FINANCIAL ANALYSIS

Financial analysis is analytical work required to

identify:
 the critical variables which are useful to determine:
 the success or
 failure of an investment.
Its concern is to:
 determine,
 analyze and
 interpret
all the financial consequences of an investment that
might be relevant to and significant for
 the investment and
 financing decisions.
It implies the viability of projects from financial
significance to stakeholders and to the economy in
general.
 Purpose of Financial Analysis in Project Planning
Investors transfer the liquid financial resources into

production assets with the objective of:

 producing and

 obtaining future benefits.

This process is known as investment, a long term

commitment of scarce resources.

 Why Financial Analysis ?
Financial analysis is essentially undertaken for the following
purposes:
 It provides an adequate financing plan for the proposed

investment
 It determines the profitability of a project
 It assists in planning the operation and control of the project
 It advises on methods of improving the financial viability of a

project entity
 It illustrates:

 the financial structure of the project and

 its existing and potential financial viability.
 Methods of Financial Analysis
To assess financial viability of a project:

 a range of tools and methods can be used and

 various types of financial statements can be prepared.

This includes:
 Resource flow statements
 Profit and loss statements
 Cash flow statements and
 Balance Sheet
1. Resource Flow Statements
The resource flow statement shows:
(1) the list of resources used in the project and
(2) (2) the resources generated by the investment on the project

The major elements of resource flow statements are

1. Investment costs: investment costs cover capital expenditure
items such as land, buildings, equipment and furniture etc.
It includes three group of costs:
a) Initial fixed investment costs.
This includes investment made for the acquisition of land,
development of land for construction purpose, civil works
(laying the foundation), equipment and machinery costs,
installation of the machines or the plant, vehicle, furniture,
building etc
b) Pre-production capital expenditure.
The pre-production capital expenditure includes:
Research and development
Pre-feasibility or feasibility study cost
Training costs incurred before the commencement of
the operation
Recruitment of personnel costs
Arrangement for marketing of the product such as
early advertisement to inform the public in advance
before the actual distribution of the product to the
market
Arrangements for supplies etc.
 c) Working capital
Table 5.1: Project Investment Costs ('000 Birr)
Project Year
Item

1 2 3 4 5 n

Land preparation X X X X X

Building X X X X X

Equipment X X X X X

Vehicles X X X X X

Working Capital X X X X X

Other costs X X X X X

Total XX XX XX XX XX XX
2. Operating Costs/Production Costs. Operating
costs can be divided into two:
Fixed and Variable components.
Variable working capital includes items such as
materials, power, labor inputs required for
manufacture which will vary directly with the volume
of production while fixed costs will include
maintenance, administration and managerial
charges, etc
 Project Operating Costs Schedule
Years
No Items 1 2 3 4 5 n

Capacity Utilization Rate (%) 50% 75% 80% 85% 90% 100%

1 Raw material

2 Labor

3 Utilities

4 Repair

5 Maintenance and Repair

6 Factory Overhead

Factory Costs (1-6) (a) XX XX XX XX XX

7 Administrative costs

8 Sales costs

9 Distribution cost

Operating Costs (7-9) (b) XX XX XX XX XX

10 Depreciation (c)

11 Interest expenses (d)

Total production

Cost (a + b + c + d) (Bold) XX XX XX XX XX
Project Resource Statements
Project Period
No Items 1 2 3 4 5 6

1 Land preparation

2 Buildings

3 Equipment

4 Vehicles

5 Total investment cost

(1 + 2 + 3 + 4)

6 Factory costs

7 Administrative costs

8 Selling expenses

9 Depreciation

10 Total operating costs

(6 + 7 + 8 + 9)

11 Incremental working capital

12 Benefits

13 Net Benefits
Project Financial Statements
Most commonly prepared financial statements are
balance sheet, loss and profit statement, and cash flow
statements.
a) Profit and Loss Statements
b) Balance sheet
c) Statement of cash flows
Ex. XYZ Project
Profit and Loss Statements

Project Period
No Items 1 2 3 4 5 6 n

1 Total sales
2 Variable production cost

3 Gross profit (1-2)

4 Other production costs
5 Corporate tax

6 Net profit after tax (3 – (4 + 5)

7 Dividend

8 Retained profit (6-7)

 Profitability of Projects
Given the estimates of sales revenue and cost of
production, the next step is to prepare the profitability
projections.
The estimates of profitability may be prepared along the
following lines
 Profitability of Projects
A. Expected Sales …………………………………………………………………xxx
B. Cost of production (DM+ DL+ MOH) ………..…………………(xxx)
C. Gross profit (A-B)…………………………………………………………....xxx
D. Total Operating Exp ( Selling +Adm exp)……………………….(xxx)
E. Operating profit (C-D)…………………………………………………....xxx
F. Other Income………………………………………………………………….xxx
G. Interest……………………………………………………………………………(xxx)
H. Profit/loss before taxation (E+F – G )……………………………..xxx
I. Provision for taxation (H x tax rate)………………………………..(xxx)
J. Profit after tax ( H-I) or H+I if there is loss……………………….xxx
K. Dividends…………………………………………………………………………(xxx)
L. Retained earnings) ( J-Dividends)…………………………………..xxx
M. Net cash (L+ Depreciation and other none cash exp)
……................................................................................xxx
MEASURES OF PROJECT WORTH/PROJECT
EVALUATION TECHNIQUES
To evaluation the profitability of projects
There are different ways of measuring project worth,
which may fall under two categories, that is
A) Discounting cash flow methods and
B) Non discounted (traditional) methods.
A. Non-Discounted cash flow methods
1. Payback Period
Payback period is one of the simplest methods to find
out the period by which the investment on the project
may be recovered from the net cash inflows.
In short it is defined as the period required recovering
the original investment cost
The basic drawbacks of this method of financial
analysis are:
 It completely ignores benefits/ cash flows after
payback period
 It ignores the time value of money

There are two methods in use to calculate the payback

period.
 A. Unequal cash flows: In this situation the pay back
period id calculated as:
Payback period = E + B/C
Where
E = number of years immediately preceding the year of final
recovery
B = the balance amount to be recovered
C = cash flow during the final recovery
Example: A company is considering investing on a
particular project. The alternative projects available
are: Project A that costs Br. 100,000, and Project B that
Costs Br. 70,000. The net cash in flows estimates are as
follows: Net Cash Inflow
Year Project A Project B
1 30,000 7,000
2 30,000 15,000
3 35,000 20,000
4 35,000 56,000
5 40,000 45,000
Which project is good?

Solution:
Project A Project B
Year

Net cash inflow Accumulated Net cash Net cash inflow Accumulated Net
inflow cash inflow

1 30,000 30,000 7,000 7,000

2 30,000 60,000 15,000 22,000

3 35,000 95,000 20,000 42,000

4 35,000 130,000 56,000 98,000

5 40,000 170,000 45,000 143,000

Payback period for Project A:
Payback period
= 3 years + 5000*
35,000
= 3.14 year or 3 years and 2 months
Payback period for Project B
PP = 3 years + 28,000
56,000
= 3.5 year or 3 years and 6 months
Note: * represent the balance to be recovered from the
cash inflow in period four; i.e.,
 100,000 – 95,000 = 5,000
B. Uniform Cash flows
Where the annual cash flows are uniform, payback
period can be calculated using the formula:
Pay back Period = Original Investment
Annual Cash Flows
Example: A project requires an investment of Br.
200,000. It is expected to generate an annual cash flow of
Br. 50,000 per year over the life of the project.
How long will it take to recover the investment?
PP = Original Investment
Annual Cash Flows
 = 200,000 Br
50,000
= 4 Years
Discounted Cash Flow Methods
It considers the time value of money
Compound Interest
Compound interest can be calculated using the
following formula:
Future value = Present value x Compound factor
FV = PV (1 + r)t
Where
r = annual interest rate
t = time in years
Fv = future value
PV = present value
Example: What will be the value of Br. 100,000
deposit in an account which pays 10% interest
compounded for a period of three years time?
Solution:
PV = Br. 100,000
r = 10%
t = 3 years
 FV = 100,000 (1 + 0.1)3
= 100,000 (1.1)3
= 133,100 Br
 This is the amount that the account accumulates after three years the
difference between the original sum of money 100,000 Br. and 133,100 i.e., 33,
100 birr is the interest earned during the period.
 Discounting
 The discount rate is the reciprocal of the compound factor and it is given by
the following formula:

PV = FV or FV (1 + r)-t
(1 + r)t

 Example: what will be the present value of the profit of Br. 100,000
generated in the third year of a project if the discount rate is 10%?

 Solution: Fv = 100,000 Br. r = 10%

t = 3 years Pv =?

 PV = 100,000 (1.1)-3
= Br. 75,134
The commonly used discounting methods are:
Net Present Value (NPV)
Benefit Cost ratio/Profitability Index
Internal Rate of Return (IRR) and
1. Net Present Value (NPV):
NPV is the net sum of total discounted benefits (cash inflows)
and total discounted costs.
It represents the present worth of an investment in excess of
the investment itself.
The NPV method is a system of finding out the excess (or
short) of the present value of the earnings from the
investments over and above the present value of the investment
itself.
Steps to find out the NPV
1. Find the project costs (Investment cost)
2. Find the future cash flows as estimated for the
projected business, net of cash outflows
3. Select an appropriate rate and a period to be
considered for such evaluation to find the present value
of the future cash flows for the period by discounting by
the selected rate
4. Find out the difference between the present value of
cash inflows (net) and the investment cost (present
value of investments over the life of the project).
This difference represents NPV.

 CFt
NPV=  (1  r ) t  C 0
Where:
CF = Cash inflows at different periods
r = discounting rate
C0 = cash outflow in the beginning
NPV = Net Present Value
t = time period
NPV =
The decision rule
Accept a project if the NPV is positive and
 Reject it if it is negative.
A project that NPV approaching zero is a marginal
project. The planner has to re modify, otherwise it will
be very risk to take such projects.
Example 1: NPV calculation
AMA Company is considering investing in a particular
project. The initial investment cost is Br. 100,000. It is
expected that the project may generate a benefit for 5 years
as shown below:
Year Operating cost Annual cash inflow
0 Br. 100,000 --
1 6,000 Br. 20,000
2 10,000 30,000
3 2,000 40,000
4 1,000 40,000
5 1,000 35,000
The discounting rate is 10%
Required: Calculate the NPV of the project
Solution
Year Cost Revenue
Present Value PV of Cost PV of Revenue
(Cash in flows)
Factor

0 Br. 100,000 -- 1 Br. 100,000 --

1 6,000 Br. 20,000 0.9091 5,454.6 Br. 18,182

2 10,000 30,000 0.8264 8,264 24,792

3 2,000 40,000 0.7513 1,502.6 30,052

4 1,000 40,000 0.6830 683 27,320

5 1,000 35,000 0.6209 620.9 23,905

Total Br. 119,462

Br. 124,251
Net present value of the project = PV of Revenue (cash
inflows) – PV of Costs
= 124,251 – 119,462
= Br. 4,789

Decision: If you are talking about only one project, the

decision is to accept this project since its NPV is positive
(Br. 4,789).
A project's NPV varies with the discount rate usually the
higher the discount rate then the smaller the NPV.
NPV method is used widely because it provides an absolute
measure of the surplus generated by the project.
A project is acceptable at a given discount rate if the NPV is
positive.
2. Benefit Cost Ratio/Profitability Index (PI)
PI = PV of Cash inflows
Initial Investment of project
Decision rule
If PI > 1 - Accept the project
If PI<1 – Reject the project
If PI =1- May accept the project
2. Internal Rate of Return (IRR)
IRR is a rate that equates the present value of cash inflows
with the present value of cash out flows.
Or it is a rate that makes NPV = O
Using the same project data as in the example 1 above,
determine the IRR? New line IRR can be estimated
approximately by interpolation from a few NPV
calculations.
This interpolation is done mathematically.
The arithmetic rule for interpolation between two
discount rates, one of which gives a positive NPV and the
other of which gives a negative NPV, is as follows
IRR = Lower rate DR + Difference between  Absolute difference
NPVs at lower DR
of NPVs at two DRs
 DRs
Where: DR = Discount rate
Using the above data, it was found that the NPV at 10% was
Br. 4789. Adopting a second trial rate of discount 12%, the
NPV is found to be (Br. 3201) which is negative.
Year Cost Revenue
Present Value Factor PV of Cost PV of Revenue Br.
Br.

0 100,000 -- 1 100,000 --

1 6,000 20,000 0.8929 5,357 18,182

2 10,000 30,000 0.7972 7,972 24,792

3 5,000 40,000 0.7118 3,559 30,052

4 2,000 40,000 0.6355 1,271 27,320

5 1,000 35,000 0.5674 567 23,905

Total Br. 118,726

Br. 115,525
NPV at a 12% rate in 115,525 – 118,726 = (-Br. 3201)
Therefore, IRR lies between 10% and 12% using the above
formula; you can calculate IRR of the project as follows:
4789
 4789 –(-3201)

4789
7990
IRR = 10% + (12% - 10%)  = 10% + 2
= 10% + 2(0.5994)
= 10 + 2(0.5994)
= 11.2%
The IRR of the project is, therefore 11.2%
Exercise
Dashen trading company is considering two projects
(Project X and Project Y). Each requires an investment of
Birr 20,000. The net cash inflows from investment in the
two projects X and Y are as follows:
The required rate of return (discount rate ) is 10 per cent.
Required : Compute
a) Net Present Value of each project and give decision.
b) Profitability Index of each project and decision
c) Pay Back Period of each project and give decision
d) Internal Rate of Return of each project and give decision
 Thank
You!!!