Finance for NonFinance People

Ayman M. El-Najjar

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Out-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 Management

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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 & 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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Keep in Mind

• 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.
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6-Groups of Financial Ratios
1. 2. 3. 4. 5. 6. Liquidity Ratios Asset Management Ratios Financial Leverage Ratios Profitability Ratios Market-Based Ratios Dividend Policy Ratios
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Liquidity Ratios Financial Ratios that indicate a firms ability to meet a short-term financial obligations
Current Assets
Current Liabilities
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1.Current Ratio =

Liquidity Ratios

2. Quick Ratio =

Current Assets - Inventories
Current Liabilities

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Asset Management Ratios

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

Account Receivables Annual Credit Sales/365
Ex. ACP=32,000,000/(65,000,000/365)= 180 days!
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Asset Management Ratios

Inventory Turnover Ratio

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Nature 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 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”
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Break Even Point

TR TC

Revenue, Cost ($)
FC

+ EBIT (Operation profits)

- EBIT (operating loss)

Output, Q

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Break Even Point =
__________________________

Fixed Cost + Target Profit Price – Variable Cost

= (Targeted Volume)

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• Contribution Margin: the difference between price and variable cost per unit.
Selling Price variable Cost Contribution A = 24 = 12 = 12 B 25 14 11
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exercise
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 analysis
1. 2. Constant selling price & variable cost per unit. Composition of costs.
(all costs are variables on the long run. some costs increase in a stepwise manner as output changes)

• •

Single product or constant mix Short-term Planning Horizon (1 year)
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Capital 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 Evaluating Alternatives
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4 - Criteria are Commonly used: 1. 2. 3. 4. Net Present Value (NPV) Internal Rate of Return (IRR) Profitability Index (PI) Payback (PB) Period
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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 Formula

NPV = t Σ (NCF)t/(1+k) - NINV
t=1 to n, k=cost of capital, required rate of return

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Decision Rule

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

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

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

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Payback (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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Decision Rule

• 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
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Con’s on PB

• 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.
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Pro’s on PB

• Easy & Inexpensive to use • Provides a crude measure of project risk • Provides a measure of project liquidity.

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