Financial Analysis

What is Financial Analysis?

Financial Analysis consider the financial features of a project to ensure that the disposable finances shall permit the smooth implementation and operation of the project.

Financial Analysis is carried out on a year to year basis. It includes liquidity analysis and capital structure analysis.

Section 1: Cost of Project Section 2: Means of Finance Section 3: Estimates of Sales & Production Section 4: Cost of Production Section 5: Working Capital Requirement & Its

Financing Section 6: Liquidity Analysis Section 7: Capital Structure Analysis Section 8: Cost of Capital Section 9: Projected Financial Position Section 10: Uncertainty Analysis

Aspects of Financial Analysis

1. Cost of Project

4. Cost of Production

5. WC Requirement

3. Estimation of Sales &

Production

7. Capital Structure Analysis

6. Liquidity Analysis

2. Means of Finance

8. Cost of Capital

9. Projected Financial Position

10. Uncertainty Analysis

Fig: Financial Projections

Section 1:Cost of Project

The cost of project represents the total of all items of outlay associated with a project which are supported by long term funds. It is the sum of the outlays on the following:

Land and site development:

Cost including conveyance and other allied charges Premium payable on leasehold Cost of leveling and development, laying approach roads and internal roads Cost of compound wall and gates, tube wells.

Building and civil works:

Buildings for the main plant and equipment. Buildings for auxiliary services like steam supply, workshops, laboratory, water supply etc. Godowns, warehouses, garages and open yard facilities Non-factory buildings like canteen, guesthouses, team office, excise house, etc. Sewers, drainage, etc. Other civil engineering works

Plant and machinery:

Cost of imported machinery: This is the sum ofi. FOB value,ii. Shipping, freight, and insurance cost,iii. Import duty andiv. Clearing, loading, unloading and transportation charges.

Cost indigenous machinery: This consists of i. FOR cost, ii. Sales tax and other taxes, if any, andiii. Railway freight and transport charges to the site.

Cost of stores and spares.

Foundation and installation charges.

Technical know-how and engineering fess:

The amount payable for obtaining the technical know-how and engineering services for setting up the project is a component of the project cost, the royalty payable annually, which is typically a percentage of sales, is an operating expense taken into account in the preparation of the projected profitability statement.

Expenses on foreign technicians:

Expenses on their travel, boarding, and lodging along with their salaries and allowances must be shown here.

Miscellaneous fixed assets:

Items like furniture, office machinery and equipment, tools, vehicles, railway siding , diesel generating sets, transformers, boilers, piping systems, laboratory equipment, workshop equipment, firefighting equipment, and so-on. Expenses incurred for the procurement or use of patents, licenses, trademarks, copyrights, etc. and deposits made with the electricity board may also be included here.

Preliminary and capital issue expenses:

The major components of capital issue expenses are: underwriting commission, brokerage, fees to managers and registrars, printing and postage expenses, advertising and publicity expenses, listing fees, and stamp duty.

Pre-operative Expenses:

The following types of expenses are incurred till the commencement of commercial production:I. Establishment expenses, II. Rent, rates, and taxes,III. Travelling expenses,IV. Interest and commitment charges on borrowings,V. Insurance charges,VI. Mortgage expenses,VII. Interest on deferred payments,VIII. Start-up expenses, andIX. Miscellaneous expenses.

Provision for Contingencies:

1) Dividing the project cost items into two categories- ‘firm’ cost items and ‘non-firm’ cost items

2) Setting the provision for contingencies at 5 to 10 percent of the estimated cost of non-firm cost items.

 Margin Money for Working Capital:

To mitigate this problem, financial institutions stipulate that a portion of the loan amount, equal to the margin money for working capital, be blocked initially so that it can be released when the project is completed.

Initial Cash Losses:

Failure to make a provision for such cash losses in the project cost generally affects the liquidity position and impairs the operations. Hence prudence calls for making a provision, over or covert, for the estimated initial cash losses.

Section 2:Means of Finance

Share Capital: There are two types of share capital- equity capital and preference capital. Equity capital represents the contribution made by the owners of the business, carries no fixed rate of dividend. Preference capital represents the contribution made by the preference shareholders and the dividend paid on it is generally fixed. Term Loans: It represents secured borrowings provided by financial institutions and commercial banks which are a very important, sometimes the major source for financing new projects.

Available Means of Finance

Debenture Capital: Debentures are instruments for raising debt capital, having categories of convertible debentures and non-convertible debentures.

Deferred Credit: It is the facility of credit purchase under which the payment may be made over a period of time.

Incentive Sources: Government and its agencies may provide financial support as an incentive to certain types of promoters or for setting up industrial units in certain locations. Miscellaneous Sources: A small portion of the project may come from miscellaneous sources like unsecured loans, public deposits, and leasing and hire purchase finance.

For planning the project, following guidelines and considerations should be kept in mind- Norms of regulatory bodies and financial institutions:

In some countries, the proposed means of finance for a project must either be approved by a regulatory agency or conform to certain norms laid down by the government or financial institutions to protect the investors. 

Planning the Means of Finance

Key business considerations: The key business considerations which are relevant for the project financing decision are- cost, risk, control and flexibility. • Cost: Cost of debt funds is lower than the cost of equity. Because, the interest payable on debt capital is tax deductible expense whereas the dividend payable on equity capital is not.

• Risk: The two main sources of risk for a project are business risk and financial risk. Business Risk refers to the variability of return on invested capital and arises mainly from fluctuations in demand and variability of prices and cost. Financial risk represents the risk arising from financial leverage.

• Control: From the point of view of the promoters of the project, control is very important. They would ordinarily prefer a scheme of financing to maximize control over the affairs of the firm.

• Flexibility: this refers to the ability of a firm to raise further capital from any source it wishes to tap to meet the future financing needs.

Section 3:Estimates of Sales &

Production

High Rate of Capacity Utilization:

It is sensible to assume that capacity utilization would be somewhat low in the first year and rise thereafter gradually to reach the maximum level in the third and fourth year of operation.

Adjustment of Stocks of Finished Goods:

It is not necessary to make adjustments to stocks of finished goods. For practical purposes, it may be assumed that production would be equal to sales.

Consideration of Selling Prices:

The selling price considered should be the price realizably by the company net of excise duty. It shall, however, include dealers’ commission which is shown as an item of expense.

Changes in Selling Price:

The selling price used may be the present selling price-it is generally assumed that changes in selling price will be matched by proportionate changes in cost of production.

Section 4:Cost of Production

The major components of cost production are: Materials: The requirements of various material inputs per unit of output may be established on the basis of one or more of the following: a. Theoretical assumption norms, b. Experience of the industry, c. Performance guarantees, andd. Specification of machinery suppliers. Utilities: Utilities consist of power, water, and fuel. The requirements of power, water, and fuel may be determined on the basis of norms specified by the collaborators, consultants, etc. or the consumption standards in the industry, whichever is higher.

Labor: Labor cost is the cost of all the manpower employed in the factory. Labor cost naturally is a function of the number of employees and the rate of remuneration. This cost may be calculated for the year in which the maximum capacity utilization is first achieved. For the earlier years, when the capacity utilization tends to be low, somewhat lower labor costs, but not proportionately lower in relation to capacity, may be assumed.

Factory Overhead: The expenses on repairs and maintenance, rent, taxes, insurance on factory assets, and so on are collectively referred to as factory overheads. Repairs and maintenance expense depends on the machinery-the expense tends to be lower in the initial years and higher in the later years. Rent, taxes, insurance, etc. may be calculated at the existing rates.

Section 5:Working Capital

Requirement & Its Financing

What is Working Capital?

The difference between current assets and current liabilities.

Working capital includes: Cash Marketable securities Accounts receivable Inventories Accounts payable Accrued wages and taxes

WCR = [Accounts Receivable + Inventory + Prepaid Expenses] – [Accounts Payable + Accruals]

How to calculate the Working Capital Requirement?

Star world Group End of Year

  Year 1 Year 2 Year 3

Accounts Receivable 232 278 362

Inventory 97 116 151

Prepaid expenses 35 20 55

Total 364 414 568

Accounts Payable 116 139 181

Accruals 36 45 55

Total 152 184 236

WCR + 212 + 230 + 332

Decision: The WCR is positive, that means a Net Requirement of funds. As the variation of WCR is positive, that means a Net Requirement of funds: 18 in 2000 and 102 in 2001.

Example:

The working capital requirement consists of following: (a) raw materials and components (indigenous as well as

imported),(b) stocks of goods-in-process (also referred to as work-in-

process), (c) stocks of finished goods, (d) debtors, and(e) operating expenses, and(f) consumable stores.

The principal sources of working capital finance are: a) working capital advances provided by commercial banks,b) trade credit,c) accruals and provisions, andd) long term sources of financing.

There are limit of obtaining working capital advances from commercial banks. They are in two forms:

a) the aggregate permissible bank finance in specified as per the norms of lending followed by the lending bank,

b) against each current asset a certain amount of money has to be provided by the firm.

The principal sources of working capital finance are: a) working capital advances provided by commercial banks,b) trade credit,c) accruals and provisions, andd) long term sources of financing.

Section 6:Liquidity Analysis

Liquidity Analysis is also called the Profitability Projection.

Liquidity Analysis is done on a year by year basis and, therefore, the annual cash positions are taken into consideration at their nominal values.

A Profitability Projection provides management an idea of how the company's profitability will look 12 months into the future. This projected profitability rests in large part on management's ability to forecast industry and customer demand, costs, as well as many other macro and micro economic factors.

What is Liquidity Analysis?

Liquidity Analysis of a project:Item Year

t0 t1 t2 t3-t10 t11 t12-t19 t20

A. Cash Inflows (CI) 100 100 70 100 100 100 120

1. Sales Revenue 70 100 100 100 100

2. Residual Value 20

3. Financial Investment 100 100

3.1. Equity 100 20

3.2 Loans 80

B. Cash Outflows (CO) 100 100 40 92 78 78 82

1. Investment 100 100

2. Cash expenses excluding interest 40 60 60 60 60

3. Taxes 5 6 6 10

4. Financial Obligations 27 12 12 12

4.1. Repayment Installment 10

4.2. Interest Charges 5

4.3. Dividends 12 12 12 12

C. Net Cash Balance (Surplus or deficit) 30 8 22 22 35

Source: Manual for Evaluation of Industrial Projects. Table: 14

Section 7:Capital Structure

Analysis

Capital structure analysis is important to measure or predict projected financial position.

It is done through the debt to equity ratio.

The Debt to Equity Ratio measures how much money a company should safely be able to borrow over long periods of time.  It does this by comparing the company's total debt (including short term and long term obligations) and dividing it by the amount of owner's equity. 

Capital Structure Analysis

Debt to equity ratio: Long-term liabilities/Shareholders equity(Equity

capital)

Formula

Suppose, a company has capital structure with 100% equity in the initial investment year. In the next year its additional investment was consist of 15% equity and 85% debt.

So, the Debt to Equity ratio = 85/115 = 0.74

Example

Source: Manual for Evaluation of Industrial Projects. Table: 8

Decision: 0.74 may not be satisfactory at all if the project is not sounds enough and if borrowing is on too short a term. If repayments already have to be made during the construction period or before the project generates significant cash earnings, a debt equity ratio of 0.74 may not assure sufficient cash surplus during the running period.

Generally, any company that has a debt to equity ratio of over 40 to 50% should be looked at more carefully to make sure there are no liquidity problems.  If you find the company's working capital, and current / quick ratios drastically low, this is a sign of serious financial weakness.

The rates of interest on loans may be lower than the expected rate of return of the project. In such circumstances it may be attractive for the investor, taking into account the risk involves, to keep equity low, thus increasing the actual rate of return on equity.

By seeking finance through loans, there may be final advantages since interest charges may be deductible from taxable profits.

Advantages of Capital Structure Analysis

Interest charges are fixed obligations which have to be paid regardless of whether a project earns a profit.

If annual repayments of principal approach the cost of depreciation per year, financial management may become increasingly tight and difficult.

A low debt equity ratio is desirable as far as circumstances permit in order to avoid undue interference by lenders.

Disadvantages of Capital Structure Analysis

Section 8:Cost of Capital

The company cost of capital is the rate of return expected by the existing capital providers. It reflects the business risk of existing assets and the capital structure currently employed.

The project cost of capital is the rate of return expected by capital providers for a new project or investment the company proposes.

Company Cost of Capital vs. Project Cost of Capital

If a firm wants to use its company cost of capital popularly called the weighted average cost of capital (WACC), for evaluating a new investment, two conditions should be satisfied- 1. The new investment will not change the business risk

complexion of the firm2. The capital structure of the firm will not be affected by the

investment.

Conditions for using Company Cost of Capital

Given the cost of specific sources of finance and the scheme of weighting, the WACC can be readily calculated by the formula- WACC= were + wprp + wdrd (1-tc)

Where we, wp and wd are the proportion of equity, preference, and debt and re, rp and rd are the component cost of equity, preference and debt and tc is the corporate tax rate.

Concept of WACC

Suppose that a company uses equity, preference and debt in the proportion of 50, 10 and 40. If the component cost of equity, preference and debt are 16%, 12%, and 8% respectively the weighted average cost of capital will be:  WACC=(proportion of equity) (cost of equity) + (proportion of

preference) (cost of preference) + (proportion of debt) (cost of debt)= (0.5) (16) + (0.10) (12) + (0.4) (8) l =12.4%

Example

Source: “Projects” by Prasanna Chandra. Page-10.2

The cost of capital is affected by several factors from two main sources- Factors outside a firm’s control: The level of interest rates Market risk premium Tax rates Factors within a firm’s control: Investment policy Capital structure policy Dividend policy.

Factors Affecting the Weighted Average Cost of Capital

Section 9:Projected Financial

Position

The Projected Balance Sheet allows management to know the state of its asset, liability and equity base. As business expands or contracts so too will the firm's assets, liabilities and equity. The projected Balance Sheet allows the company to project debt levels and covenants.

What is Projected Balance Sheet?

Format of Balance Sheet Prescribed by the Companies Act

Liabilities Assets

Share capital Fixed assets

Reserve and surplus Investments

Secured loans Current assets, loans and advances

Unsecured loans Miscellaneous expenditures and losses

Current liabilities and provisions

Source: “Projects” by Prasanna Chandra. Exhibit- 6.7

Share capital consists of paid-up equity and preference capital.

Reserves and surplus represent mainly the accumulated retained earnings. Secured loans represent the borrowings of the firm against which security has been provided.

Current liabilities are obligations which mature in the near future, usually within a year. Provisions include mainly tax provision, provision for provident fund, provision for pension and gratuity, and provision for proposed dividends.

Explanations of Items

Fixed assets are tangible long-lived resources ordinarily used for producing goods and services. Investments represent financial securities owned by the firm.

Current assets, loans and advances consist of cash, debtors, inventors of different kinds, and loans and advances made by the firm.

Miscellaneous expenditures and losses represent outlays not covered by the previously described asset accounts and accumulated losses, if any.

Section 10:Uncertainty Analysis

Uncertainty Analysis is also known as Risk Analysis. The future is always uncertain and risk is inherent in almost

every business decision. All investment decisions are made under conditions of some

uncertainty. In uncertainty Analysis the underlying sources of risk are

identified and the consequences are explored thereof.

What is Uncertainty Analysis?

Sources of Risk

There are several sources of risk in a project. Some variables are common sources of uncertainty in evaluating investment projects. These are:

• Size of investment• Operating costs and• Sales Revenue

The other important sources are:

Project-specific risk: The earnings and cash flows of the project may be lower than expected because of estimation error or due to some other factors specific to the project like the quality of management.

Competitive risk: The earnings and cash flows of the project may be affected by unanticipated actions of the competitors.

Industry-specific risk: Unexpected technological developments and regulatory changes, that are specific to the industry to which the project belongs, will have an impact on the earnings and cash flows of the project as well.

Market risk: Unanticipated changes in macroeconomic factors like the GDP growth rate, interest rate, and inflation have an impact on all projects, albeit in varying degrees.

International risk: In the case of a foreign project, the earnings and cash flows may be different than expected due to the exchange rate risk or political risk.

There are mainly three steps in uncertainty analysis:

Break-Even analysis

Sensitivity analysis whereby instead of using one estimate of each variable several estimates are used under varying conditions

Probability analysis in which all the probable values of each variable that have a significant chance of occurrence are used.

Steps in Uncertainty Analysis:

Break Even Point is the unit or dollar sales at which an organization neither makes a profit nor a loss.

What is Break Even Point

Accounting Break-even Analysis: A project that breaks even in accounting terms is like a stock that gives you a return of zero percent.

Financial Break-even Analysis: The focus of financial break-even analysis is on NVP and not on accounting profit.

Accounting BEP vs. Financial BEP

Break-Even in terms of Physical Units:

FCBEP = SP-VC

Break-Even in terms of Sales Revenue:

FCBEP = SP

SP-VC

Total Cost

Variable Cost

LOSS Fixed Cost

BE Point PROFIT

Unit Volume0

Dollars

Break Even Analysis Chart

Fixed Costs = $50,000Price per unit = $5Variable Cost = $3Contribution Margin = $5 - $3 = $2Breakeven Volume = $50,000 $2 = 25,000 unitsBreakeven Dollars = 25,000 x $5

= $125,000

Example

• Since the future is uncertain, one may like to know what will happen to the viability of the project when some variable like sales or investment deviates from its expected value.

• In this purpose, we do ‘what if’ analysis or ‘Sensitivity Analysis’.

• Sensitivity analysis may be used in the early stages of project preparation to identify the variables in the estimation of which special care should be taken.

Sensitivity Analysis

(Rs in thousands) (Rs in thousands)Year 0 Year 1-10

1. Investment2. sales3. Variable cost

(66.67% of sales)4. Fixed cost5. Depreciation6. Pre-tax profit7. Taxes8. profit after taxes9. cash flow from

operation10.net cash flow

(20000)

(20000)

1800012000100020003000100020004000

4000

Cash flow forecast for Naveen’s Flour Mill Project

Source: “Projects” by Prasanna Chandra. Exhibit-11.2

Since the cash flow from operations is an annuity, the NPV of the flour mill project is:=(20,000,000)+4,000,000* PVIFA(r=12%,n=10)=(20,000,000)+4,000,000*5.650=2,600,000.

The NPV based on the expected values of the underlying variables looks positive. However, the underlying variables can vary widely this should affect the NPV. So, to do the Sensitivity analysis, we should vary one variable at a time. That is, define the optimistic and pessimistic values of each of the underlying variables.

Rs. In millions Rs. In millions

Range NPV

Variables Pessimistic Expected Optimistic Pessimistic Expected Optimistic

Investment 24 20 18 -0.65 2.60 4.22

Sales 15 18 21 -1.17 2.60 6.40

Variable cost as a percent of sales

70 66.66 65 0.34 2.60 3.73

Fixed cost 1.3 1.0 0.8 1.47 2.60 3.33

Sensitivity of NPV to variations in the value of key variables

Source: “Projects” by Prasanna Chandra. Exhibit- 11.3

For example, to study the effect of variation in sales, from the expected Rs.18 million, to the pessimistic Rs. 15 million and optimistic Rs. 21 million, the other variables should be unchanged.

The NPV will be:At pessimistic sales: (1.17)millionsAt optimistic sales : 6.40 millions, where At expected sales : 2.60 millions.

•  In sensitivity analysis, typically one variable is varied at a time.

• In scenario analysis, several variables are varied simultaneously.

• Most commonly, three scenarios are considered. Expected or normal, pessimistic scenario, and optimistic scenario.

Scenario Analysis

Rs. In millions Rs. In millions Rs. In millionsVariables Pessimistic Expected Optimistic1. Investment 24 20 182. Sales 15 18 213.Variable costs(% of sales)

10.5(70%) 12(66.7%) 13.65(65%)

4. Fixed costs 1.3 1.0 0.85. Depreciation 2.4 2.0 1.86. Pre-tax profit 0.8 3.0 4.757. Tax 0.27 1.0 1.588. Profit after tax 0.53 2.0 3.179. Annual cash flow from operation

2.93 4.0 4.97

10. NPV (9)* PVIFA(12%,10 years)- (1)

(7.45) 2.60 10.06

The NPV of the project of Naveen Flour Mills under these three scenarios is given below:

Source: “Projects” by Prasanna Chandra. Exhibit- 11.4

Probability Analysis• Probability as used here refers to the frequency of occurrence of

an event, measured as a ratio of the number of different ways that the specific event can happen to the total number of possible outcome.

• The purpose of the probability analysis is to eliminate the need for restricting judgment to a single optimistic, pessimistic or realistic estimation by identifying the possible range of each variable and attaching a probability of occurrence to each possible value of the variables within this range

• Each possible value of each variable is associated with a number between 0 and 1. So that for each variable, the sum of all these numbers (probabilities) is equal to one.

Variables Situation A Situation B

1.Investment Probability

2,00,00070%

2,50,00030%

2. Annual net cash earnings from t3 to t10 t11 to t19

Probability

35,00034,000

60%

31,00030,000

40%

For example, the findings of the analysis of X Company are as follows:

Source: Manual for Evaluation of Industrial Projects. Table: 34

Variables Alternative probability

Estimated values

Expected values

1. Investment 2,00,000*0.70 =2,50,000*0.30 =

1,40,00075,000 2,15,000

2. Annual net cash earningsFrom t3 to t10

From t11 to T19

35,000*0.60 =31,000*0.40 =

34,000*0.60 =30,000*0.40 =

21,00012,000

20,40012,000

33,400

32,400

So, from this distribution we can calculate the probable values of the variables:

Source: Manual for Evaluation of Industrial Projects. Table: 34

Measures of Risk

Risk refers to variability. It is a complex and multi-faceted phenomenon. A variety of measures have been used to capture different facets of risk.

The more important ones are: range, standard deviation, coefficient of variation and semi-variance.

Example

NPV Probability

200 0.3

600 0.5

900 0.2

Source: “Projects” by Prasanna Chandra. Page- 11.3

The probability weighted NPV works out to:

Range:

Obviously the simplest measure of risk, is the difference between the highest value and the lowest value.

The range of above distribution is 900-200 =700

Standard Deviation:

The standard deviation of the NVP distribution presented above is:

½

½

½

Coefficient of variation:

Standard DeviationCV =

Expected Value

CV = 249.8 / 540 = 0.46

The semi-variance is computed the way the variance is computed, except that only outcomes below the expected value are taken into account.

It is defined as:

The semi-variance or the investment in our illustration is:

Semi-Variance:

Thank You