimated cash flows is more by $5,279. This means that the project is worth doing.

Understanding it differently, we can conclude that we are getting $45,279 for a payment of $40,000. $5279 is the reward for all the hard work that the organization will do over the project’s life to implement and execute it successfully.

We have used the investment analysis tool of net present value, but other tools and techniques also exist, i.e., Internal Rate of Return, Profitability Index, etc. We believe that the net current value is the best method of investment analysis compared to all other methods. Refer to our article on “Why Net Present Value is the Best Measure for Investment Appraisal?“