# Financial and Cash Flow Analysis Methods.

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1 Financial and Cash Flow Analysis Methods

2 Financial analysis Historic analysis (BS, ratios, CF analysis, management strategy) Current position (environment, industry, products, management) Future (competitiveness, forecasts, future cash flows)

3 Historic analysis - Financial statements P&L or income statement: Net Operating Profit (NOP, Gross returns - tot operating expenses), Profit before Tax, Net Profit after Tax (NPAT). BS: shows the book value of assets and liabilities of a company at year end. Current assets (convertible into cash within a year), fixed assets (land and buildings, plant and machinery...)

4 Historic analysis - ratios Ratios - backward looking (but can also be forward looking), they vary for different industries: Return on sales % = NPAT / Sales (amounts) Asset turnover = Sales (amounts) / tot Assets Asset/equity ratio = tot Assets / Equity Asset/equity ratio indicates a company's leverage, the amount of debt used to finance the firm. A company's asset/ equity ratio depends on the industry in which it operates, its size, economic conditions and other factors. NB: by multiplying the above 3 ratios we obtain the return on equity %: NPAT / Equity

5 Other important ra-os are: Debt- Service Coverage Ra-o - DSCR: amount of cash flow available to meet annual interest and principal payments on debt: Net opera-ng income/ Total Debt Service A DSCR of less than 1 would mean a nega-ve cash flow. A DSCR of 0.90, means that there is only enough net opera-ng income to cover 90% of annual debt payments Liquidity ra-os: it expresses a company's ability to repay short- term debt obliga-ons

6 Historic analysis - CF analysis Starting cash balance + Cash generated from operations and other sources (i.e.investments) - Cash used to fund operations, investments (passive interest rates), research = Ending cash balance

7 Future Cash Flow Analysis - Appraisal Methods Aim of project appraisal: Select best projects for investment in order to: Provide adequate return to investors Maximise value of business to owners (shareholders) Projects may involve: Large sums of expenditure Benefits accruing over a long period

8 Steps in Project Planning (1) Identification of Opportunities, e.g. design of a new product. (2) Identification of Alternatives, e.g. expansion in Ireland or Scotland. (3) Obtaining data, e.g. costs, revenue, equipment. (4) Evaluation of Options (5) Choice & Planning

9 Appraisal Methods (A) Accounting Rate of Return (B) Payback Method (C) Net Present Value (NPV) (D) Internal Rate of Return (IRR) (E) Profitability Index

10 Versions of ARR Method (1) ARR = average annual profits /average annual investment (2) ARR = total profits / initial investment (3) ARR = average annual profits / initial investment

11 Drawbacks of the ARR Method Ignores timing of costs and revenues during project life. Does not identify payback period. Variety of versions, making comparison difficult.

12 Payback Method Period required to recover initial cash outflow (depreciation not considered). Annual net cash flow needs to be estimated. Aim to select investments that recover expenses in shortest possible time. Discounted payback is a refinement on the simple payback Management may set a payback target, within an overall process

13 Payback, example Payback: This can be illustrated by calculating the cumulative cash flows, as follows: Year C.F. Cumulative C.F 1 10,000 10, ,000 25, ,000 45, ,000 70, , ,000 original cost of investment Project (A) = 4 years & 4 months. As the payback will occur within yr. 4, we need 10,000 30,000 = 0.33 of yr. 4, i.e. 4 months. Hence, the PBP is 4 yrs. and 4 months, on the assumption that cash flow is uniform during the year.

14 Drawbacks of payback method Ignores timing of benefits (unless the discounted model is used) Ignores differences of project life, expenses and revenues after recovery of investment.

15 Discounted Cash Flow Techniques consider timing of revenues and expenses Total profitability of the project is looked at Techniques superior to ARR and Payback Looks at cash flows not accounting profits

16 NPV Method NPV = - Initial Investment + T = endofproj CF t t= 1 (1 + r) t where: CF t : Net Cash flows (positive CF - expenses) at time t T: end of project r: discount rate which needs to take into account the level of risk of project

17 NPV Method Inflows and outflows are discounted using a target rate of return to find the net present value If NPV positive: return in excess of target rate If NPV negative: return less than target rate If NPV is zero: return is equal to target rate

18 Internal Rate of Return Determine discount rate that makes NPV=0 Often referred to as the DCF yield of project If yield is higher than target project is viable and should be undertaken Uses interpolation to find final rate Note: the two rates between which we interpolate must not be distant from each other, a large difference will distort the final result. Also, one of these two rates needs to give a positive NPV, while the other leads to a negative NPV. This might require experimenting with several rates.

19 IRR Interpolation (R 2 - R 1 ) *NPV 1 IRR = R 1 + [ ] where: (NPV 1 - NPV 2 ) R 1 = first estimate of IRR giving NPV 1 R 2 = second estimate of IRR giving NPV 2 if NPV 1 was >0, R 2 should be > R 1, if NPV 1 was <0, R 2 should be < R 1.

20 Profitability Index PV of Future Cash Flows PI = Initial Outlay Index gives PV of net profit per 1 of capital investment.

21 Risk Risk occurs when there are several possible future outcomes, the probabilities of which can be quantified on some reasonable basis. Risk tends to increase as the life of the project increases, due to difficulties in looking into the far future. Techniques have been developed for decision-making in situations of risk

22 Probability and Expected Values It may be possible to make alternative predictions (e.g. sales revenues associated with different states of the economy), and assign degrees of probability to them, scenario analysis. It is possible to calculate the expected NPV and IRR, through multiplying the gain/loss of each alternative by the respective probability, and then adding the products. Both the probability figures and the respective gains and losses are subjective, the resulting IRR is a weighted arithmetic average of all the possible IRRs.

23 Scenario Distribu-ons E(IRR) = (0.1)(0-.05) + (0.2)(0.05)+(0.4)(0.15)+ +(0.2)(0.25) + (0.1)(0.35) E(IRR) = 0.15 or 15%

24 Sensitivity Analysis 1 Sensitivity analysis is a technique for analysing risk associated with investment projects. It looks at the sensitivity of the profitability of the project to changes in key factors, such as discount rates, sales prices, and input prices. Such analysis assists in evolving the best strategy for the project, tackling its nature, size, the surrounding environment and relevant risks. E.g. variables that require a special focus will be clearly identified.

25 Sensitivity Analysis 2 It involves calculating for each factor, the change that will make the NPV = zero. We can also change a variable by set amounts, to see the effect. For example, we can reduce the product price by 5%, so as to compute the resulting NPV for three other possible (lower) prices. E.g. if the original estimated price was 1 per unit, we can consider three other lower prices (95p, 90p, 85p).

26 Sensitivity Analysis 3 Usually variations in each key factor are made separately, however dual-factor or multi-factor changes analyses are possible.

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FINANCIAL MANAGEMENT BBA (IV Semester Core Course) B.Com (V Semester SpecialisationFinance) 2011 Admission onwards UNIVERSITY OF CALICUT SCHOOL OF DISTANCE EDUCATION CALICUT UNIVERSITY.P.O., MALAPPURAM,