Let’s face it:
Accounting is boring as isht.
Assets. Liabilities. Cost basis. Accrual. GAAP. Cost principle. Double entry system…
Finance is not much funner… In fact, it can downright make your head spin…
Liquidity. Risk tolerance. Asset allocation. Dollar cost averaging. Capital asset pricing…
As a product manager, why in the world would you need to know how to do financial analysis?
Actually, there are some excellent reasons why. And you ignore them at the risk of your “brilliant” product idea dying a painful death.
First, the exercise of financial analysis forces you to think long and hard about the viability of your product idea.
It can help surface major issues early on or support your hunch that what you’re wanting to work on actually has some potential.
Second, if you’ve got an idea for a new product or new major feature, you’ll need to articulate to your stakeholders the market opportunity and ROI for it.
They’ll want to understand your assumptions about the market opportunity, and what will be the key revenue or ROI drivers.
Third, these financial analyses, once done, can serve as a strategic roadmap for execution. They allow you to track benchmarks, and you’ll be able to quickly assess where you are vs. where you thought you’d be.
So many product managers are unable to do this effectively. And, as a result, their product ideas die. Don’t let this be your fate.
The good news is you don’t need to torture a spreadsheet for days and weeks with crazy unfounded assumptions to produce some silly made up 3-year projection.
It comes down to 3 core financial analyses that need to be understood:
- Market sizing
- Net Present Value (NPV)
- Internal Rate of Return (IRR)
I talked about market sizing — it’s importance and how to do it — in a previous post. So let’s talk about the other two.
Remember: When you go ask to have your product idea funded, it means you’re trying to convince people that YOUR idea is the best place for the company to spend its money vs. something else.
So it’s almost certain your finance department is going to be in charge of running the numbers on your product idea. This means it’s important to understand how the finance department is going to evaluate the financial merits of your product idea.
NPV and IRR aren’t really that complicated once you learn them.
So here’s a quick primer to help you start using them TODAY:
Net Present Value (NPV)
To understand NPV, we first need to talk about weighted cost of capital.
Since you’re eventually going to have to work with your finance department on the numbers, you need to understand your company’s cost of capital so you can ensure that you’re going to get the best deal possible.
A simple way to think about cost of capital is that it’s the cost of the money used to pay for funding a business endeavor, which is exactly what your product idea is, of course.
The money may come from debt, like a bank loan. In this case, the cost of capital is the interest rate the bank charges you for the loan, called the cost of debt.
Alternatively, the money may come from equity, like from investors. In this case, the cost of capital is the return these investors expect, called the cost of equity.
Most companies have a mix of debt and equity on their balance sheets.
So the weighted cost of capital is typically a weighted average of the cost of their debt and the cost of their equity.
Let’s go through a simple example:
- Let’s say your company’s cost of debt is 3.5% and cost of equity is 10%
- In other words, the company is paying 3.5% interest on its loans and its investors are expecting a 10% return
- Let’s also say your company’s capital structure is 70% equity and 30% debt (i.e., the percentage of debt relative to the percentage of equity the company uses to finance its operations)
- So your company’s weighted average cost of capital = (70% * 10%) + (30% * 3.5%) = 8%
How is this related to Net Present Value?
The weighted cost of capital is used to calculate the NPV of a business investment.
And the higher the cost of capital, the lower the expected profitability of your product.
So you definitely want to know what your company’s cost of capital is and what assumptions are going into calculating it.
Net Present Value (NPV) is a way of assessing the profitability of an investment by factoring in the present value of any future cash flows your product projects to generate over a given period of time, like 3 or 5 years.
Let’s explain via another simple example:
- Let’s say you deposit your money in a savings account at your bank, and you earn 10% interest on your money.
- So $1,000 today would earn you $100 in a year — in other words, your $1,000 today will become $1,100 next year.
- This means $1100 next year is the same as $1,000 now.
- So the present value of $1100 next year = $1,000 at the discounted rate of 10%.
Note that the interest rate you’re earning in your savings account is also called the discounted rate when calculating the present value of your future earnings.
So to calculate NPV, your finance department will:
- Calculate the present value of future cash flows your product is expected to generate over a specific time horizon (i.e., revenue over 3 or 5 years)…
- Subtract from it the present value of the initial investment needed for your product and any future expenditures projected to be incurred over the same time horizon
NPV = present value of future cash inflows – present value of future cash outflows
NPV is pretty easy to calculate in Excel. In fact, it has a formula for it.
Internal Rate of Return (IRR)
Now that you know what NPV is, this one is easier to explain…
The IRR is the interest rate at which the net present value of all the cash flows from an investment equal zero.
So the idea is that the higher an investment’s IRR the more desirable it is to undertake that investment relative to other projects (assuming all other factors are equal).
BTW, this is also pretty easy to calculate in Excel — it has a formula for IRR too.
So let’s say you calculate the IRR of your product idea is 92%. Is this good or bad?
That depends on the IRRs of the other projects competing for the same dollars!
Additional thoughts on NPV and Cost of Capital
The cost of capital should vary depending on the type of product initiative you’re pursuing.
If it’s truly a new product innovation, a higher number could be justified, since the project is going to be riskier, but may be worth it.
For a line extension, a relatively lower rate could work, since it’s relatively less risky.
Either way, do your homework, and then sit down with your finance counterparts and understand what values they’re using and why.
You don’t need to be a finance genius, but you do want to be able to negotiate with them intelligently. You may or may not win the day, but you will gain their respect, and at least everyone will be aligned on how to value your product idea properly and in relation to other projects the company is investing in.
Bottom line: yeah, finance may be boring, but it doesn’t need to be confusing, and it’s super important. Rockstar product managers understand that it’s well worth their time to learn, and get decent enough at it to be able to justify and defend their product ideas.
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