PA chapter 5.doc - Chapter five Financial analysis and...

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Unformatted text preview: Chapter five Financial analysis and project selection Financial analysis is analytical work required to identify the critical variables which are useful for likely 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. This unit discusses the viability of projects from financial significance to stakeholders and to the economy in general. For this purpose different statements such as resource flow and financial statements how then are and financial analysis tools (NPV, IRR and payback period) are discussed in detail. 5.1 Purpose of financial analysis in project preparation Investors transfer the liquid financial resources (his own personal selling or borrowed money) into production assets with the objective of producing and obtaining future benefits. This process is known as investment, along term commitment of scarce resources. The long-term commitment by the investor needs the transformation of liquid financial resources (own or borrowed) into productive assets for financing an investment project. Project financing includes the design of proper financial structure, considering the adequacy of the financial plan, and the optimization of project financing from the different actors or beneficiaries point of view. Therefore, the scope and objective of financial analysis are to determine, analyze and interpret all the financial consequences of an investment that might be relevant for and significant for the investment and financing decisions. Financial analysis is essentially undertaken for the following purposes: 1. It provides an adequate financing plan for the proposed investment 2. It determines the profitability of a project 3. It assists in planning the operation and control of the project by providing management information to both internal and external users 4. It advises on methods of improving the financial viability of a project entity 5. It illustrates the financial structure of the project and its existing and potential financial viability. Therefore, the purpose of financial analysis is not just to document the expected impact of the project, liquidity, credit worthiness, financial efficiency, etc, of the various agents involved; it should also be part of the process of project design itself. 5.2 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: 1. Resource flow statements 2. Profit and loss statements 1 3. Cash flow statements and 4. Balance Sheet These statements are explained in detail below. 5.2.1 Resource Flow Statements The starting point of the financial analysis of a project is drawing up of a statement of project cost and benefits. The benefit and cost items included in the statement should include only those items, which are incremental. The resource flow statement shows: (1) the list of resources used in the project and (2) the resources generated by the investment on the project. The major elements of resource flow statements are: 1. Investment costs: 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. All these above costs are subject to depreciation except land which is depleted over time. (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. Working capital is simply a revolving fund. It is the difference between current asset and current liability. This is known as a circulating fund because at the end of the project's life it can be put as a benefit of the project. Defining the working capital requirement appropriately is important because many projects fail while they are in operation due to shortage of cash or working capital. The amount of the total working capital required depends upon the operating costs for the project. There are three basic components of physical working and capital inventories needed for production to be continuous. These are: - Initial stock and materials - Work-in-process and - Stock of outputs 2 When these three components of working capital have been estimated, they can be summed to give the total working capital requirements in any year. The working capital resources that need to be included in a project statement are the incremental amount (additional commitment of resources) as the inventories build up or vary from year to year. Table 71: 71: Project Investment Costs ('000 Birr) Item Project Year 1 2 3 4 Land preparation X X X X Building X X X X Equipment X X X X Vehicles X X X X Working Capital X X X X Other costs X X X X Total XX XX XX XX 5 X X X X X X XX N XX Generally speaking, the amount of funds required for operating needs varies from time to time in every business. But a certain amount of assets in the form of working capital are always required; if the business has to carry out its functions efficiently and without a break. The two types of requirements are permanent (fixed) and variable. The permanent working capital in that part of capital which is permanently locked up in the circulation of current assets and in keeping it moving. On the other hand, variable working capital changes with the volume of the output of the project. 2. Operating Costs/Production Costs. 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. which will be relatively fixed with respect to the volume of production. The total operating costs will then be the sum of the fixed and variable costs and will increase over the operating years until full utilization of the investment asset is reached. 3 Table 7.2 Project Operating Costs Schedule Years No 1 2 3 4 5 6 7 8 9 10 11 Items Capacity Utilization Rate (%) Raw material Labor Utilities Repair Maintenance and Repair Factory Overhead Factory Costs (1-6) (a) Administrative costs Sales costs Distribution cost Operating Costs (7-9) (b) Depreciation (c) Interest expenses (d) Total production Cost (a + b + c + d) (Bold) 1 50% 2 75% 3 80% 4 85% 5 90% XX XX XX XX XX XX XX XX XX XX XX XX XX XX XX N 100% Note: Note: n represents the number of periods covered in the project appraisal. As it is shown in the above schedule, operating cost includes: cost of production/cost of sales, administrative expenses, selling expenses, depreciation on fixed assets, and write off of preliminary and preoperative expenses. a) Cost of Production The cost of production includes 1. Material cost 2. Wages including salaries for executives 3. Utilities 4. Repairs and maintenance 5. Factory over heads. These items include expenses for the factory as: - rent, for factory, if any - insurance premium for factory assets and factory workers - postage, telephone, fax, e-mail, etc, in the factory - traveling expenses - depreciation of plant and machinery and other factory equipment; - proportionate management expenses, which may be charged to factory on the basis of time spent by management on the project operation. b) Administrative Expenses This represents all indirect expenses incurred in the organization including estimates for - salaries of all indirect staff - postage, telephone, fax, e-mail etc 4 - traveling expenses insurance other than for the factory assets rent, rates, taxes, electricity etc and depreciations of all fixed assets other than factory assets other than factory fixed assets c) Selling Expenses This represents estimated expenses in sales divisions as per projected organizations and includes the items: - salaries and personnel cost for sales staff and managers as planned - publicity, advertisement, exhibitions, etc. - subsidies, commissions, discounts to dealers, etc. - administrative expenses of sales office including rent. d) Depreciation Depreciation expenses represent consumption of utility units contained in an asset. It relates to the cost center where such assets are installed. e) Production Build Up In the first years of operation, a project may not be 100% build up or it may not utilizes the full capacity. It build up over the years of its operation. From the technical details of the plant and machinery and the available other resources as manpower, space etc. an estimation of the plant’s installed capacity is worked out. Once the installed capacity is worked out, estimation is made about the plant’s operation achieving from the initial zero to eighty or ninety percent of the installed capacity. The peak is achieved in a span of three or four years from the start in the phase manner – like 50%, 60%, 75%, 90% of the installed capacity – estimated by year 1, 2, 3, and 4 respectively. The capacity utilization factor is included in the projects operating costs schedule. 3. Benefits Benefits of a project can be several. For example, a range of different farm products in an agricultural project, or cost savings as well as production benefit from a transport infrastructure project. The different benefits will all be variable with respect to their associated costs, and hence, total benefits will also be variable. Benefits can be direct (production output) which may include items like: - main product - by product - residual and other income Benefits can also be indirect or external. For example, in a road projects reducing transportation costs, reducing operating costs for maintenance of vehicles and saving time of the society are indirect benefits of the project. 5 Benefits are associated with the capacity utilization factor to which operating costs were also related. When the value and timing of investment costs of and operating costs have been determined the net benefits of the project can be calculated. The net benefit is computed by simply subtracting the investment, operating and working capital costs from benefits. The following table depicts the complete project resource statement, which brings together the investment costs, operating costs, working capital and project benefits. Table 7.3 Project Resource Statements Project Period No Items 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 1 2 3 4 5 6 The net benefits are negative in the first year’s whiles investment is taking place, and become positive when the utilization of the new assets is building up. Example on resource flow statement Assume Zebra PLC has spent birr 75,000 on research in developing a new product. For the purpose of financial analysis, the following information has been collected: 1. The fixed cost that will be incurred due to the product is birr 10,000 top cover insurance and maintenance of new equipment 6 2. Advertising the new product will total birr 75,000 in first year, birr 50,000 in the second year and birr 60,000 in the third year. 3. The new machinery will have to be purchased at cost of birr 650,000 and depreciates for the next three years at straight line method and expected to have salvage value of birr 50,000 at the end of third year. 4. Sales of this product were estimated to be birr 2,000,000 in first year, birr 3,000,000 and birr 4,000,000 in third years. 5. Variable costs to manufacture and sell this product were estimated to be 70% of the sales in each year. 6. In addition to the main product, the organization gets benefit by selling by products. Birr 25,000,10,000 and 15,000 in first, second and third years respectively Required: prepare the resource flow of the project and give decision to accept or reject the project based on this analysis. Answer: (385,000), 660,000 and 955,000 for first, second and third respectively 5.2.2 Project Financial Statements Financial analysis also involves formulation of various financial statements, which enable project owners and other interested stakeholders to know whether the projects worthy or not. Most commonly prepared financial statements are balance sheet, loss and profit statement, and cash flow statements. a) Profit and Loss Statements The main purpose of profit and loss or trading profit and loss account in short income statement is to calculate the profit or loss of enterprise or project. It is the measure of the profitability of the project. Firms are required by law to prepare an income statement at the end of each year to report to stakeholders on the performance and profitability of the project and at the same time it is used to calculate the tax liability to the government. Borrowers also use this income statement as the base to grant loans. An example of typical income statement is given below. No 1 2 XYZ Project Profit and Loss Statements Project Period 1 2 3 Items Total sales Variable production cost 4 5 6 n 7 3 4 5 6 7 8 Gross profit (1-2) Other production costs Corporate tax Net profit after tax (3 – (4 + 5) Dividend Retained profit (6-7) The format of the profit and loss account varies according to who is preparing it and for what purpose, and on the type of activity, be it manufacturing, retail or service projects. Gross profit is calculated by deducting direct production costs (cost of sales) from sales revenue. Net profit item (6) in the above schedule is calculated by deducting other operation costs, such as over head costs including depreciation, loan interest and corporate tax from gross profit. The last part of P/L account is the appropriation account, which shows how much of the net profit is retained to be reinvested in the project and how much is distributed to stockholders. b) Balance Sheet Balance sheet is a statement of the assets and liabilities of the enterprise and gives "the net worth" an enterprise at a point of time. It is prepared to present a picture of the firm on one day in the year. The information represents the account balances recorded and does not indicate exact economic values. The balance sheet shows the way in which a project is financed, whether by sponsors, lenders or creditors and how these funds have be employed. The sources of funds, even where they represent the capital invested by shareholders are regarded as the liabilities of the company and the use to which funds have been put are the assets. The Balance Sheet is the key to understanding the financial position of a project or enterprise unlike the profit and loss account, which shows how well a project has performed over a period of time; the balance sheet is a measure of what the project is worth at a particular point in time. This is done by comparing assets (what the project owns) and liabilities (what the project owes). Balance sheet is usually prepared annually for project analysis and it is considered by commercial bankers to be one of the most important statement when deciding whether or not to invest in an existing project. Balance sheets are presented in a number of different formats. An example of a typical vertical format is shown below. XYZ Project Balance Sheet On Sene 30, 1996 E.C Years No Items 1 2 3 4 5 6 1 Current Assets: 8 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 Cash Inventories and supplies Accounts receivables Total current assets (2+3+4) Fixed assets: Building Machinery and equipment Other assets Total fixed assets (7 + 8 + 9) Accumulated depreciation Net book value of assets (10 – 11) Current liabilities: Short term loan Loan Tax payable Total current liability (14 + 15 + 16) Networking capital (5 – 17) Employment of funds (18 + 12) Funds employed: Owners equity Retained earnings Term loans Total funds (21 + 22 + 23) c) Cash flow statement Finance is considered by many as the lifeblood of an organization or any project. A well designed project may fail due to insufficient cash for its day to day operation. Therefore, a project planner has to develop some techniques of forecasting cash in flows and out flows. Cash flow statement is a basis for showing the cash flows associated with operating resources, funding and investment. Cash flow statements are prepared for two reasons: First, it is prepared for financial planning purpose: in this case, the purpose is to know the liquidity position of the project. It helps project planners to identify potential periods of cash shortages and enables them to plan appropriate responses designed to remove such shortages or how to utilize excess amount of fund during the life of the project. 9 Secondly, cash flow statement may be prepared for the purpose of Net Present Value (NPV) and Internal Rate of Return (IRR) calculation. The purpose here is to measure the overall profitability of the project. In general, cash flow statement is the main tool of financial planning and is sometimes referred to as the "Source and application of funds statement". An example of a typical cash flow statement is given below: XYZ Project Cash Flow Statement for Financial Planning ('000) No 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 Years Items 1 Cash in flows Financial sources: Loans Equity Bank over draft Supplies Credit Total in flow (2 + 3 + 4 + 5 + 6) XX Cash out flows: Operating costs (fixed and variable) Debt service (Interest plus loan repayment) Corporate tax Total assets Dividend Working capital (physical and financial) Surplus or deficit (Net cash flow) (7 – 14) Cumulative cash balance (151 + 152 + 153 etc) 2 3 4 5 XX XX XX XX 6 n The following schedule shows the cash flow statement prepared for NPV and IRR calculation. XYZ Project Cash Flow Statement for NPV and IRR Calculation Years No 1 2 3 Items Cash in flows Cash out flow: total investment outlay operating costs corporate tax total cash out flow Net cash flow (1 – 2) 1 XX 2 XX 3 XX 4 XX 5 XX 6 XX 7 XX XX XX XX XX XX XX XX XX XX XX XX XX XX XX 10 4 Present value (PV) XX XX XX XX XX XX XX Present value is the net cash flow of the project over its life subject to discounting. If you are given the discounting rate say 10%, you can calculate discounting factors and then the present value of the net cash flow of the project. Example: if the Net cash flow of the project is in its first year of operation is Br. 100,000 and discounting rate is 10%, the present value of this sum of money (at Zero period) is given by the formula: PV PV = A (1 + r)-n = 100,000 (1 + 0.1)-1 = 100,000 (1.1)-1 or = 100,000 1.1 = 90909.09Br Where: A = Amount r = discounting rate PV = present value n = number of periods for which the amount of money is discounted r)-n = is the either discounting The value of the discounting factor (1+i) -n can (1 be+determined using factor. a calculator or a financial table prepared for this purpose. The cumulative cash flow must always show a positive balance. Because, a negative amount indicates that the project has run out of cash. Cash flow statement records (cash in flow and out flow) are presented on the cash basis of accounting not on the accruals concept, hence it does not give an indication ...
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