Guide to Financial Analysis

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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

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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.

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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

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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.

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Defining Costs

Capital costs

Operating costs

Development costs

Operational costs

Maintenance costs

By type:

By behaviour: By time:

By function:

Fixed costs

Variable costs

Recurring costs

Non-recurring costs

There are different ways of defining costs:

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Capital CostsCapital 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.

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

• Equipment • Non-consumable Materials*• Infrastructure

Identify the capital costs for the project for the following items:

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Operating CostsOperating 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.

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

• Internal business resources• Internal IT resources• External resources• Office accommodation• Licenses• Support

• Training • System administration• Equipment hire• Consumable materials*• Travel• Accommodation

Identify the operating costs for the project for the following:

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Identifying the Benefits

Refer to the guide to benefits analysis

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

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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

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Assess the Financial Indicators

Financial indicators used in the spreadsheet are:

Net Present Value (NPV)

Internal Rate of Return (IRR)

Sensitivity Analysis

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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 today’s value.

• This is achieved by modifying the future value by a factor that represents the change in value of money from today’s value.

• This factor is called the discount factor. It is calculated as: 1 – (discount rate / 100)

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Investment Analysis

Year 1 Year 2 Year 3 Year 4 Year 5

Benefits 9250 21000 21000 21000 21000Less Costs 23570 15320 15320 15320 18320Cash Flow -14320 5680 5680 5680 2680X Discount factor 0.87 0.756 0.658 0.572 0.497Present Value -12458 4254 3737 3249 1332Net Present Value $154

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.

If the Net Present Value is less than zero then this indicates the project is not financially worthwhile.

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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

Internal Rate of Return

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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.

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Further Assistance

Guide to Benefits Analysis

For additional supporting guides refer to: