Financial analysis for business analysts

Business analysts use financial analysis to understand the financial features of a solution.

Financial analysis is the evaluation of the expected financial realization, stability, and benefits of an investment option. It includes an examination of the total cost of the change as well as the total costs and benefits of using and supporting the solution.

Business analysts use financial analysis to make a recommendation on an investment in a particular change initiative by comparing one solution to another, based on an analysis of the following:

• initial cost and the time frame in which those costs are obtained.
• potential financial benefits and when they would be attained.
•operational costs of using and supporting the solution.
• risks connected with the change initiative.
• ongoing risks to the business of using that solution.

A blend of analysis techniques are usually used because each technique gives a different perspective. The stakeholders use the results of the financial analysis results to make decisions on which change initiatives to support.

Financial analysis is repeatedly used during the initiative to decide if the change is going to deliver on its expected business value. Based on the financial analysis results, the business analyst may advise that the change initiative should be modified or stopped, If new information changes the financial analysis results in such a way that it no longer supports the initial solution recommendation.

There are some elements of financial analysis which include:
1. Cost of the change: The cost of a change includes the expected cost of acquiring the solution components and the associated costs of moving the enterprise from its current state to the future state.

These costs includes the cost for new equipment purchase, software, facilities, data transfer, training, change management, and Implementation.

2. Total cost of ownership (TCO): The total cost of ownership (TCO) is the cost of purchasing or leasing a solution, the cost of operating the solution, and the total lifetime cost of owning the solution.

3. Value Realization: this is the expected value of the solution which would usually be realized over time.

4. Cost-benefit analysis: Cost-benefit analysis is a forecast of the expected total benefits minus the expected total costs, which produces an expected net benefit. All cost and benefits should be clearly stated so that there won’t be any misconceptions.

The time period of a cost-benefit analysis should be long enough to ensure that the solution’s value would be fully realized because some benefits, project and operating costs may be realized until future years, until then the cumulative net benefits could be negative for some time.

As the change initiative progresses the business analyst has to ensure that they repeatedly review the cost-benefit analysis to ensure that they are still valid.

5. Financial calculations: Organizations use a blend of standard financial calculations to understand different perspectives about when and how various investments may provide value.

These calculations consider factors such as the basic risks in various investments, the capital to be invested when compared to the when those benefits would be realized, the opportunity cost, and the amount of time it will take to recover the original investment. Financial software such as spreadsheets, can be used to accurately perform these financial calculations.

Return on investment: The return on investment (ROI) of a scheduled change is expressed as a percentage, which calculates the net benefits divided by the cost of the change.

The change initiative, is compared to that of other change initiatives to determine which one has the higher overall return when compared to the amount of the investment in the same period.
The formula to calculate ROI is:
Return on Investment = (Total Benefits – Cost of the Investment) / Cost of
the Investment.
The higher the ROI, the better the investment.

Discount rate: The discount rate is the presumed interest rate used in present value calculations. This is comparable to the interest rate that the organization is supposed to earn if it had invested the money elsewhere.

Present value: various solutions could realize benefits at different rates and over a different time based on different factors. To accommodate differences in factors such as different rates and time periods, the benefits are calculated in terms of present-day value. Future benefits are decreased by the discount rate to calculate its present day worth.

The formula to calculate present value is
Present value = Sum of (Net Benefits in that period / (1 + Discount Rate for
that period)) for all periods in the cost-benefit analysis.
Present value is calculated in currencies, the larger the present value, the greater is the total benefit. Present value does not consider the original investment cost.

Net present value: Net present value (NPV) is calculated as the present value of the benefits minus the original cost of the investment.

It is used to compare the present day value of different investments, and different benefit patterns. The greater the NPV, the better the investment.

The formula to calculate the net present value is:
Net Present Value = Present Value – Cost of Investment
Net present value is calculated in currencies, the larger the present value, the greater is the total benefit

Internal rate of return: The internal rate of return (IRR) is the interest rate at which an investment breaks even, and it is generally used to decide if the change is worth investing in.

The business analyst may compare the IRR of one solution to a minimum limit which is called the hurdle rate, that the organization expects to earn from its investments. If the change initiative IRR is below that of the hurdle rate, then the investment should not be made.

If two solution approaches are being considered, the one with the higher IRR would be the better investment. The IRR is limited to the internal factors within the organization because it does not consider factors
such as inflation or changing interest rates.

The IRR calculation is based on the interest rate at which the NPV is 0:
Net Present Value = (-1 x Original Investment) + Sum of (net benefit for
that period / (1 + IRR) for all periods) = 0.

Payback period: The payback period produces a forecast on the time period needed to produce enough benefits to recoup the cost of the change, regardless of the discount rate.

Once the payback period has passed which is usually years after, the initiative should usually show a net financial benefit to the organization, unless its operational costs rise.

Financial analysis has both its strengths and limitations, which include:

  • Strengths
  • Financial analysis allows the stakeholder to impartially compare very different investments from different perspectives.
  • All factors such as assumptions and estimates inputted into the financial calculations, have to be clearly stated to prevent misunderstandings.
  • It reduces the precariousness of a change by requiring the identification and analysis of factors that could affect the investment.
  • If any factors such as the context, business need, or stakeholder needs change during a change initiative, it allows the business analyst to impartially re-evaluate the recommended solution.
  • Limitation
  • Some costs and benefits are difficult to assess financially.
  • Because financial analysis are projected into the future, there would always be some uncertainty about expected costs and benefits
  • It may produce inaccurate results due to inadequate information.