In business, the term financial justification applies to proposalsfor action or investments. The phrase justified in financial termsusually means that decision makers expect the action or investment to lead to net financial gain. Or, it sometimes means simply that the action in view will cover its own costs.
Prospective proposal authors are well advised, however, to determine as early as possible if local management uses still other additional criteria to define financial justification. Some organizations require, for instance, a payback period shorter than a given time span, or an internal rate of return above a certain rate (such as the organization's cost of capital), or profitability above a given percentage. Financial officers and other managers often define "justification" in terms they believe are appropriate for their own organizations.
Financial Justification vs. Cost Justification
Some organizations use the term cost justification instead of financial justification. These terms in fact have essentially the same meaning, but choosing one or the other reveals something about the organizations's view of the proposed action.
- Financial justification suggests an investment viewpoint, meaning the action will bring returns to compare against investment costs.
- Cost justification emphasizes costs rather than returns. The term can mean simply that the proposed action is the most cost effective solution to a problem or need that absolutely must be addressed.
Explaining Financial Justification in Context
Sections below show how some organizations define a hurdle rate for this purpose, or otherwise use business case analyis and metrics such as net present value NPV, internal rate of return IRR, payback period, break even point, and return on investment ROI to decide whether or not proposals achieve financial justifiction.
The following sections further explain and illustrate financial justification in context with related business concepts, emphasizing four themes.
- First, the meaning of Financial Justification versus the meaning of Cost Justification.
- Second, the financial justification concept in to support for funding decisions, alongside other objectives.
- Third, financial metrics that often serve as financial justification criteria.
- Fourth, the Hurdle Rate Test as a financial justification screening criterion.
- What is Financial Justification? Cost Justification?
- What is the deeper purpose of financial justification tests? What does management really want to know?
- How do Firms use a hurdle rate to test for financial justification?
- The article Hurdle Rate explains the use of this concept in more depth.
- For a complete introduction to financial metrics that address financial justifiction questions, see the article Financial Metrics.
- The article Business Case Analysis explains in more depth how proposal authors use analysis and metrics to prove financial justifiction.
Decisions to approve or deny funding to proposal authors sometimes turn on the answers to just a few kinds of questions. These questions are normally center stage in formal reviews of project proposals, organizational budget requests, capital spending plans, and investment proposals.
Financial Justification Among Equally Important Issues
The financial justification question is important—sometimes crucially important—but proposal reviews normally focus on several other kinds of questions as well. Very briefly, those who review proposals of all kinds usually seek answers to questions such as these:
- Does the proposal align with high level strategy? Will action or investment outcomes contribute to meeting the organization's high level strategic objectives?
- Does the proposal address individual stakeholder needs? Does the proposal address the specific needs of the managers and organizational units that have a "stake" in the action (will see an impact from the action)?
- Is the proposal action justifiable in financial terms?
- Does the proposal action bring unacceptable risks? Does the proposal anticipate likely risks and provide a plan for managing them?
Reviewers and decision makers normally view proposals that fail on any of these four points as "non starters." In many cases, they see financial justification as easiest of these questions to test. For that reason, review processes often approach the financial question with an initial screen tool, the hurdle rate test (see the following section).
Financial Justification: One Criterion or Several?
Reviewers and decision makers who ask proposal authors to prove financial justification are themselves responsible for specificying in clear operational terms the specific criteria they will use for judging financial justification.
The same reviewers and decision makers are also responsible for informing proposal authors how best to provide compelling proof that proposals meet or exceed stated financial justification criteria. Different reviewers can recommend different, "proof" methods, ranging from a simple "back of the envelope" ROI calculation, to a rigorous multi-scenario business case analysis.
In any case, proposal authors serve their own interests by finding out—insofar as possible—the specific financial questions that most concern the individuals evaluating their proposals. Such questions may have to relatively less to do with showing a "net gain" from the action and relatively more to do with addressing concerns about the specific action such as these:
- Does the software system we propose represent the best use of funds?
- Can the new building we propose improve our financial position?
- Will the proposed security service "pay for itself" by reducing pilferage?
- What can the project we propose contribute to financial performance of the overall project portfolio?
Armed with a knowledge of individual reviewer interests, the author can then ensure that the proposal provides evidence, financial metrics, and the rationale, that address such questions directly
An organization's hurdle rate is usualy the minimum rate of return it will consider, when evaluating investment and action proposals.
- Proposals that score above the hurdle rate may receive further consideration.
- Proposals scoring below the hurdle rate receive no further consideration.
In other words, when its rate of return clears the hurdle, the proposalqualifies for funding consideration.
Textbooks use the term "rate of return" to explain hurdle rate. Here, they have in mind a financial metric based on financial results in the proposal. This is the rate the analyst will compare to the existing hurdle rate. One problem, however, is that "rate of return," does not have a standard definition. And, the term does not designate any metric in particular. For the hurdle rate test, therefore, financial specialists usually turn to one metric that does have a standard definition. The metric of choice for this purpose is the internal rate of return (IRR).
The Hurdle Rate Role in Proposal Review
Action proposals almost always contain projected financial results. And, they almost always present these as a cash flow stream. Hence, almost all action proposals project a series of cash flow events that follow the investment or action.
Reviewers evaluate proposals with the help of financial metrics for analyzing cash flows. They are concerned with proposal acceptance and funding, after all, and they turn to metrics that take an "investment view." Consequently, they will probably analyze with net present value, return on investment, payback, and internal rate of return. In brief, all of these are relevant in a thorough review. In addition, a thorough review also finds and measures investment risks. And, finally, a thorough review also addresses this question: "Do projected outcomes align with strategic objectives?"
The hurdle rate serves in this context as an initial screening test. The hurdle rate test, therefore, normally precedes the full proposal review. The idea is to filter out, or disqualify, weak proposals, early. Reviewers, therefore, have more time and resources to focus on the stronger proposals.
For more on the use of hurdle rates in this sense, see the article Hurdle Rate