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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
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