Prestige Institute of Management &

Research

Project Management
Financial Analysis
Contents

• Financial Analysis and its Goals

• Project Cost Management
• Major Types of Estimates
• Cash Conversion Cycle (CCC)
• Cash Flow and Cash Flow vs. Profit
• Capital Structure - What It Is and Why It Matters
Financial Analysis
• Financial analysis (also referred to as financial statement
analysis or accounting analysis) refers to an assessment of
the viability, stability and profitability of a business, sub-
business or project.

• Major aspects of financial analysis

 Cost of project
 Estimated sales and production
 Working capital requirement and its financing
Based on Financial Analysis
Management may:
• Make decisions regarding Investing or Lending capital;
• Continue or discontinue its main operation or part of its
business;
• Make or Buy certain materials in the manufacture of its
product;
• Acquire or Rent/Lease certain machineries and equipment in
the production of its goods;
• Issue stocks or negotiate for a bank loan to increase its
working capital;
• Other decisions that allow management to make an informed
selection on various alternatives in the conduct of its business.
Goals Financial Analysis
1. Profitability - Its ability to earn income and sustain growth
in both short-term and long-term;
2. Solvency - Its ability to pay its obligation to creditors and
other third parties in the long-term;
3. Liquidity - Its ability to maintain positive cash flow, while
satisfying immediate obligations;
4. Stability- It is firm's ability to remain in business in the long
run, without having to sustain significant losses in the
conduct of its business.
Project Cost Management
• How do we know what a project will cost? We really don't,
until the project is complete, because we can't accurately
predict the future.
 
• What we can do is create an estimate. An estimate is more
than pulling a random number out of the air, adding 20% for
good measure, and then saying, "That'll work."
 
• A real estimate evolves as project details become available.
This is progressive elaboration.
Project Cost Management
• Project estimates start out broad, and as the project
deliverables come into focus we're able to more accurately
define our estimates.

• Each estimate should provide an acceptable range of variance,

the conditions of the estimates, and any assumptions made by
the estimate provider.

• For example, an estimate to build a new warehouse may state

that the warehouse will cost Rs.350,000, +/- 10%, is valid for
30 days, and assumes that the warehouse will be built in the
month of June.
Cost of Project
• It includes all items of outlay associated with a project which
are supported by long-term funds:
 Land and site development
 Building and civil works
 Plant machinery and installation
 Technology
 Misc. fixed assets
 Pre operative expenses
 Provision for contingencies
 Margin money for working capital
Estimates of Project
• There are three major estimate types that project managers
should rely on:

1. The Ballpark Estimate

2. The Budget Estimate
3. The Definitive Estimate
The Ballpark Estimate
• It is also known as the rough order of magnitude (ROM).

• A ROM estimate is based on high-level objectives, provides a

bird's-eye view of the project deliverables, and has lots of
room for adjustment.

• Most ROM estimates, depending on the industry, have a range

of variance from -25% all the way to +75%.

• The project manager shouldn't invest too much time in

creating these initial estimates.
The Budget Estimate
• Also known as top-down estimate

• It is a bit more accurate. Formulated fairly early in the

project's planning stage.

• The budget estimate is most often based on analogous

estimating, taking budget lessons learned from a similar
project and applying them to the current project.

• With the budget estimate, we start at the top and work our way
down into the project details. The range of variance on the
budget estimate is from -10 percent to +25 percent.
The Definitive Estimate
• Also known as bottom-up estimate is the most accurate of the
estimate types, but takes the most time to create.

• The definitive estimate requires a work breakdown structure

(WBS).

• A WBS is not a list of activities.

• A WBS is a deliverables-oriented decomposition of the project

scope.
Cost of Production

• It comprises of:
 Material cost
 Labour cost
 Overheads
 Utilities cost
Profitability Projections
A. Cost of production
B. Total admin expenses
C. Total sales expenses
D. Royalty and know how cost
E. Total cost of production (A + B + C + D)
F. Expected sales
G. Gross profit (F - E)
H. Depreciation and other financial expenses
I. Operating profit (G - H)
J. Taxation and other reserves
K. Net profit (I - J)
L. Retained earning (Net profit - Dividend)
BEP
• BEP= Fixed costs / (SP- VC)
• BEP= Fixed costs / Contribution = Let it is ‘X’

• BEP (in terms of Volume of Production)= X * Expected

Production in the year
• BEP (in terms of Percentage of Installed Capacity)= X *
Expected Capacity Utilization in the year
• BEP (in terms of Rupees)= X * Expected Sales realization in
the year
Cash Conversion Cycle (CCC)
• The term "cash conversion cycle" refers to the time span
between a firm's disbursing and collecting cash.

• The Cash Conversion Cycle emerges as interval between

disbursing cash and collecting cash).
 
• It is measure of how long a firm will be deprived of cash if it
increases its investment in resources in order to expand
customer sales.
 
• It is thus a measure of the liquidity risk entailed by growth.
Cash Flow
• Cash flow is the movement of cash into or out of a business,
project, or financial product.
• It is usually measured during a specified, finite period of time.
Measurement of cash flow can be used:
 To determine a project's rate of return or value.
 To determine problems with a business's liquidity. Being
profitable does not necessarily mean being liquid. A company
can fail because of a shortage of cash, even while profitable.
 To evaluate the risks within a financial product. E.g. matching
cash requirements, evaluating default risk, re-investment
requirements, etc.
Statement of Cash Flow in a
Business's Financials
• The (total) net cash flow of a company over a period (typically
a quarter or a full year) is equal to the change in cash balance
over this period.
• It is positive if the cash balance increases (more cash becomes
available) and negative if the cash balance decreases.
• The total net cash flow is the sum of cash flows that are
classified in three areas:
 Operational cash flows
 Investment cash flows
 Financing cash flows
The 3 Sources of Cash Flows
 Operational cash flows:
• It is cash received or expended as a result of the company's
internal business activities.
• It includes cash earnings plus changes to working capital.
• Over the medium term this must be net positive if the
company is to remain solvent.
 Investment cash flows:
• It is cash received from the sale of long-life assets, or spent on
capital expenditure (investments, acquisitions and long-life
assets).
 Financing cash flows:
• It is cash received from the issue of debt and equity, or paid
out as dividends, share repurchases or debt repayments.
Example

Description Amount (Rs.) Totals (Rs.)

Cash flow from operations: +10
Sales (paid in cash) +30
  Materials -10
  Labor -10
Cash flow from financing: +40
  Incoming loan +50
  Loan repayment -5
Taxes -5
Cash flow from investments: -10
Purchased capital -10
Total +40
The net cash flow only provides a limited amount of information.
Compare, for example, the cash flows over three years of two
companies:
Company A Company B

Year 1 Year 2 Year 3 Year 1 Year 2 Year 3

Cash flow from operations +20K +21K +22K +10K +11K +12K

Cash flow from financing +5K +5K +5K +5K +5K +5K

Cash flow from investment -15K -15K -15K 0K 0K 0K

Net cash flow +10K +11K +12K +15K +16K +17K

Company B has a higher yearly cash flow. However, Company A is

actually earning more cash by its core activities and has already
spent 45K in long term investments, of which the revenues will only
show up after three years
• Importance of Cash Flow- Bear in mind that more businesses
fail for lack of cash flow than for want of profit.

• Cash Flow vs. Profit- The net result of cash cycle is that cash
receipts often lag cash payments and, whilst profits may be
reported, the business may experience a short-term cash
shortfall.
• For this reason it is essential to forecast cash flows as well as
project likely profits.
• The following simplified example illustrates the timing
differences between profits and cash flows:
Income Statement: Quarter 1
Illustration: Sales (Rs.000) 75
Costs (Rs.000) 65
Profit (Rs.000) 10

Month Month Month

Cash flows relating to Month 1: Total
1 2 3

Receipts from sales (Rs.000) 20 35 20 75

Payments to suppliers etc. (Rs.000) 40 20 5 65

Net cash flow (Rs.000) (20) 15 15 10

Cumulative net cash flow (Rs.000) (20) (5) 10 10

• This shows that the cash associated with the reported profit for
Month 1 will not fully materialize until Month 3.

• And that a serious cash short- fall will be experienced during

Month 1 when receipts from sales will total only Rs.20,000 as
compared with cash payments to suppliers of Rs.40,000.
Basic Principles for Measuring
Project Cash Flows

1. Incremental Principle: It looks at what happens to cash

flows of the firm with and without project
• Guidelines
 Consider all incidental effects
 Ignore sunk cost
 Include opportunity costs
 Question the allocation of overheads costs

2. Long term fund Principle: Its focus is on the profitability of

long term funds
3. Exclusion of Financing Costs Principle:
 Interest on long term debt is ignored while computing profits
and taxes thereon and
 Expected dividends are deemed irrelevant in cash flow
analysis.
 Since interest is usually deducted in the process of arriving at
PAT, an amount equals to interest (1 – tax rate) should be
added back to figure of PAT

4. Post Tax Principle: Cash flow must be defined in post tax

terms.
Component of Cash Flows

• Initial Investment
• Operating Cash Flows
• Terminal Cash Flows: It is cash flow occurring at the end of
the project life on account of liquidation of project
Initial Investment

New Project Replacement Project

• Installation cost • Installation cost
• (+) Working capital margin • (+) Change in Working
• (+) Preliminary and capital margin
Preoperative expenses • (-) Post tax proceeds from
• (-) Tax shield, if any on the sale of old capital assets
capital assets • (-) Tax shield, if any on
replacement of capital assets
Operating Cash Flows

New Project Replacement Project

• Profit after tax • Changes in Profit after tax
• (+) Depreciation • (+) Change in Depreciation
• (+) Other non cash charges • (+) Changes in other non
• (+) Interest on long term cash charges
debt (1-tax rate) • (+) Changes Interest on long
term debt (1-tax rate)
Terminal Cash Flows

New Project Replacement Project

• Post tax proceeds (net • Post tax proceeds from the
salvage value) from the sale sale of replacement capital
of capital assets assets
• (+) Net recovery of • (+) Post tax proceeds from
Working capital margin the sale of present capital
assets
• (+) Net recovery of
Working capital margin
Capital Structure - What It Is and
Why It Matters

• The term capital structure refers to the percentage of capital

(money) at work in a business by type.

• Broadly speaking, there are two forms of capital: equity

capital and debt capital.

• Each has its own benefits and drawbacks.

• The perfect capital structure is formed in terms of risk / reward

payoff for shareholders.
 Equity Capital: This refers to money put up and owned by the
shareholders (owners). Typically, equity capital consists of two
types:
 Contributed capital, which is the money that was originally
invested in the business in exchange for shares of stock or
ownership and
 Retained earnings, which represents profits from past years that
have been kept by the company and used to strengthen the balance
sheet or fund growth, acquisitions, or expansion.

 Debt Capital: The debt capital in a company's capital structure

refers to borrowed money that is at work in the business.
Seeking the Optimal Capital
Structure
• Many individuals believe that the goal in life is to be debt-free.
 
• Of course, how much debt you take on comes down to how secure
the revenues your business generates.
 
• Again, this is where managerial talent, experience, and wisdom
come into play. The great managers have a knack for consistently
lowering their weighted average cost of capital by increasing
productivity, seeking out higher return products, and more.

• Optimum capital structure is combination of debt and equity that

leads to maximum value of firm and hence wealth to its owners
minimizing cost of capital.
Features of optimum capital
structure
• It should be flexible
• Maximum possible use of leverage (use of fixed cost funds
because it maximizes returns to equity)
• Use tax leverage
• Avoid undue financial/ business risk with the increase of debt
• Use of debt should be in capacity of firm. The firm should be
in position to meet its obligations in paying the loan and
interest charges as and when due.
• It should involve minimum possible risk of loss of control
• It must avoid undue restriction in agreement of debt
Cost of capital
For Debt
1. Kd= (I / C)* 100
 I = Contractual rate + [(Floating charges + Premium –
Discount)/ Period of issue]
 C = Par value – [(Floating charges + Premium – Discount)/ 2]
2. Kdt = Kd (1-t)

For equity
1. Ket = (D/C) * 100 + G (growth rate in dividend)
2. Ke = Ket / (1-t)
References
• Chandra Prasanna (1995). Projects: Planning, Analysis, Selection, Implementation
and Review, New Delhi: Tata McGraw- Hill ed. 4th.
• Gopalkrishnan P. and V. E. R. Moorthy (1993). Project Management, New Delhi:
Macmillan India ltd.
• Gupta S. K. & R.K. Sharma (2004). Financial Management, Ludhiana: Kalyani
Publishers ed. 4th.
• http://en.wikipedia.org/wiki/Financial_analysis
• http://www.interplansystems.com/html-docs/cost-estimating-project-planning.html
• http://www.projectsmart.co.uk/project-cost-management.html
• http://en.wikipedia.org/wiki/Cash_conversion_cycle
• http://en.wikipedia.org/wiki/Cash_flow
• http://www.planware.org/cashflowforecast.htm
• http://beginnersinvest.about.com/od/financialratio/a/capital-structure.htm
Thank you