Guide to Financial Analysis

Contents
Purpose of this Guide Financial Analysis defined

Defining Costs
Capital Costs Operating Costs Benefits The Financial Calculator The value of money NPV Payback period Sensitivity Analysis Further assistance
2

The Purpose of this Guide

The purpose of this guide is to provide assistance in completing the financial components of the business case, namely the costs and benefits and in using the financial calculator to obtain a financial assessment of a project. The guide also provides explanations of the financial indicators: NPV, payback period and sensitivity analysis.

Financial Analysis Defined:

Comparing the costs and benefits over time to determine whether a project is profitable or not. To achieve this the following financial indicators are used: Net Present Value (NPV) Internal Rate of Return (IRR) Sensitivity Analysis

Steps in conducting a Financial Analysis:

1. Identify the costs

2. Identify the benefits

3. Enter the costs and benefits into the financial calculator

4. Assess the financial indicators to determine if the project is financially favourable.

Defining Costs
There are different ways of defining costs:
By type: Capital costs Operating costs By function: Development costs Operational costs Maintenance costs By behaviour: Fixed costs Variable costs By time: Recurring costs Non-recurring costs
6

Capital Costs
Capital costs are the expenses incurred in purchase of items that are recorded as assets; their value is depreciated over time and they are recorded in the Balance Sheet. Identify the capital costs for the project for the following items: Equipment Non-consumable Materials* Infrastructure

*Non-consumable materials are capital costs because these are materials that persist (eg. furniture, bricks)
7

Operating Costs
Operating costs are expenses incurred in the execution of the project or in the operation of the business (after the project) They are not depreciated over time and are recorded in the profit and loss statement. Identify the operating costs for the project for the following: Internal business resources Internal IT resources External resources Office accommodation Licenses Support Training System administration Equipment hire Consumable materials* Travel Accommodation

*Consumable materials are operating expenses because they are materials that are used up by the project (eg. stationery, batteries)

Identifying the Benefits

Identify the benefits that the project will provide, and the value that can be assigned to each benefit.

Refer to the guide to benefits analysis

9

Enter the costs and benefits into the Financial Calculator

For each year enter the anticipated capital and operating expenses into the financial calculator spreadsheet. For each year enter the anticipated benefits into the spreadsheet. Adjust the discount rate if appropriate. Enter sensitivity values (% cost increase and % revenue decrease values) The spreadsheet will automatically calculate the financial indicators

10

Assess the Financial Indicators

Financial indicators used in the spreadsheet are: Net Present Value (NPV) Internal Rate of Return (IRR)

Sensitivity Analysis

11

The value of Money

The value of money changes over time. With most projects, the financial benefits are realised at a different time to the costs. Net present value (NPV) provides a means to compare these by adjusting the value to todays value. This is achieved by modifying the future value by a factor that represents the change in value of money from todays value. This factor is called the discount factor. It is calculated as: 1 (discount rate / 100)

12

Investment Analysis
Year 1 Year 2 Year 3 Year 4 Year 5

Benefits Less Costs Cash Flow X Discount factor Present Value Net Present Value

9250 23570 -14320 0.87 -12458 $154

21000 15320 5680 0.756 4254

21000 15320 5680 0.658 3737

21000 15320 5680 0.572 3249

21000 18320 2680 0.497 1332

If the Net Present Value is less than zero then this indicates the project is not financially worthwhile. Note: The discount factor is based on a discount rate of 13%. Hence at the end of the first year $1 is worth 87c, drops to 75.6c in the second year, 65.8c in the third year etc.
13

Internal Rate of Return

Is defined as the discount rate at which an investment has a zero net present value. The internal rate of return equates to the interest rate, expressed as a percentage, that would yield the same return if the funds had been invested over the same period of time. Therefore, if the internal rate of return for the project is less than the current bank interest rate it would be more profitable to put the money in the bank than execute the project

14

Sensitivity Analysis
Projects do not always run to plan. Costs and benefits estimated at an early stage of a project may indicate a profitable project, but this profit could be eroded by an increase in costs or a decrease in the value of the benefits (the revenue).

Sensitivity analysis provides a means of determining the financial impact of this type of fluctuation.
By entering an anticipated percentage increase in costs or decrease in revenue the financial impact on the project can be identified by looking at the change to the NPV or IRR measures.
15

Further Assistance
For additional supporting guides refer to:
Guide to Benefits Analysis

16