Chapter 3

Financial Analysis
 Contents
1. Objectives of Financial Analysis
2. Pricing Project Costs and Benefits
3. Change in prices
4. Financial ratios
a) Efficiency Ratios
b) Income ratios
c) Creditworthiness ratios
5. Discounted project worth measures
• NPV, IRR, BCR, discounted payback
 Financial Analysis
 Financial analysis answers the question :
 “is the project financially profitable to a given
individual, group or business?

 Is the project financially sustainable?”

 In financial analysis costs and benefits are
valued at market prices
 5.1 Objectives of Financial Analysis
 Assessment of financial impact on participants:
Farmers
Firms
Government
Other financers
 Judgment of efficient resource use-investment and
ratio analysis.
 Assessment of incentives - related with returns.
 Provision of sound financial plan-provide base for
(activities and corresponding budget).
 Important Variables in Financial Analysis

 Revenues and cost items

 Sources of financing

 Financial viability
 The Investment Costs of a Project
 Initial investment Costs of a project
 Land and site Development
 Buildings and Civil Works
 Plant and Machinery
 Technical know-how and engineering fees
 Miscellaneous Fixed Assets
 Capital issue expenses
 Pre-operative Expenses
 Provision for contingencies, etc.
 Other costs
 Sunk costs
 Depreciation
 Operation Costs of a Project
 Direct and indirect costs:
 Direct costs are directly attributable to the
production
 Indirect costs are incurred to facilitate the
production process but are not the direct inputs of
production.
 Variable costs and fixed costs:
 Variable costs are costs that vary with the volume
of the product
 Fixed costs are costs that do not vary with the
volume of the product.
 Cost of production comprises of three main
factors:
 Cost of materials,
 Labor cost and
 Factory overhead
 Cost of production = Material cost + labor
cost + factory overhead Total COP
cost.
CoPperUnit
Total Noof Units
 Working Capital Estimates
 Working capital is the financial requirement needed
to finance the current asset of the balance sheet.
 raw materials, supplies and components
temporarily held in stock until usage,
 Work-in-process,
 finished goods until the time of selling,
 accounts receivable until payment made by
the customer, etc.
 Net Working Capital = Current Assets –Current
Liabilities
 Means of Finance
 Government
 International organizations
 Partially international organizations and
partially government

 Entreprenuers (individually or in group)

 Individuals and govt.
 The major sources of capital of projects that are
aiming at making a commercial profit are the
following:
• Share Capital
• Bonds
• Term Loans
• Trade Credit
• Accrued Liabilities
• Incentive Sources
• Miscellaneous Sources
Cretiria to select the most suitable sources
• Cost
• Risk
• Control
• Flexibility
• Rules and Regulations of the govt. and
financial institutions
 Estimates of sales and production
Year 1 2 3 4
Installed capacity (Qty)
Estimated output as % of plant
capacity (Qty)
No of working days
Estimated annual production (Qty)
Value of sales (SP * Qty)

After estimating the quantity of production, the

cost of production has to be estimated.
 Profitability Projection
After the estimates of sales revenue and the
cost of production are made, the next step is
to prepare the profitability projection.

This is done by preparing a projected

income statement and cash flow statement .
 Income Statement Vs Cash Flows
Income statement
• Estimating sales revenue and costs over years of the
project operation helps to prepare projected balance
sheet and income statement and to decide on the
profitability of the project.
• Major purposes of preparing income statements:
• to determine indicators of relative efficiency;
• to determine the net profit to be incorporated in the
balance sheet;
• to determine the tax liability of the project;
• To provide financial information to concerned
stakeholders.
Projected Income statement
Items 1 2 3 4
Sales in Units a
Sales Revenue (Unit price x a ) b
Operating Costs (Unit cost x a ) c
Gross profit (b – c) d
Overhead costs e
Depreciation f
Operating Income (EBIT) (d- (e + f)) g
Interest on loan h
Earning Before Tax (EBT) ( g – h) i
Taxes (20%) (20 % of i ) j
Earning After Tax (EAT) ( i – j) k
 Exercise 1: Assume the following:
•The life of a project = 4 years.
•Initial investment cost = 100 million.
•Depreciation : 2 million/year.
•Annual interest rate on loan = 8,6,4,2 million for year 1, 2,3 and 4
respectively
•Unit sales: 1milion (1st year), 2 million (2,3,&4)
•Selling price per unit = Birr 60
•Operation cost per unit = Birr 32
•The overhead fixed cost = 4 million/year
•Tax rate is 20% of the net profit

Required: Prepare the forecasted income statement of the project

for four years.
Forecasted Income Statement
Year 1st 2nd 3rd 4th
Sales in Units 1 2 2 2
Sales Revenue (Birr 60 * Units) 60 120 120 120
64 64
Operating Costs (Birr 32 * Units) 32 64
56 56
Gross profit 28 56
Overhead costs 4 4 4 4
2 2 2
Depreciation 2
50 50
Operating Income (EBIT) 22 50
Interest 8 6 4 2
Earning Before Tax (EBT) 14 44 46 48
Taxes (20%) 2.8 8.8 9.2 9.6
Earning After Tax (EAT) 11.2 35.2 36.8 38.4
Cumulative EAT 11.2 46.4 83.2 121.6

The above table shows that the project has a nominal

cumulative
of Birr 121.6 million net profits by the end of the fourth year.
 Cash Flows
It is a process of review of costs and benefits, measured in terms of cash
outflows and cash inflows.
• The cash inflow of a project includes:
• the project revenues,
• government grants,
• resale/scrap values of assets,
• tax receipts and other cash inflows as a result of accepting a project.
• The cash outflow of a project includes:
• initial investments in acquiring the assets,
• project costs (labour, materials, etc.),
• working capital investments,
• tax payments and any other cash outflows as a result of accepting
the project.
 Exercise 2:
• Based on the information given in exercise 1 and
• Capital = 50 million
• Loan = 50 million
• Working capital 1st year = 20 million and 2nd year = 10
million
• Salvage value is expected to be 8 million
• Initial investment cost =100 million

Required: Prepare cash flow statement

 Financial Analysis Economic Analysis

• Appraise the project from the • Appraise the project from the
view point of an entrepreneurs, view of macro or national
investor or financier. economy or its contribution to
the society.

• Covers only private costs and • It takes into account social costs
benefits and benefits.

• Taxes are treated as costs and • Taxes and subsidies are treated
subsidies as a return. as transfer payments.

• The overriding objective is • The objective is economic

viability [social benefits] based
financial viability (i.e. making on shadow price.
profit) based on market price.
 5.2 Financial Ratios

• Financial ratios will base on financial

statements:
• Balance sheet (Asset-current and fixed assets;
Liabilities-current and long-term liabilities;
Capital- owners equity).
• Income statement (Revenues and Expenses).
• Cash flow [source and use of fund] statement
(cash inflows = benefits; cash outflows = costs,
net cash balance or net benefit).
 i. Efficiency ratio:
• Inventory turnover (ITO) = Cost of goods
sold (CGS) / Inventory
• Operating ratio = Operating Expenses/
Revenue.
 ii. Income (Profitability) ratio

• Return on sales = Net Income / Revenue

• Return on Equity = Net Income After Tax /
Equity
• Return on Investment = average net income/
total investment
• Return on Assets = Operating Income / Assets
 iii. Creditworthiness ratio

• Current ratio = Current Assets / Current Liability

• Debt-equity ratio: Long-term Liability / Equity
• Debt-Service Coverage ratio = Net Income +
Depreciation + Interest / Interest Paid + Long-term
Loan Repayment.
 Payback Period
• The payback period is the length of time
required to recover the initial investment.
• According to the payback criterion, the shorter
the payback period, the more desirable the
project is.
• If the net cash inflow is uniform each year,
then,
Intial Investment
Payback Period 
AnnualUniformCashInflow
• If the cash flows of a project are not uniform, the
payback period is calculated by accumulating a
series of cash flows until the amount reaches the
initial investment.
• Example,
Year 0 1 2 3 4 5

Cash flow -30000 5,000 12,000 12,000 6,000 8,000

The payback period = 3 years + 1000 * 12 = 3 yrs and 2 months

6000
Advantages of payback period
• It is simple to apply
• It is helpful in weeding out risky projects.
• It helps to assess the firm’s ability to meet
its financial obligations
Disadvantages of payback period
• It ignores the time value of money.
• It overlooks cash flows beyond the
payback period.
• It may divert attention from profitability
5.3 Discounted measures of project worth
Time value of money
• Present values are better than the same values in
the future and earlier returns are better than
later. This shows that money has time value.
Thus, to include the time dimension in our
project evaluation, we have to use discounting
methods.
• Discounting is essentially a technique that
‘reduces’ future benefits and costs to their
‘present worth’. The rate used for discounting
is called discount rate.

• As compounding asks “what is the future

worth of a known present amount”?
discounting asks “what is the present worth of
a known future amount”?
• The factor used to discount future costs and
benefits is called the discount rate (r) and
is usually expressed as a percentage.

• The discount rate is usually determined by

the central authorities (national Bank).
• Suppose a bank lends 1567.05 Birr for a
project at 5% interest rate. The project owner is
supposed to repay the principal & interest rate
after 5 years. How much the owner will have to
pay at the end of year 5?
At = P(1 + r) t
At = total amount after t years
r = interest rate
t = time
A5 = 1567.05 (1 + 0.05)5
= 2000 Birr
• Suppose again a project is expected to obtain 2000
Birr after 5 years. Value of this money today can
be calculated as:
At 2000
P   1567.05
1  r t 1  0.05
5

• The difference between this & the previous is only

the viewpoint. The interest rate used for
compounding assumes a viewpoint from here to
the future, whereas discounting looks back ward
from the future to the present.
a) The Net Present Value (NPV)

The net present value formula is:

( Bt  Ct )
n
NPV   t
t 0 (1  r )

Where:
 Bt stands for the project benefits in period t
 Ct stands for the project costs in period t
 r, stands for the appropriate financial or economic
discount rate
 n, stands for the number of years for which the
project will operate, i.e. the economic life of the
project
 Decision Rule:
• If the NPV is positive, accept the project.
• If the NPV is zero, be indifferent
• If the NPV is negative, reject the project.
• If we compare two or more projects, the
higher the NPV, the better the project is.
 Undiscounted Discounted
  1 2 3 4 5
Year(t) Costs Benefit Net benefits Discount factors (10%)= Discounted Net Benefits (Net
(Cash flow) 1/(1+0.10)-t Cash Flow) (3)*(4)
(2) – (1)

0 20 0 -20 1/(1+0.10)0 = 1.000 -20(1.000) = -20.00

1 10 14 4 1/(1+0.10)1 = 0.909 4(0.909) = 3.64
2 10 14 4 1/(1+ 0.10)2 = 0.826 4(0.826) = 3.30
3 10 14 4 1/(1+0.10)3 = 0.751 4(0.751) = 3.00
4 10 14 4 1/(1+0.10)4 = 0. 683 =2.73
5 10 14 4 =0.621 =2.48
6 10 14 4 =0.564 =2.26
7 10 14 4 =0.513 =2.05
8 10 14 4 =0.467 =1.87
9 10 14 4 =0.424 =1.70
10 10 14 4 1/(1+0.10)10 = 0.386 4(0.386) = 1.54
Total 120 140 20.00 1/(1+0.10)t = 6.144 NPV = 4.57
Advantages of NPV
•The time value of money is taken into account
•The cash flows from the beginning to the end of the project are
considered
•It focuses on the profitability of the project
•It is useful for the comparison of mutually exclusive projects
•Since the NPV is expressed in Dollar or Birr, the managers can
understand it more easily than percentages.
 

Disadvantages of NPV
•The NPV method can be employed in selecting from mutually
exclusive projects only when the projects are of the same size.
•The NPV method assumes that funds are reinvested at the cost of
capital
•The cost of capital is assumed to remain constant throughout the
life of the project.
 Internal Rate of Return
• The IRR is the rate of discount, which makes
the present value of the benefits exactly equal
to the present value of the costs.

t
Pt t
( Bt  C t )
NPV  P0   0
t 0 1  R t
t 0 1  R t
Calculation of IRR
If the positive and negative NPVs are close to zero,
a precise and less time consuming way to arrive at
the IRR is using the following interpolation
formula.
PV ( I 2  I1 )
IRR  I1 
PV  NV

Where: I1 = the lower discount rate

I2= the upper discount rate
PV = NPV (positive) at the low discount rate of I1
NV = NPV (negative) at the high discount rate of I2
Note: I1 and I2 should not differ by more than one or two
percent.
 Decision Rule for IRR is
• Accept :if IRR is greater than the cost of
capital
 Reject: if IRR is less than the cost of capital
 Indifferent: if IRR is equal to the cost of
capital
 If we are comparing two or more projects,
the higher the IRR, the better the project is.
 Example:

• Find the IRR of a project with 20,000

initial investments, the cost of capital of
12 % and with the following table of
cash flows.

Year 1 2 3 4
Cash flow 6000 6000 8000 9000
Try to compute the NPV with 12% discount rate.

 6000 6000 8000 9000 

  2
 3
   20000  5357  4800  5714  5732  20000  1603
4
 1.12 (1.12) (1.12) (1.12) 

Since the NPV is still positive, (1603), try again

with a higher discount rate: 15%

 6000 6000 8000 9000 

  2
 3
 4
  20000
 1 . 15 (1 . 15) (1 . 15) (1 . 15) 

= 167
Still the NPV is positive. Try again
with a higher discount rate i.e.
16%.
 6000 6000 8000 9000 

 1.16      20000

 (1.16) 2 (1.16) 3 (1.16) 4 

= -344
• Thus, it can be concluded that the
IRR is between 15% and 16%
Advantages of IRR
• It gives due consideration for the time value of
money
• It recognizes the total cash flows during the
project life
• It conveys the direct message about the yield on
the project.
 Disadvantages of IRR
• It involves tedious work through trial and error
• It assumes that all proceeds are reinvested at the
particular IRR, whereas the NPV approach
assumes reinvestment at the cost of capital.
 Benefit Cost Ratio (BCR)

• The BCR is defined as the ratio of the sum of the

project’s discounted benefits to the sum of its
discounted investment and operating costs.
• This is given as,
Btn

 (1  r ) t
t 0
BCR  n
Ct
 (1  r ) t
t 0
 Decision rules:

• When BCR > 1, accept the project

• When BCR < 1, reject the project
• When BCR = 1, be indifferent

• If we compare two or more projects, the

higher the BCR, the better the project is
 Example: Consider a project with initial investment of Birr
50,000 and the following Cash inflows. Discounting rate is
12% Year 1 2 3 4
A) BCR Cash inflow 12500 10000 30000 25000

PV
BCR 
I
12500 10000 30000 25000
(    )  50000
(1.12) (1.12) 2 (1.12) 3 (1.12) 4

11160  8000  21428  15924

50000
56512
 1.13
50000
b) NBCR = 1.13 –1 = 0.13

Decision: ???
 Advantages of BCR
• BCR indicates a relative and not absolute
measure of profits i.e. the benefit per dollar (Birr)
of investment.

Disadvantages of BCR
• This method cannot be employed when a
package of smaller projects is to be considered in
relation to a large project.
 Discounted Payback Period
 To overcome the limitations of the payback
period, the discounted payback period
method has been suggested
 The decision is similar with payback
period. The difference is multiplying
each cash flow by discount factor.
 Sensitivity Analysis
 Measures of project worth are first calculated using
the best estimate of inputs and outputs and the
discount rate. The project decision will be based on
these best estimates.
 However, how sensitive is a project in financial
prices and economic values?
 There might be:
 an increase in construction costs,
 an extension of the implementation period
 a fall in prices, etc.

51
 It is analytical tool to test
systematically what happens to the
earning capacity of the project if
events differ from the estimates made
about them in planning.
 The key variables to which sensitivity
analysis could be applied include: skill and
technology requirements, Price of inputs,
Price of output, Operating Costs, Sales
volume and Initial cost outlay.

52
 Reworking an analysis to see what
happens under these changed
circumstances is called sensitivity
analysis.
 All projects should be subjected to
sensitivity analysis.
 In agriculture for example, projects are
sensitive to change in four principal areas:
Price of output and inputs, delay in
implementation, costs overrun & yield.
 The application of sensitivity analysis
involves varying one project item at a
time and measuring the effect on project
worth. Because this is easier to interpret
in absolute terms, the project worth
measure generally employed in
sensitivity analysis is the net present
value (NPV).
Thank You!!