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Finance for Non-Finance for Non-Finance PeopleFinance People

Ayman M. El-Najjar

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Out-LineOut-Line• Overview of Financial Management• Nature of Costs• Break-Even Analysis• Financial Statements ( e.g. Balance Sheet,

Cash Flows, Profit loss statement)• Ratio analysis & Performance Measures• Capital Budgeting • Investment Appraisal

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Overview of Financial Overview of Financial ManagementManagement

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• Financial Manager has the primary responsibility for acquiring funds (cash) needed by the firm and for directing those funds into projects that will maximize the value of the firm

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• Financial Management responsibilities are divided between –Controller, who has all responsibilities

related to accounting, &

–Treasurer, who is concerned with the acquisition, custody, and expenditure of funds.

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Financial Analysis & RatiosFinancial Analysis & Ratios

• Financial ratio is a relationship that indicates something about a firm’s activities.

• Financial Ratios enable an analyst to make a comparison of a firm’s financial condition over time or in relation to other firms.

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• Financial Ratios are only “Flags” indicating potential areas of strength or weakness.

• A Financial Ratio is meaningful only when it is compared with some standard, such as industry ratio trend, a ratio trend for the specific firm being analyzed, or a stated management objective.

Keep in MindKeep in Mind

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6-Groups of Financial Ratios6-Groups of Financial Ratios

1. Liquidity Ratios2. Asset Management Ratios3. Financial Leverage Ratios4. Profitability Ratios5. Market-Based Ratios6. Dividend Policy Ratios

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Liquidity RatiosLiquidity Ratios

Financial Ratios that indicate a firms ability to meet a short-term financial obligations

1.Current Ratio =Current Assets

Current Liabilities

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2. Quick Ratio =

Liquidity RatiosLiquidity Ratios

Current Assets - Inventories

Current Liabilities

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1. Average Collection Period

(average number of days an account receivable remains outstanding) =

Asset Management RatiosAsset Management Ratios

Account Receivables

Annual Credit Sales/365

Ex. ACP=32,000,000/(65,000,000/365)= 180 days!

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Asset Management RatiosAsset Management Ratios

1. Inventory Turnover Ratio

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Nature of CostsNature of Costs

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• Fixed Costs:– Definition: Don’t change by

changing production volumes

– Examples: Rents, insurance, depreciation, salaries, fees, fixed bank loans charges, …

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• Semi-Fixed Costs:– Def.: don’t change as a result of

changes in production volume except when a specific ceiling is reached

– Ex.: new salaried staff required, penalty charges,…

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• Variable Costs:– Definition: directly proportionately

related to production volumes

– Examples: light, heat, energy bills, labor, direct materials, transportations, …

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• Semi-Variables Costs:– Def.:A step change variation once a

specific ceiling is reached

– Ex.: overtime payments, electricity charges, …

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• Sunk Cost:– Def.: costs that have been paid out before

a specific project under review was ever considered

• Marginal Costs:– Def.: the additional cost of one extra unit

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Break Even AnalysisBreak Even Analysis

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Definition: A technique used to examine the relationship between a firm’s sales, costs, and profits at various levels of output. It is sometimes termed “cost-volume-profit analysis”

21Output, Q

Revenue,Cost($)

TR

TC

Break Even Point

- EBIT(operating loss)

+ EBIT(Operation profits)

FC

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Break Even Point =

Fixed Cost __________________________

Price – Variable Cost

+ Target Profit

= (Targeted Volume)

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• Contribution Margin: the difference between price and variable cost per unit.

A B

Selling Price = 24 25

variable Cost = 12 14

Contribution = 12 11

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exerciseexercise

Firm A manufactures one product, which sells at $250. Total sales is $5 million. Fixed cost is $1 million & the total variable costs are $3 million. Find the breakeven output.

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Limitations of Breakeven analysisLimitations of Breakeven analysis

1. Constant selling price & variable cost per unit.

2. Composition of costs.(all costs are variables on the long run. some costs increase in a stepwise manner as output changes)

3. Single product or constant mix

4. Short-term Planning Horizon (1 year)

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Capital BudgetingCapital Budgeting

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• Capital Budgeting: the process of planning for purchases of assets whose returns are expected to continue beyond one year.

• Capital expenditure: is a cash outlay that is expected to generate a flow of future cash benefits lasting longer than one year.

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• Cost of capital: Cost of Fund; – “the required rate of return”

• Depreciation: a systematic allocation of the cost of an asset over more than one year.

– non-cash expense

– reduce reported earning

– reduces also taxes

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Decision Models for Decision Models for Evaluating Evaluating

AlternativesAlternatives

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4 - Criteria are Commonly used:4 - Criteria are Commonly used:

1. Net Present Value (NPV)

2. Internal Rate of Return (IRR)

3. Profitability Index (PI)

4. Payback (PB) Period

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Net Present Value (NPV)Net Present Value (NPV)

• Def.: the present value of the stream of net operating cash flows from the project minus the project’s net investment– NPV = PVNCF – NINV

• PVNC: present value of net operating cash flow• NINV: net investment

– “Discounted Cash Flow (DCF)” method

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NPV FormulaNPV Formula

NPV =

(NCF)t/(1+k)t - NINV

t=1 to n,

k=cost of capital, required rate of return

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A Project should be accepted if its NPV is greater than or equal to zero.

Decision RuleDecision Rule

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Internal Rate of Return (IRR)Internal Rate of Return (IRR)

• Def.: the discount rate that equates the present value of the NCF’s with the ININV

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The IRR method indicate that a project whose IRR is greater than or equal t the firm’s cost of capital should be accepted.

Decision RuleDecision Rule

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Profitability Index (PI)Profitability Index (PI)

• It is benefit-cost ratio

• It is the ratio of the PVNCF to NINV

• It is the present value return for each dollar of initial investment

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A Project whose PI is greater than or equal to 1 is considered acceptable

Decision RuleDecision Rule

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Payback (PB) PeriodPayback (PB) Period• De.: is the period of time

required for the cumulative cash inflows (i.e. NCF) to equal the initial cash outlay (i.e. NINV)PB = (NINV)/(Annual NCF)

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• Because the PB method has a number of serious shortcomings, it should not be used in deciding whether to accept or reject an investment project.

• It can be useful as a supplementary decision-making tool

Decision RuleDecision Rule

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• Ignores the time value of money

• Ignores cash flows occurring after the payback period

• Provides no Objective criterion for decision making. Different people using same data may make different accept-reject decisions.

Con’s on PBCon’s on PB

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• Easy & Inexpensive to use

• Provides a crude measure of project risk

• Provides a measure of project liquidity.

Pro’s on PBPro’s on PB