Chapter Five: Financial Analysis

5.1 Objectives of Financial Analysis

Assessment of financial impact
Judgment of efficient resource Use
Assessment of Incentives
Provision of sound financial plan
 Assessment of financial impact
 The most important objective of financial analysis is to assess the
financial effects the project will have on participants (farmer, firms,
government, etc).

 This assessment is based on the comparison of each participant’s

current and future financial status with the project against the
projection of his future financial performance as the project is
implemented.
 Judgment of efficient resource Use
For management especially, overall return is important because managers must
work within the market price framework they face.
Investment analysis & financial ratio analysis provide the tool for this review.

 Assessment of Incentives
The financial analysis is of critical importance in assessing the incentives
for different participants of the project.

Will participants have an incremental income large enough to compensate

them for the additional effort and risk they will incur?

Will private sector firms earn a sufficient return on their equity investment
& borrowed resources to justify making the investment the project requires?
 Provision of sound financial plan

The financial plan provides a basis for:

 Determining the amount and timing of investment,

Debt repayment capacity,

And also helps to coordinate financial contributions.

5.2 Market Analysis

 Is concerned with the arrangement for marketing the output to be

produced and

 The arrangement for the supply of inputs needed to build and

operate the project.
 Given the importance of market and demand analysis in project
analysis, it should be carried out in an orderly and systematic
manner.

 The Six key steps in such analysis are as follows.

1. Situational analysis and specification of objectives

2. Collection of secondary information

3. Conduct of Market study/ survey

4. Characterization of the market

5. Demand forecasting

6. Market planning
1. Situational analysis and specification of objectives
 In order to get the relationship between the product and its market, the
project analyst may talk to stockholders look at their preferences and
purchasing power, actions and strategies of competition and practices
of the middlemen.
 The objective of the market and demand analysis is to answer some of the
following questions
 Who are the buyers of this product? (Consumers)
 What is the total current demand?
 How is the demand distributed temporally /pattern of sale over the year
and geographically?
 What price will the consumers be willing to pay for the product?
 How can consumers be convinced that the product could be substituted
for other products?
 What channels of distributions are most suited for the product?

 What trade margins will induce distributors to carry it out?

 What are the possible immediate sales?

2. Collection of secondary information

 Information may be obtained from secondary or primary sources.

 Secondary information provides the base and the starting point for
market and demand analysis.
 It includes what is known and often provides clues for gathering primary
information required for further analysis.

 Several sources including; census data, national sample survey reports, plan
reports, statistical abstracts, industry specific sources of data etc.
3. Conduct of Market study/ survey
 Secondary information is useful, often does not provide a
comprehensive basis for market and demand analysis.
It needs to be supplemented with primary information gathered
through a market survey specific to the projects being appraised.
The information sought in market survey may relate to one or
more of the following.
Total demand and rate of growth of demand
Demand in different segments of the market
Income and price elasticity of demand
Motives for buying
Purchasing plans and interventions
Satisfaction with existing products
Attitudes towards various products
Socio economic characterization of buyers
4. Characterization of the market
 Based on the secondary sources and through the market surveys,
the market for the product /service may be described in terms of the
following:
Breakdown of demand/ Effective demand in the past and
present
Prices
Methods of distribution/channel/ and sales promotion
Consumers behavior and preferences
Supply and competition
Government policy and level of interventions
5. Demand Forecasting

After gathering information about various aspects of the market

and demand from primary and secondary sources, an attempt
may be made to estimate future demand.

A wide variety of forecasting methods is available to the market

analyst.

The methods may be divided into

Qualitative methods,
Time series projection methods and
Causal methods.
1. Qualitative Methods:
 Relies on expert opinions and judgments to make forecasts.
 Examples: Delphi method, market surveys, sales force estimates.
 Best suited for new products or when historical data is limited.
2. Time Series Projection Methods:
 Analyzes historical data patterns to identify trends, seasonal variations, and
cyclical patterns.
 Examples: Moving average, exponential smoothing, ARIMA models.
 Suitable when historical data is available and future trends are expected to be
similar to past trends.
3. Causal Methods:
 Identifies relationships between demand and other factors (independent
variables) like economic indicators, competitor activities, etc.
 Examples: Regression analysis, econometric models.
 Best suited when there are identifiable factors that influence demand and
historical data is available.
 Demand forecasting

It involved with the estimation of the future demand of a given

product on the basis of the past and present demand data.

This forecasting is helpful in that it helps the producer to decide

how much to produce and hence how much input to use so as
to get maximum profit without wasting the inputs and the
outputs.
 5.3. Pricing Project Costs and Benefits

Once costs and benefits have been identified if they are to be

compared they must be valued.
Since the only practical way to compare differing goods and
services directly is to give each a money value,
Therefore, we must find the proper prices for the costs and
benefits in our analysis.
 5.3.1. Finding Market Prices

Project analysis characteristically are built first by identifying the

technical inputs and output for a proposed investment, then by

valuing the inputs and outputs at market prices to construct the

financial accounts, and finally by adjusting the financial prices so

they better reflect economic values.

 Thus, the first step in valuing costs and benefits is finding the

market prices for the inputs and outputs.

 The project analyst will have to consult many sources such as

merchants, consumers, experts, published statistical bulletins, etc.

Point of first sale and farm-gate price
 In project analysis, a good rule for determining a market price for
agricultural commodities produced in the project is to seek the
price at the “point of first sale”.
 The increased value added of the product as it goes to higher
markets in the channel arises as a payment for marketing
services.
 Thus, if the project includes such marketing services in its
design, we can take these higher prices.
 Even in this case, the analyst must make the project as small as
possible and try to analyze the marketing service component
independently of the production component.
 If the product is sold only in central markets, no local market,
then the analyst must find out the value of marketing service to
arrive at price at project site.
 Prices for some products like agricultural products generally are
subjected to substantial seasonal fluctuation.
 Therefore, some decision must be made about the price in the
seasonal cycle to choose the price to be used for the analysis.
 A good starting point is the farm-gate price at the peak of the
harvest season.
 This is probably close to the lowest price in the cycle.
 The reason is that the rise in price is due to marketing services.

Financial analysis is made base on market price.

The project may use imported inputs and export its output, to
foreign markets.
If there are domestic markets for these inputs and outputs, and if
the firm is free to sell or buy at the domestic or world market, we
take the domestic price with appropriate adjustment to reflect the
price at the project site.

If, on the other hand, commodities of the project are produced only
for foreign market or if the domestic demand cannot absorb the
firm’s output, we will take export-parity and import parity prices
ever in financial analysis.
In financial analysis, we use export and import parity prices if the
project will export its output to and import inputs from foreign
markets.

A project for several reasons may use imported inputs or export

outputs even though there are domestic markets.

In both cases what we need to determine is the amount of income the

project receives from its exports or the amount the project pays for
imports at the project location.
5.3.2. Predicting Future Prices
 Since project analysis is about judging future returns from future
investment, we have to judge what the future prices of inputs and
outputs may be.
 The best starting point is to see the trend of these prices over the
past few years.
 Having this data, the project analyst can forecast the price with
certain degree of precision.
Change in prices
 Change in prices could be general change in price or change in
relative prices of goods
 Change in relative price:
 If relative price of inputs or outputs are variable over time, i.e.,
 These changes in relative price of items imply a change in
marginal productivity of inputs in production or a change in
marginal satisfaction (MU) in consumption.
 Thus, changes in relative prices have a real effect on the project
objective
 It must be reflected in project accounts in the years when such
changes are expected.
 This can be judged from past trend.
 For instance, the price of agricultural products to price of
inputs (manufactured) may rise over time.
 This would have a real effect on the net benefit of the firm.
Inflation: an increase in general prices of goods
 Inflation is common for every country although the magnitude

may vary between countries.

 However, the approach most often taken is to work the project

analysis in constant price.

 It is assumed that inflation will affect most prices to the same

extent so that prices retain their same general relations.

 The analyst then need only adjust future price estimates for

anticipated relative changes, not for any change in the general

price level.
[Link] Ratios

 From the projected financial statements for an enterprise, the financial

analyst is able to calculate financial ratios that allow him to form a
judgment about the efficiency of the enterprise, its return on key
aggregates and its credit worthiness.

 5.3.1. Efficiency Ratios

Inventory turnover

 This measure the number of times that an enterprise turns over its
stock each year and indicates the amount of inventory required to
support a given level of sales.

 It can be computed as:

 The inventory turnover can also relate to the average length of time
a firm keeps its inventory on hand.

 A low ratio may mean that the company with large stocks on hand
may find it difficult to sell its product, and this may be an indicator
that the management is not able to control its inventory effectively.

 Thus a low ratio, may indicate cash shortage & the firm might
sometime be forced to sell by forgoing sales opportunities.
Operating ratio
 This is obtained by dividing the operating expenses by the revenue.

5.3.2. Income ratios

 The long-term financial viability of an enterprise depends on the
funds it can generate for reinvestment and growth and on its ability
to provide a satisfactory return on investment.
Return on sales
 This shows how large an operating margin the enterprise has on its
sales.
Return on equity

 It is an amount received by the owner of the equity. It is obtained

by dividing the net income after taxes by the equity.

 Equity - an ownership right in an enterprise.

 Equity capital is the residual amount left after deducting total

liabilities (excluding stockholder's claim) from total assets.

 This ratio is frequently used because it is one of the main criteria

by which owners are guided in their investment decisions.
Return on assets

 The earning power of the assets of an enterprise is viral to its

success.
 The return on assets is the financial ratio that comes closest to the
rate of return on all resources engaged.
 A crude rule of thumb is this value should exceed interest rate.
5.3.3. Credit-worthiness Ratios
 The purpose of creditworthiness ratios is to enable a judgment about
the degree of financial risk inherent in the enterprise before
undertaking a project.
 It also helps to estimate the amount and terms finance needed.
Current ratio
 This is computed by dividing the current assets by the current liabilities.
 Though it needs caution, as a rule of thumb, a current ratio of 2 is
acceptable.

Debt-equity ratio
 This is an important ratio for credit agencies. It is calculated by dividing
long-term liabilities by the sum of long-term liabilities plus equity to
obtain the proportion that long-term liabilities are to total debt and
equity, and then by dividing equity to obtain the proportion that equity is
of the total debt and equity. These are then compared in the form of a
ratio.
 It tells us, of the total capital, how much proportion is equity & how
much is debt. If for example we have 40 to 60, it means that of the total
capital 40% is debt and 60% is equity.

 In general strong equity base is good for a project to overcome risk &
uncertainty.

 Especially in some risky projects, high ratio is a necessary condition.

Debt-service coverage ratio
 The most comprehensive ratio of creditworthiness is the debt-
service coverage ratio.
 This is calculated by dividing net income plus depreciation plus
interest paid by interest paid plus repayment of long-term loans.

 It tells us how a project can absorb only shocks without impairing

the firm's ability of meeting obligations.
 In contrary to this, it can also tell us how the firm chose an
appropriate credit term.