Financial Measures and

Profitability analysis
Dr. K. Sarkodie
Objectives
To know and apply the concepts project profitability such as
• Annual rate Return (Return on Investment, R.O.I.)
• Payout Period (P.P), Payback Time or Cash Recovery Period
• Discounted Cash flow rate , internal rate of return
• Present Value Index
• Net present Value
Introduction
• The basic aim of financial measures and profitability analysis is to
provide some yardsticks for the attractiveness of a venture or a
project, where the expected benefits (revenues) must exceed the
total production costs.
• There are many different ways to measure financial performance, but
all measures should be taken in aggregation.
Profitability

• Profitability measures the extent to which a business generates a

profit from the use of resources, land, labor, or capital.

• Behind the need for profitability is the fact that any business
enterprise makes use of invested money to earn profits.

• Profitability is measured by dividing the profits earned by the

company by the investment (or money) used by the company
 Methods of profitability analysis
The most common measures, methods, and economic indicators of
economically evaluating the return on capital investment include
• Rate of return, or return on investment (R.O.I.)
• Payment period (P.P.)
• Discounted cash-flow rate of return (D.C.F.R.) and present value index
(P.V.I.)
• Net present value (N.P.V)
 Which is the best yardstick for profitability?
• No one method is by itself a sufficient basis for judgment.

• A combination of more than one profitability standard is needed to

approve or recommend a venture.

• In addition, it must be recognized that such a quantified profitability

measure would serve as a guide.

• Many unpredictable factors and uncertainties cannot be accounted for,

specifically those in exploration and production operations.
 Mathematical Methods for Evaluating Profitability
Classification of these methods into two groups is considered,
where the time value of the cash flow received from a project is the criterion
used in this classification:
1. Time value of money is neglected.
Two methods fall in this group.
A. the annual rate of return (R.O.I.)
B. the payout period (P.P.).
2. Time value of money is considered.
Two methods represent this group.
A. the discounted cash flow of return (D.C.F.R.) and
B. the net present value (N.P.V.).
 Annual Rate of Return (Return on
Investment, R.O.I.)
• The annual rate of return is defined by the equation

• Consideration of income taxes is provided in calculating the R.O.I. by

using either “net” profit or “gross” profit.

Equation 1

The main drawback of this method is the fact that money received in the future (cash
flow) is treated as money of present value (which is less, of course).
 Example- Return on Investment (RIO)
• It is necessary to calculate the R.O.I. for two projects involving the desalting of
crude oil; each has an initial investment of $500,000. The useful life of project
1 is 4 years and of project 2 is 5 years.

• The earnings pattern is given in the table below

$111,000
$55,000
Comparison between two projects

Project 1 Project 2
Payout Period (P.P.), Payback Time, or Cash
Recovery Period
• Payout period is defined as the time required for the recovery of the
depreciable capital investment in the form of cash flow to the project.
Cash flow would imply the total income minus all costs except
depreciation.
• Mathematically, this is given by Equation (2), where the interest
charge on capital investment is neglected:

Equation 2
• Explanation to the cash flow figure
• Investment for land (if needed) comes first, followed by investment for the
depreciable asset throughout the construction period (points 1 and 2).
• The need for the working capital comes next for startup and actual production
(points 2 and 3).
• Production starts now at point 3 (zero time) and goes all the way profitably to
cross the zero cash line at point 4.
• This point corresponds to the time spent to recover the cumulative
expenditure, which consists of capital of land + capital cost of depreciable
assets + working capital.
• The payout period will accordingly be defined by point 4—that is, the time
required to recover the depreciable capital only.
• Point 4 could be considered an alternative way (but different in value) to
define payout period as the time needed for the cumulative expenditure to
balance the cumulative cash flow exactly.
The oil industry in focus
• The payback period is used by oil companies in ascertaining the
desirability of capital expenditures, because it is a means of rating
capital proposals.
• It is particularly good as a “screening” means relative to various
capital proposals.
• For example, expenditures for units may not be made by an oil
refinery unless the payback period is no longer than 3 years.
• On the other hand, the proposed purchase of a subsidiary may not be
considered further unless the payback period is 5 years or less.
Drawbacks of the Payback period

• Payback ignores the actual useful length of life of a project.

• Also, no calculation of income beyond the payback period is made.
Payback is not a direct measure of earning power, so the payback
method can lead to decisions that are really not in the best interests
of an oil company.
 Example- Payback Period.
• Calculate the payout period for the two alternatives of capital expenditures involving an
investment of $2 million each for a sulfur removal plant, as given in the Table. The life of
project 1 and project 2 is 7 and 10 years, respectively.
 Solution
• From the cash flow given in payout table, the payout period (P.P.) is calculated as

follows:

• (P.P.)1 = 2 × 106/471,429 = 4.24 years

where $471,429 is the average annual cash flow. Note ($3,300,00/7years)

• (P.P.)2 = 2 × 106/370,000 = 5.41 years

where $370,000 is the average annual cash flow. Note ($3700,000/10 years
 Which of the projects is practically viable?
The pay period index would thus
recommend project 1 in favor of project 2
(fewer years are required to recover the
same initial capital increment).
However, project 1, ceases to generate any
cash flow after the seventh year, while
project 2 continues, through the added cash
flow, to generate $400,000 each year after
the investment has been paid back in full at
the end of the sixth year (P.P. is 7 years).
It is pointless to select project 1 on the
ground that over the period from year 7 to
year 10, $1.2 million would be generated by
project 2, which makes a total of $0.8 million
more by project 2 over project 1 for the 10-
year period.
AGREE OR DISAGREE?
 Example – Payback period 2
• With reference to the investment made to procure boilers for surface
facilities in an oil field, as shown in the Table below, calculate the payback
period for each alternative and give reasons for selecting one and not the
other.
• Solution
Choice between both boiler investments

• As far as the P.P. as a criterion for choice, the number of years to recover
the depreciable capital is the same for both types of boilers.

• However, the recovery of investment for boiler 1 is faster than for boiler 2
(for example, compare $20,000 to $5,000 for the first year).

• Therefore, from the standpoint of cost of money (time value of money),

investment in boiler 1 is preferable to investment in boiler 2.
Comparison of boiler investments
 Further comments on the payback time
• This example points out that when using the payout period method, oil
management should also observe the rapidity of cash flows between
alternatives.
• The alternatives may have the same number of years-to-pay-back as
they do here, but one may be more favorable than the other because
the largest amount of cash flow comes in the first few years.
• This could be an excellent point in favor of investment in one alternative
over another when both have approximately the same payout periods.
• It could be a strong factor in selection of one especially if a greater
amount of cash “back” is needed early in the investment.
Further example
• Company C is planning to undertake a project requiring initial
investment of $105 million.
• The project is expected to generate $25 million per year in net cash
flows for 7 years.
• Calculate the payback period of the project.
Further example 2
• Company C is planning to undertake another project requiring initial
investment of $50 million and is expected to generate $10 million net
cash flow in Year 1, $13 million in Year 2, $16 million in year 3, $19
million in Year 4 and $22 million in Year 5.
• Calculate the payback value of the project.
Further example 3 – PP and ROI
• The salt content of a Middle-Eastern crude oil (API gravity 24.2) was found to be 60
PTB. In order to ship and market this oil, it is necessary to install a desalting unit in
the field, which will reduce the salt content to 15 PTB. This upgrading in the quality
of oil in terms of an acceptable PTB could realize a possible saving of 0.1 $/bbl in the
shipping cost of the oil:
Assume the following:
• The crude oil desalter has a design capacity of 120,000 bbl/day.
• The current capital investment of the desalting unit is estimated to be $3 million plus
another $2 million for storage tanks and other facilities.
• Service life of equipment is 10 years with negligible salvage value, while the
operating factor = 0.95.
• The total operating expenses of the desalter are estimated to be $10/1000 bbl.
• The annual maintenance expenses are 10% of the total capital investment.
• Evaluate the economic merits of the desalter by calculating the (ROI) Return on
investment and payout period (P.P.).
 Solution
• Yearly crude oil production = 120,000 bbl/day * 365 = 43,800,000 bbl / year
• Annual saving in shipping cost = 0.1$/bbl * 43,800,000 bbl *0.95 =$ 4,161,000
/year (total saving)
Note: (0.95 is the efficiency of the desalter )
• Capital investment = 3,000,000 + 2,000,000 = $5,000,000/ year
• Annual ops expense = $10/1000 bbl *43,800,000* 0.95 bbl = $416,100 / year
• Annual maintenance = 0.1* 5,000,000 = $500,000/ year
• Annual depreciation cost = 5,000,000/10 = $500,000/ year (using SLD)
• Total annual cost = 500,000+ 416,000+ 500,000 = $1,416,100 / year
• Net savings or profit = =$ 4,161,000 - $1,416,100 = $2744900/ year
• ROI = Net profit /Total capital investment = $2744900/$5,000,000 * 100 =
54.9 %
• P.P = $5,000,000/ $2,744,900 = 1.82 years
Net Present Value
NPV EXAMPLE
Net Present Value (N.P.V.)
 Further Examples- NPV
• During field operations, the manager
in charge is considering the purchase
and the installation of a new pump
that will deliver crude oil at a faster
rate than the existing one.
• The purchase and the installation of
the new pump will require an
immediate layout of $15,000. This
pump however, will recover the costs
by the end of one year.
• The relevant cash flows for the case
study are established as given in Table
below
• If the oil company requires 10%
minimum annual rate of return on
money invested, which alternative
should be chosen?
SOLUTION
 Discounted Cash-Flow Rate of Return (D.C.F.R.) and
Present Value Index (P.V.I.)
• If we have an oil asset (oil well, surface treatment facilities, a refining unit,
etc.) with an initial capital investment P, generating annual cash flow over a
lifetime n, then the D.C.F.R. is defined as the rate of return, or interest rate
that can be applied to yearly cash flow, so that the sum of their present
value equals P.
• In order words it is a measure of the maximum interest rate that a project
could afford just by paying the total capital investment.
• From the computational point of view, D.C.F.R. cannot be expressed by an
equation or formula, similar to the previous methods.
• A three-step procedure involving trial and error is required to solve such
problems.
• The next example explains these steps
Internal rate of return (IRR) or the DCFR
OR DCFR
IRR – CRITERIA
 Example - DCFR
• Assume an oil company is offered a lease of oil
wells which would require a total capital
investment of $110,000 for equipment used for
production.

• This capital includes $10,000 working money,

$90,000 depreciable investment, and $10,000
salvage value for a lifetime of 5 years.

• Cash flow to project (after taxes) gained by selling

the oil is as given in the table .

• Based on calculating the D.C.F.R., a decision has

to be made: should this project be accepted?
Comments on the Techniques of Economic
Analysis
• All four methods described above determine the return on investment
or the attractiveness of a project.
• the R.O.I. and P.P. are economic indicators to be used for rough and
quick preliminary analyses.
• The R.O.I. method does not include the time value of money and
involves some approximation for estimating average income or cash
flow.
• The P.P., on the other hand, ignores the useful life of an asset (later
years of project life) and does not consider the working capital.
Comments on the Techniques of Economic
Analysis cont.
The D.C.F.R. and N.P.V. are regarded as the most generally acceptable
economic indexes to be used in the oil industry. They take into account
the following factors
• Cash flows and their magnitude
• Lifetime of project
• Time value of money
Comments on the Techniques of Economic
Analysis cont.
Although the D.C.F.R. involves a trial-and-error calculation, computers
can be easily used in this regard.
• The D.C.F.R. is characterized by the following:
• It gives no indication of the cash value.
• It measures the efficiency of utilizing a capital investment.
• It does not indicate the magnitude of the profits.
• It is recommended for projects where the supply of capital is
restricted and capital funds must be rationed to selected projects.
• The N.P.V. method, on the other hand, is considered to measure
“profit.”
• The values reported by the N.P.V. yield the direct cash measure of the
success of a project; hence they are additive (compare with D.C.F.R.).
 Model example 1
• If an oil company expects a cash flow of $800,000 by the end of 10 years,
and 10% is the current interest rate on money, calculate the N.P.V. of this
venture.

• Solution
• No capital investment is involved here, so the problem is simply a
discounting procedure.
• The present value of the cash flow
= 800,000(1 + 0.1)–10 = $308,000
 Trial exercise 1
• Assume that a distillation unit with an initial cost of $200,000 is expected to
have a useful life of 10 years, with a salvage value of $10,000 at the end of its
life.
• Also, it is expected to generate a net cash flow above maintenance and
expenses amounting to $50,000 each year. Assuming a selected discount rate
of 10%, calculate the N.P.V