Financial Analysis

Overview

Financial
Analysis

Financial Financial analysis Cost &

The finance
objectives & & decision management
function
business strategy making accounting
 Financial objectives and business strategy

● Financial risk

● Financial return

● Funding (cont)
 Funding

Launch Growth Maturity Decline

(Question (Star) (Cash Cow) (Dog)
Mark)
Business risk Very high High Medium to Low
low

Financial risk Keep very low Keep low May be Can be high
increased

Funding Venture Equity Debt and Secured Debt

capital Equity

dividends Nil Nominal , if High Total

any
 The finance function

Impact of technology on finance function and professionals

● Big Data

● Cloud Computing

● Predictive analytics
 Finance function structure

● Business partner

● Outsource

● Shared or global business services

 Financial analysis and decision making techniques

Financing requirements: 3 types of decisions

1. Investment decisions
2. Financing decisions
3. Dividend decisions
 Summary of most common sources of finance
Method Advantages Disadvantages
Retained profits/operating Simple, no change in Restricts dividend payouts,
cash flows ownership may not be sufficient for
growth
Issue shares Long term capital May dilute existing control
Bank loan Repayments are known Increase gearing and
and can be budgeted , financial risk, interest must
flexible , quick , no dilution be paid
of control
Bank overdraft Flexible, only pay interest Repayable on demand so
on amount owing , doesn’t less reliable , often more
count towards gearing as expensive
short term debt
Loan capital Similar to bank loan , may Slower to put in place than
not have restrictive bank loan , more public ,
covenants issue costs
 Sources of finance-Evaluation
Sources of finance can be evaluated using SFA model:

● Suitability
● Acceptability
● Feasibility
 Investment Appraisal
Capital expenditure often represents a significant investment by a company
so it needs to be assessed very carefully. A long term view of costs and
benefits must be taken when reviewing a capital expenditure project.

Detailed concepts:
 Risk and Uncertainty
The basic definition of risk is that the final outcome of a decision, such as an
investment, may differ from that which was expected when the decision was
taken.
We tend to distinguish between risk and uncertainty in terms of the
availability of probabilities.
● Risk is when the probabilities of the possible outcomes are known (such
as when tossing a coin or throwing a dice)

● Uncertainty is where the randomness of outcomes cannot be expressed

in terms of specific probabilities.
Attitudes towards Risk
 Expected Value
Using the information regarding the potential outcomes and their associated
probabilities, the expected value of the outcome can be calculated simply by
multiplying the value associated with each potential outcome by its
probability.

It is the weighted average of all possible outcomes

 Expected Value-Example

The expected value of the sales for year one is given by:

= ($500,000 x 0.1) + ($700,000 x 0.2) + ($1,000,000 x 0.4) + ($1,250,000 x 0.2) +

($1,500,000 x 0.1)
= $50,000 + $140,000 + $400,000 + $250,000 + $150,000
= $990,000
 Expected Values-Continued
● In this example, the expected value is very close to the most likely outcome, but
this is not necessarily always the case.
● Moreover, it is likely that the expected value does not correspond to any of the
individual potential outcomes. For example, the average score from throwing a
dice is (1 + 2 + 3 + 4 + 5 + 6) / 6 or 3.5, and the average family (in the UK)
supposedly has 2.4 children.
● A further point regarding the use of expected values is that the probabilities are
based upon the event occurring repeatedly, whereas, in reality, most events only
occur once.
● This methods is used by Risk neutral Decision makers
● Expected value is used for decision making. If two or more options are considered
the selected option is the one which has the highest expected value.
 Decision Trees

A decision tree is a diagrammatic representation of a problem and on it we show all possible

courses of action that we can take in a particular situation and all possible outcomes for each
possible course of action.

It is particularly useful where there are a series of decisions to be made and/or several outcomes
arising at each stage of the decision-making process.
 Decision Trees-Drawing the Tree
1. Always work chronologically from left to right. i.e.
2. Start with a labeled decision point

3. Add branches for each option/alternative

4. If the outcome of an option is 100% certain, the branch for that alternative is complete
5. If the outcome of an option is uncertain (because there are a number of possible outcomes),
add an outcome point
B
A
 Decision Trees
6.For each possible outcome point, add a branch with a relative probability)
to the outcome point.
B
A

Rollback analysis:
is the evaluation and recommendation stage. Here, the decision is ‘rolled
back’ by calculating all the expected values at each of the outcome points and
using these to make decisions while working back across the decision tree. A
course of action is then recommended for management.
 Example-EV & Decision Trees
A company has to decide whether to launch a new product in Country Asia A or in Asia B.
If the product is launched in Asia A, the probability that forecast sales revenues will be high at
$575,000 is 0.2, the probability they will be low at $300,000 is 0.15 and the probability they will
be medium at $440,000 is 0.65.
If the product is launched in Asia B, the probability that forecast sales revenues will be high at
$700,000 is 0.45 and the probability they will be low at $250,000 is 0.55.

a)Where should the company launch the new product, assuming that investment is mutually
exclusive using Expected values?
b) Draw a decision tree.
EV & Decision Tress
 Performance Evaluation
Financial performance measures/indicators (FPIs)
Non-financial performance measures/indicators (NFPIs)

Financial measures can be used to measure the following three areas of

performance:

1. Profitability
2. Liquidity
3. Risk
Ratio Analysis
Ratio Analysis
Ratio Analysis
 Non Financial Indicators
More recently there has been an emphasis on introducing non-financial
measures to augment, and in some cases, replace the financial measures
traditionally used. The use of non-financial measures is intended to address
some of the problems highlighted with financial measures, particularly
relating to qualitative issues, wider performance areas and internal focus.

A weakness of non-financial measures is that they cannot be easily

reconciled or linked together meaning that we have a wide mix of unrelated
measures. There is no easy way to avoid this.
Evaluating Performance
Evaluating Performance
Cost & management Accounting
 Short Term Decisions
Contribution:
 Forecasting
Correlation: relationship between two variable
○ Positive
○ Negative
○ No correlation
Correlation coefficient(r):
● it tells the strength of relationship between two variables
● Range= -1 to +1
● Perfect negative-inversely proportional
● Perfect positive-directly proportional
Coefficient of determination(r )
It tells us the % dependency of dependent variable on independent variable
 Forecasting

Linear Regression Analysis: finds the equation of the straight line (line of best
fit) and used to forecast.
Y=a + b x
where
y = total cost
x = No of units produced
a = the slope or gradient of the line (e.g. how much the cost increases for
each additional unit)
b = the intersection of the line on the y axis (the cost that would be incurred
even if production were zero).
It is also known as least square method.
 Forecasting

Time series: A time series shows how an amount changes over time. Time
series analysis usually recognises four effects:

• A trend. This is the underlying growth or decline in an amount

• Seasonal variations. These are variations which repeat fairly consistently
within a period of no more than a year
• Cyclical variations. These are variations which repeat over longer than a
year. For example, economic boom and depression
• Random variations. Unexpected changes in what might be expected.
Forecasting-Example
Forecasting-Example
 Budgeting
A plan, not a forecast. It’s a short term plan expressed in financial terms .It converts strategic plans into specific targets.

Objectives of budgetary planning and control systems

• Ensure the organization’s objectives are achieved

• Compel planning

• Communicate ideas and plans

• Co-ordinate activities

• Provide a framework for responsibility accounting

• Establish a system of control

• Motivate employees to improve their performance

Styles of budgeting:

Imposed ( top-down )

Participation (bottom-up)
 Budgeting
Fixed budgets:

Flexible Budgets:

Flexed budgets:
 Standard costing
• Standard costs

• Types of standards

• Variance Analysis
 Standard costing
Flexible budget and variance analysis:
Standard costing-Limitations