Financial Statement Series: Understanding Net Present Value and Present Value

Rylan Kaliel
6 days ago
7 min read

Person in a suit signing a contract with a pen. A blue toy car and car key are on the document. Calculator nearby, office setting.

How Net Present Value (NPV) and Present Value (PV) Can Help You Make Smart Financial Decision

Dear readers If you’re new to accounting, you might have come across terms like Net Present Value (NPV) and Present Value (PV) and wondered what they mean, why they're important, and how they relate to your business’s financial statements. Don’t worry—this blog is designed to break down these concepts in simple terms, with interactive examples, step-by-step math, and clear explanations. By the end of this article, you’ll feel more confident using NPV and PV to make informed decisions for your business.

What Is Present Value (PV)?

Let’s start with Present Value, often called PV.

Definition: Present Value is the value today of a sum of money that you will receive or pay in the future, discounted by a specific interest rate (also known as the discount rate).

Think of PV as asking: “How much is a dollar I’ll receive in the future worth to me right now?”

Why Discount Future Money? Money now is more valuable than the same amount of money later, because you can invest it, spend it, or use it for your business immediately. This idea is called the “time value of money.”

The Formula:

PV = FV / (1 + r)^n

Where:

PV = Present Value
FV = Future Value (the amount of money in the future)
r = Discount rate (as a decimal, e.g., 0.05 for 5%)
n = Number of periods (years, months, etc.)

Simple Example of Present Value

Imagine someone promises to pay you $1,000 a year from now. If your chosen discount rate is 5% (0.05), the calculation is:

Step 1: Identify future value (FV): $1,000
Step 2: Identify the discount rate (r): 5% = 0.05
Step 3: Identify the number of periods (n): 1
Step 4: Apply the formula:
PV = $1,000 / (1 + 0.05)^1 = $1,000 / 1.05 = $952.38

So, $1,000 one year from now is worth $952.38 to you today.

Where Is PV Used in Accounting?

Present Value is used in many accounting situations, such as:

Calculating lease liabilities: Present value helps determine the current worth of future lease payments, ensuring that the liabilities reported on the Balance Sheet accurately reflect the time value of money.
Analyzing investment opportunities: By discounting expected future cash flows, businesses can assess whether an investment is attractive compared to alternatives or the cost of capital.
Asset impairment testing: Present value is used to evaluate whether the recoverable amount of an asset (the net present value of future cash flows) is less than its carrying value, which could indicate impairment.

PV in the Balance Sheet

When your business expects to receive (or pay) money in the future, you record its present value on the Balance Sheet.

Example: Suppose a client will pay you $10,000 in two years, and your discount rate is 7%.

Step 1: Identify FV = $10,000
Step 2: r = 7% = 0.07
Step 3: n = 2
Step 4: Apply the formula:
PV = $10,000 / (1 + 0.07)^2 = $10,000 / (1.07 × 1.07) = $10,000 / 1.1449 = $8,734.39

On your Balance Sheet, you record $8,734.39 as the value of this receivable—not the full $10,000.

PV in the Income Statement

When you use PV for things like leases or loans, it impacts “interest expense” or “interest income” over time.

Example: If you receive $8,734.39 now for a promise of $10,000 in two years:

Step 1: First year’s interest income:
Interest = PV × r = $8,734.39 × 0.07 = $611.41
Receivable after Year 1 = $8,734.39 + $611.41 = $9,345.80
Step 2: Second year’s interest income:
Interest = $9,345.80 × 0.07 = $654.21
Receivable after Year 2 = $9,345.80 + $654.21 = $10,000.01 (rounding difference)

The interest income appears on your Income Statement each year.

What Is Net Present Value (NPV)?

Now, let’s tackle NPV.

Definition: Net Present Value (NPV) is the sum of the present values of all cash inflows and outflows of a project or investment, using a chosen discount rate.

In other words, NPV tells you whether a project or investment will make you money after considering the time value of money.

The Formula:

NPV = (PV of all cash inflows) – (PV of all cash outflows)

Or, more generally:

NPV = Σ [Cash flow at time t / (1 + r)t] – Initial investment

Simple Example of Net Present Value

Suppose you’re considering buying a new machine for $5,000. You expect it to generate $2,000 per year for 3 years. Discount rate is 5%.

Step 1: Calculate each year’s PV:
Year 1: PV = $2,000 / (1.05)^1 = $2,000 / 1.05 = $1,904.76
Year 2: PV = $2,000 / (1.05)^2 = $2,000 / 1.1025 = $1,814.06
Year 3: PV = $2,000 / (1.05)^3 = $2,000 / 1.157625 = $1,727.68
Step 2: Add all PVs:
Total PV of inflows = $1,904.76 + $1,814.06 + $1,727.68 = $5,446.50
Step 3: Subtract initial investment:
NPV = $5,446.50 – $5,000 = $446.50

A positive NPV means the investment adds value to your business!

Where Is NPV Used in Accounting?

NPV is mainly used for decision-making:

Comparing different business options: NPV helps determine which project or investment yields the greatest value by calculating the present worth of future cash flows, making it easier to choose the most profitable option.
Evaluating mergers, acquisitions, or equipment purchases: By estimating the future cash inflows and outflows associated with these decisions, NPV shows whether the venture is likely to add value to your company.
Budgeting and long-term planning: NPV provides a clear financial forecast for proposed projects, helping businesses allocate capital efficiently and prioritize investments that maximize returns.

NPV in the Balance Sheet

While “NPV” isn’t a line item, assets you add to your BalanceSsheet (like machinery, vehicles, or investments) are often chosen based on their NPV.

Example: If you purchase equipment with a positive NPV, the actual cost—$5,000 in the machine example—is recorded as an asset.

NPV in the Income Statement

The results of your NPV analysis show up through depreciation and revenue generation.

Example: Your new machine helps generate extra income. For instance, if it produces $2,000 in annual sales:

Each year, you recognize $2,000 in revenue on your income statement.
You also record depreciation, spreading the $5,000 cost over its useful life (e.g., $1,666.67 per year for 3 years).

Interactive Examples and Scenarios—with In-Depth Math

Scenario 1: Leasing a Van

You’re considering leasing a van for your delivery business. The dealer offers you two payment options:

Pay $12,000 now
Pay $4,500 per year for 3 years (total $13,500)

Discount rate is 8%. What’s the present value of the second option?

Year 1: PV = $4,500 / (1.08)^1 = $4,500 / 1.08 = $4,166.67
Year 2: PV = $4,500 / (1.08)^2 = $4,500 / 1.1664 = $3,858.04
Year 3: PV = $4,500 / (1.08)^3 = $4,500 / 1.259712 = $3,573.18
Total PV = $4,166.67 + $3,858.04 + $3,573.18 = $11,597.89

So, the second payment option (even though it totals $13,500) is actually less expensive in today's money than paying $12,000 upfront. Despite appearances, paying $12,000 now is actually costlier when the discount rate is considered.

Scenario 2: Offering Credit to Customers

You offer a client the choice to pay $5,000 now or $5,500 in one year. Discount rate is 6%.

PV of $5,500 in one year: PV = $5,500 / (1.06) = $5,188.68

Since $5,188.68 is more than $5,000, it’s better for you if the client pays in one year (unless you need cash right away). This calculation is useful for setting your credit policies.

Scenario 3: Expansion Project

Imagine you’re expanding your bakery and considering an investment of $20,000 that will earn you $7,000 each year for 4 years. Your discount rate is 7%.

Year 1: PV = $7,000 / (1.07)^1 = $7,000 / 1.07 = $6,542.06
Year 2: PV = $7,000 / (1.07)^2 = $7,000 / 1.1449 = $6,114.06
Year 3: PV = $7,000 / (1.07)^3 = $7,000 / 1.225043 = $5,714.06
Year 4: PV = $7,000 / (1.07)^4 = $7,000 / 1.310796 = $5,339.31
Total PV = $6,542.06 + $6,114.06 + $5,714.06 + $5,339.31 = $23,709.49
NPV = $23,709.49 - $20,000 = $3,709.49

Since NPV is positive, your expansion project makes financial sense.

Quick Tips for Small Business Owners

Use PV when valuing receivables, loans, or future payments.
Use NPV to evaluate investments, purchases, and big decisions.
Remember: a positive NPV means value added; a negative NPV means reconsider!
Work with your accountant to ensure your balance sheet and income statement reflect the real value of long-term assets and liabilities.
Practice! Run through a few scenarios with your business numbers to build confidence.

Conclusion

If you ever need guidance applying PV, NPV, or have questions about any accounting or business challenge, don’t hesitate to reach out to KLV Accounting. The team at KLV Accounting is ready to support you, answer your questions, and help your business thrive.

Understanding PV and NPV isn’t just for accountants—these concepts empower you to make smarter choices, protect your business’s financial health, and plan for the future. Whether you’re deciding to buy equipment, extend credit, or expand your services, knowing how to value money over time gives you a powerful advantage.

If you want to see these concepts in action for your business, try building a simple spreadsheet—play with different discount rates, cash flows, and timelines. With practice, PV and NPV will become useful tools in your daily decision-making toolkit.

Feel free to share your questions and experiences below—let’s keep learning together!

In the next blog we will discuss creating a cash flow statement, how these are prepared and used as part of the financial statements.

KLV Accounting, a Calgary-based accounting firm, is here to help. Contact us today to enhance your financial strategy, minimize your taxes, and drive business success! For a free consultation, call us at 403-679-3772 or email us at info@klvaccounting.ca.