Financial analysis is essential in making investment decisions for an organization as it evaluates and presents the financial position of the organization. In case the development involves two distinct investment project, the decision of choosing one must be informed by comprehensively analyzing the financial position of the organization. There are various techniques employed in conducting a financial analysis of an organization. In this article, there is a detailed evaluation of the possible implications which can arise as a result of initiating a project in a hospital. Due to limited resources, the hospital has to choose between building a neonatal wing or a rehab center.
There are various concepts designed to determine the financial situation of any given organization at a given period. One of the renowned applied techniques in financial analysis exercise is the Return on Investment (ROI). There has always been confusion between this concept and the profit as many people take it to connote the profit of an organization. With ROI, there are injections put in business or an organization in form of investments. The yield realized from such investments in terms of the net profit gained is termed as the Return on Investment. In the case of profit, there is an overall measurement of the organization’s performance within a given period.
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There are several ways in which Return on Investment can be applied in gauging the profitability of an investment. This technique applies different ways of conducting a financial analysis. It can use the pricing policy, capital equipment investment and inventory investment. Importantly, Return on Investment can be used within a company to divide the net income taxes and interest by the overall liabilities in order to measure the rate of earnings of the total capital used. Alternatively, Return on Investment can be arrived at by dividing the net income as well as income taxes by fixed liabilities to realize the rate of earning on the invested capital. Lastly, it can apply the idea of dividing the net income by reserve and total capital so as to calculate the rate of earnings on stock and property equities. The concept of ROI will continue to find itself in the accounting field so long as accountability concerns are present ( Phillips,2012).
The case of whether to invest in the Rehab Center or the Neonatal wing will depend on the returns, for instance, taking total investment for Rehab Center to be $400,000 and the expected return is $500,000 then ROI will be
ROI= ($500000-$400000)
400,000
= 25%
With this, the rate will be 25%. The best Return on Investment is 15% with this figure there is the potential for a good return for the organization. Therefore, the hospital can invest in the Rehab Center in case the percentage is below 15% then there should be consideration of other factors. There are strengths linked to the application of ROI as compared to other tools. One of the advantages of using the tool is that it is simple to understand and to use. This is because it only requires two variables and also it does not apply strictness in the use of the term return. Another advantage is that the concept is within the confines of the knowledge of financial class universally hence easier to use. There are limitations associated with this concept when applied to financial evaluation. The drawback is that it does not put into consideration the aspect of time. For instance, in a case where there are two projects like in this case, it may indicate that the total value for both is 40% which can prove to be good for investment. However, the completion of one project may lead to inadequate finance for the other. Therefore, it does not give the investor a futuristic time-based analysis and outcome that is comprehensively thought. Another limitation is that the tool is exposed to manipulation. This comes when different financial technocrats use different formulae in calculating the ROI. One may use the simple method of returns minus cost which is simple. Another professional may include other small cots which automatically results in different figures. Therefore, for reasons of responsibility an investor should look in depth the best method. The recommended calculation should be holistic in nature in which there is consideration of all minor cost in the calculation of the Return on Investment (C.F.I., n.d.).
Profitability Index is arrived at by measuring the ratio between the initial investment and the present value of the cash flow future. Profitability Index is an essential tool for indicating the value created for the unit as well as ranking the investment project. It should be put into consideration that when the PI is more than 1, the project to be invested in will generate value and the business should invest in such a project. In a situation where the Profitability Index (PI) is less than 1 the company should shun the investment operations as there will be no returns. In a scenario where there is the equivalence of PI and 1 then investment in the project will lead the company to the state of dilemma. In which the urgency for the project will carry the day. For the case of the hospital projects, the evaluation will depend on the most needed service and investment at the time.
Advantages of the Profitability Index is that it is key to determining whether the injection of an investment in a company will interfere with the company’s value. Together with that, the concept is considering the value as well as the risk of the future cash flow by the use of cost capital. Lastly, it is essential for ranking and choosing capital in case of realizing the capital. The concept has drawbacks such as it requires the estimate of the capital cost in order to be calculated. In addition, it is ineffective in the case of mutually executable projects in which the initial investments are different as it may fail to indicate the correct value, thus leading to poor decisions (C.F.I., n.d.).
In simple terms, the Net Present Value (NPV) is the difference in the value of cash coming into the company as at present and the cash value which is remitted from the business. The NPV is calculated by subtracting from the today value of expected cash flow the present value of invested cash. It is assumed that the project with a positive NPV is healthy for the business and thus the project should be carried out. In the case of the two projects, consideration will be given to the one whose NPV is positive. This concept uses the principle that a risky investment tomorrow is less valuable than a certain money invested today. It is true that riskier projects and investments are likely to give huge returns in terms of profits. In the case of NPV contrary to other tools like Return on Investment, there is the aspect of risk adjustment ( Glazebrook, 1976).
Conclusion
In summary, there are advantages associated with all these concepts. It can be inferred that the best alternative to use in this case is the Return on Investment with consideration to all the variables to be included. This is due to the fact that when the concept is comprehensively analyzed, it can give both the present and future predictions of the financial state of the organization.
References
C.F.I (n.d.). What is Profitability Index? Corporate Finance Institute . Retrieved from https://corporatefinanceinstitute.com/resources/knowledge/accounting/profitability-index/
Glazebrook, K. D. (1976). A profitability index for alternative research projects. Omega , 4 (1), 79-83.
Phillips, J. J. (2012). Return on investment in training and performance improvement programs . Routledge.
