III.

Financial Analysis of a project

Introduction

A project is evaluated (or analyzed) from financial point of view to ascertain

whether the proposed project will be financially viable in the sense of being
able to meet the burden of servicing debt and whether the proposed project
will satisfy the return expectation of those who provide the capital financial
analysis of the project is concerned with the analysis of the profitability of
the project based on monetary costs and benefits. The financial analysis
constitutes an important part of a feasibility study, giving the picture of the
project’s financial viability. The ultimate objective of the financial analysis is
to answer the question whether the project is commercially profitable or not.

Elements of financial analysis

The following activities are to be undertaken in financial analysis

1. Project cost Estimation

2. Planning for means of finance

3. Sales revenue estimation

4. Cost of production estimation

5. Profitability project

6. Project cash flows statements

7. Project balance sheet

1. Project cost Estimation

Correct estimation of the capital cost of a project is the foundation over

which the edifice of financial appraisal stands. Resources for the project are
tied up after the project cost is estimated. If the project cost is under-
estimated, the will run short of funds during implementation and there is risk
of the project coming to a grinding halt if the promoter is not able to bring in
additional capital to meet the increase in project cost or if the bank/financial
institution that has extended financial assistance for the building up of fixed
assets of the building up fixed assets of the project does not come forward to
extend additional loan to meet the increase in project cost. This emphasizes
the need for a correct estimate of the project cost. On the other hand, if the
project cost is over estimated, it leads to a situation where more funds are
available than required and under thee circumstance it is more likely that the
promoters may divert the resources for other purposes which again is
determinate to the interests of both the promoters and the financing
institutions.

COMPONENTS OF CAPITAL COST OF A PROJECT

The following are the components that constitute the capital cost of any
project.

(i) Land (vii) Know-how/consultancy

fees.
(ii) Land development
(viii)Miscellaneous assets.
(iii) Buildings
(ix) Preliminary and
(iv) Plant and machinery
preoperative expenses
(v) Electrical
(x) Provision money for working
(vi) Transport and erection capital.
charges

NB: The aim deciding upon the various components of project cost should be
to reduce the cost to the minimum, keeping the functional requirements
adequate.

(a) Land

Cost of a land: - refers to all expenditures in cured in association

with the land such as purchase price and cost of completing the
purchase transaction (title transfer, brokerage fees, legal fees…)

Before deciding upon the extent of land required for the project, the cost of
land etc., the first question to be asked is whether it is essential to invest on
land and building. If the project is small in size, the possibilities of acquiring a
building on lease may be thought of the comparative cost advantage and
effect on profitability between the two options viz., starting the project in a
leased building and starting the project in owned building by acquiring land
and constructing building thereon may be studied. Small project can be
started in leased building, which will reduce the cost of investment
considerably. It may be noted that it is only the plant and machinery that are
going to produce goods and building only acts as a shelter to house the
production facilities and investment on building is not directly going to add
to the production capacity.

However, this can not be the case always. Buildings suitable for the chosen
project may not be always on lease. Some project may require building of
certain minimum size/specifications, in which case it will not be possible to
identify a building on lease that is suitable for meeting the requirements of
the project.

The component ‘Land’ comes into picture only after having decided to
purchases land and construct building instead of starting the project in
leased premises.

The extent of land should be so chosen that it is neither too large as to

inflate the cost of the project nor too small as to provide no leeway for
making additions/alterations to the building and for future expansion.

The extent of land required for a project can be estimated after upon the
building plan. Sufficient allowances for open space around the building
should be provided for. Also open space shall be provided to take up
expansion proposals that may come up in the near future. In respect of
industries where raw materials are stored in the open, sufficient vacant land
should be available. For example, wood working units store a large volume of
wooden logs in open space. Similarly, steel foundries and steel re-rolling
mills also stock raw materials in huge quantity in open yards. Sufficient
vacant land surrounding the building should be available to take care of the
near future, say within a span of three years or so, the extent of land should
be chosen accordingly, since it may not be possible to acquired additional
land when required, if the adjacent lands have already been put into some
use by the owners.

(b) Land development

Land development charges include cost of leveling & grading of land, cost of
laying internal roads, cost of providing fencing and gates. Land development
charges deserve to be carefully assessed since this is an area where there is
a likelihood of under estimation if detailed and correct estimate are not
made.

(c) Building
Provision for different types of buildings shall be envisaged and provided for.
The following are the types of buildings that are normally required for any
project.

 Main factory building

 Ancillary factory building

 Administrative building

 Laboratory

 Toilet blocks

 Underground water storage tanks.

 Canteen, rest rooms guesthouse.

 Quarters for essential staff etc.

It must be ensured that the built-up area of different buildings proposed is

sufficient to meet the requirements and that unnecessary construction is
done. After having arrived at the size and design of different buildings, their
cost of construction can be arrived at by preparing a detailed estimate,
entrusting the work to a qualified civil/structural engineer.

(d) Plant and Machinery

The cost of the plant and machinery, typically the most significant
components of the project cost, consists of the following:

• Purchase price

• Freight and insurance

• Import duty/taxes

• etc

Indigenous Plants & Machinery: While choosing machinery suppliers, their

reputation and past performance act as the leading indicators. Performance
of machinery supplied by them earlier is to be seen to have a first hand
knowledge. Quotations from a few reputed machinery suppliers can be
obtained and a comparative study of the prices quoted by them can be done
before deciding upon a particular supplier. Cost of indigenous plants includes
purchase price plus taxes, if any.

Imported plants: The cost of imported plant and machinery is the sum of
the F.O.B (Free-on-board) value of the plant to be imported, the shipping/Air
cargo freight charges, marine/air insurance charges, import duty payable on
the machinery, clearing charges, loading and unloading charges at different
places etc. it is always advisable to import necessary spares along
consuming. While the cost of new imported machinery can be arrived at
fairly accurately as mentioned above, caution should be exercised when
second hand machinery price from the machinery dealers, the price of the
machinery should also be assessed by an independent, competent engineer
after duly inspecting the machinery. The unexpired future life of second hand
machinery is also to be got estimated by the engineer.

Cost of power generator is to be included in the cost of plant and machinery,

whenever it is felt essential to have a generator as a stand-by source of
power. Apart from main machinery, the requirement of items like laboratory
equipments, tool room machinery etc., are also to be carefully assessed and
included in the scheme of plant and machinery proposed for the project.

(e) Electrical

The cost of electrical items includes the cost of cables, panel boards, voltage
stabilizers etc. Whenever the industry is to draw electric power form a high
tension power line, necessary voltage step-down transformer should be
included in the project and its cost should be accounted for.

(f) Transport and Erection charges

Transport charges till the plant and machinery reaches the factory site,
including loading and unloading charges are to be accounted for. Erection
charge include machinery foundation cost and machinery assembling and
other erection expenses

(g) Technical Know-how and consultancy fees

Often it is necessary to engage technical consultants or collaborators from

Ethiopia and/or abroad for advice and help in various technical matters like
preparation of the project report; choice of technology; selection of the
obtaining the technical know-how and engineering services for setting up the
project is a component of the project cost; the royalty payable annually;
which is typically a percentage of sales; is an operating expense taken in to
account in the preparation of the projected profitability statements.

Likewise, expenses of training employees in the production process must be

included here

(h) MISCELLANEOUS FIXED ASSETS

Fixed asset and machinery which are not part of the direct manufacturing
process may be referred to as miscellaneous fixed assets. They include items
furniture, office machinery and equipment, tools, vehicles, railway, siding,
diesel generating sets, transformers, boilers, piping equipment, and so on.
Expenses incurred for the procurement or use of patents, licenses, trade.

(i) Preliminary, Capital Issue Expenses, Pre-operative Expenses

Expenses incurred for identifying project, conducting the market survey,

preparing the feasibility report, drafting the memorandum and articles of
association and incorporating the company are referred to as preliminary
expenses.

Expenses borne in connection with the raising of capital from the public are
referred to as capital issue expenses. The major components of capital issue
expenses are: underwriting commission, brokerage, fees to managers and
registrars, printing and postage expenses, advertising and expenses, listing
fees, and stamp duty.

Pre-operative Expenses:- Expenses of the following types incurred till the

commencement of commercial production are referred to as pre-operative
expenses: (i) establishment expenses, (ii) rent, rates, and taxes, (iii)
traveling expenses, (iv) interest and commitment charges on borrowings, (v)
insurance charges, (vi) mortgage expenses, (vii) interest on deferred
payments, (viii) startup expenses, and (ix) miscellaneous expenses.

Pre-operative expenses incurred up to the point of time the plant machinery

are set up may be capitalized by apportioning them to fixed assets on
machinery are set up are treated as revenue expenditure. The firm may,
however, treat them as deferred revenue expenditure and write them off
over a period of time.

(j) Provision for Contingencies

A provision for contingencies is made to provide for certain unforeseen
expenses and price increases over and above the normal inflation rate which
is already incorporated in the cost estimates.

To estimate the provision for contingencies the following procedure may be

followed:

(i) Divide the project cost items into two categories, vis., ‘firm’ cost
items and ‘non-firm’ cost items (firm cost items are those which
have already been acquired or for which definite arrangements
have been made).

(ii) Set the provision for contingencies as percentage of the

estimated cost of non-firm cost items.

(k) Margin Money for Working Capital

The principal support for working capital is provided by commercial banks

and trade creditors. However, a certain part of the working capital
requirement has to come from long-term sources of finance-Referred to as
the ‘margin money for working capital, this is an important element of the
project cost.

2. Identifying Means of finance

To meet the cost of the project, the means of finance that are available
include share capital (common stock & Preferred stock), Term loans, Bonds,
Incentive sources, and Miscellaneous sources.

a. Share Capital. There are two types of share capital; namely, equity
capital (through the issuance of common stock) and preference capital
(through the issuance of preferred stock). Common stock (Equity
capital) represents the contribution made by the owners of the
business, the equity shareholders, who enjoy the rewards and bear the
risks of ownership. Equity capital being a risk capital carries no fixed
rate of divided. Preference capital represents the contribution made by
preference shareholders and dividend paid on it is generally fixed.

b. Term Loans, They are provided by financial institutions and

commercial banks. Term loans represent secured borrowings which are
a very important source (and often the major source) for financing new
projects as well as for the expansion, modernization, and renovation
schemes of existing firms.
 c. Bond capital. Bonds are instruments for raising debt capital. The
typical example of bonds is debentures. Typically they carry a fixed
rate of interest.

d. Deferred Credit (long term credit purchase):- Many a time the

suppliers of the plant and machinery offer a deferred credit facility
under which payment for the purchase of the plant and machinery can
be made over a period of time.

e. Incentive Sources. The government and agencies may provide

financial support as an incentive to certain types of promoters or for
setting up industrial units in certain locations.

Planning the Means of Finance

The various means of finance that can be tapped for a project have been
described above. The guidelines and considerations that should be borne in
mind for identifying the specific source of finance are as follows:

i. Government policies, Norms of Regulatory Bodies and Financial

Institutions. In some countries, the proposed means of finance for a
project must either be approved by a regulatory agency or conform
to certain norms laid down by the government or financial
institutions regard.

The primary purpose of such regulations is to impart prudence to project

financing decisions and provide a measure of protection to investors. In
additions, the norms of financial institutions, which often provide
substantial assistance to project significantly shape and circumscribe
project financing decisions.

ii. Cost. In general, the cost of debt funds is lower than the cost of equity
funds. Why? The primary reason is that the interest payable on debt
capital is a tax-deductible expense whereas the dividend payable on
equity capital is not.

iii. Risk. The main sources of risk for a firm (or project) are business risk
and financial risk. Business risk refers to the variability of earnings
before interest and taxes and arises mainly from fluctuations in
demand and variability of prices and costs. Financial risk represents
the risk arising from financial leverage. It must be emphasized that
while debt capital is cheap it is also risky because of the fixed
financial burden associated with it.
 Generally the affairs of the firm are, or should be, managed in such
a way that the total risk borne by equity shareholders, which
consists of business risk and financial risk, is not unduly high. This
implies that if the firm is exposed to a high degree of business risk,
its financial risk should be kept low. On the other hand, if the firm
has a low business risk profile, it can assume a high degree of
financial risk.

3. Estimates of Production costs

There are three major categories of Production costs. These are

1. Direct materials cost:- the acquisition costs of all materials that

are identified as part of the cost object and that may be traced to
the cost object in an economically feasible way. Acquisition costs of
direct materials include inward delivery charge, tax, and custom
duties. Direct material often does not include minor items such as
glue or tacks because the cost of tracing insignificant items do not
seem worth the possible benefits of having more accurate product
costs. Such items are called supplies or indirect materials and
classified a part of the indirect manufacturing costs.

2. Direct labor. The compensation of all labor that can be identified

in an economically feasible labor costs are all factory labor
compensation other than to a specific product. They are classified
as part of the indirect manufacturing cost. Examples include wages
of janitors, and plant guards.

3. Indirect manufacturing costs (manufacturing overhead). All

manufacturing costs that cannot be identified specifically with or
traced to the cost object in an economically feasible way. Other
terms used are factory overhead, factory burden, manufacturing
overhead, and manufacturing expenses. Examples of factory
overhead (when products are cost object) include power, supplies,
indirect labor, factory rent, insurance, property taxes, and
depreciation.

4. SALES REVENUE ESTIMATION

Sales revenue may be estimated for each year of operation with the
careful consideration of the followings.
 1. Capacity utilization:- expect low capacity utilization in
the first few years of operations and thereafter
gradually increasing capacity utilization.

2. Expect reasonable selling price

5. PROFITABILITY PROJECTION

Given the estimates of sales revenues and cost of production, the next
activity is to prepare the profitability projections or estimates of working
results. The estimates of working results. The estimates of working results
/profitability may be prepared the following lines:

A. Expected sales

B. Cost of production

C. Total administrative expenses

D. Total sales expenses

E. Preliminary & capital issue expenses

F. Royalty and know-how expenses

G. Total operating expenses (B + C + D + E + F)

H. Operating profit before interest & taxes (A – B + C + D + E + F)

I. Interest

J. Operating profit before tax (H – I)

K. Other income

L. Profit /loss before taxation (J + K)

M. Provision for taxation

N. Profit after tax (L – M)

In the above format the following items are included:

Cost of production:- this represents the cost of materials, labor, utilities,

and factory over-heads
Total Administrative expenses This consists of (i) administrative, (ii)
remuneration to directors, (iii) professional fees, (iv) light, postage,
telegrams, and telephones, and office supplies (stationery, printing, etc), (v)
insurance and taxes on office property, and (vi) Miscellaneous items.

Total sales Expenses: - The expenses included under this head are: (i)
commission payable to dealers. (ii) Packing and forwarding charges, (iii)
salary of sales staff (which may be increases at 5 percent per annum), (iv)
sales promotion and advertising expenses, and (v) other miscellaneous
expenses.

The selling expenses depend mainly on the nature of industry and the kinds
of competitive conditions that prevail.

Royalty and know-how payable:- Royalty and know-how payable,

annually may be shown here.

Total operating expenses:- This is simply the sum of cost production, total
administrative expenses, total sales expenses, and royalty and know- how
payable….

Expected sales:- The figures of expected sales are drawn from the
estimates of sales.

Operating profit before Interest:- This represents the difference between

expected sales and Total operating expenses

Total interest Expenses consist of interest on term loans, interest on bank

borrowings commitment charges on term loans, and commission for bank
guarantees. The principal financial expenses, of course, are interest on term
loans and interest on bank.

5. Projected Cash flow Statements

The cash statement shows the movement of cash into and out of the firm
and its net impact on the cash balance with the firm. The format for
preparing the cash flow statement, which is really a cash flow budget, is
shown below.

Projected Cash Flow Statement

Sources of funds

1. Share issue Br. XXX

2. Profit before taxation with interest added back XXX
3. Depreciation & amortization provision for the year (XX)
4. Increase in secured medium and long-term borrowings for the project XXX
5. Increase in unsecured loans XXX
6. Increase in unsecured loans XXX
7. Sales of fixed assets XXX
8. Sales of investment XXX
9. Other income XXX
Total cash in flows during the period Br. XXXXX
Uses/Disposition/of funds
1. Capital expenditure for the project Br. XXX
2. Other normal capital expenditure XXX
3. Increase in working capital. XXX
4. Decrease in secured medium and long-term borrowings XXX
5. Decrease in unsecured loans XXX
6. Decrease in bank borrowings for working capital XXX
7. Increase in investments in other companies XXX
8. Interest loans XXX
9. Taxation XXX
10. Dividends XXX
11. Other expenditures XXX
Total cash out flows during the period Br.
XXXX

Net increase/ decrease/ Br. XXXX

Add: beginning balance of cash in hand and bank

XXX

Ending balance of cash in hand in hand and bank Br.

XXXX

6. Projected Balance sheets

The balance sheet, showing the balance in various asset and liability
accounts, reflects, reflects the, financial conditions of the firm at a given
point of time. The format of projected balance sheet is given in below.

Assets Liability & Capital

Current assets Current liability and provisions
Fixed assets Investments Secured loans
 Intangible assets unsecured loans
Share capital
Retained earning
Total assets Total liab. &
capital

The liabilities & capital side of the balance sheets shows the sources of
finance employed by the business. A word about its components shown on
the right hand side of above format is in order. Share capital consists of paid-
up equity and preference capital. Retained earning represents mainly the
accumulated retained earnings. They are shown in different accounts like the
represent the borrowings of the firm against which security have been
provided. The most important components of secured loans are debentures,
term loans from financial institutions, and loans from commercial banks.
Unsecured loans represent borrowings against which no specific security has
been provided. Current liabilities are obligation which in the near future,
usually a year. These obligations arise mainly from items which enter the
operating cycle: payables from acquiring materials and supplies used in
production, and accruals of wages, salaries, and rentals. Provisions include
mainly tax provision, and provision for proposed dividends.

The assets side of the balance sheet shows how funds have been used in the
business. The major asset compotes may be described briefly. Fixed assets
are tangible long-lived resources ordinarily used for producing goods and
services. They are shown at original cost less depreciation. Investments
represent financial securities owned by the firm. Current assets consist of
cash, debtors, inventories of different kinds; and loans and advances made
by the firm.

For preparing the projected balance sheet at the end of year n+1, we need
information about the following:

• The balance sheet at the end of year n.

• The projected income statement and the distribution of earnings for

the year n+1

• The sources of external financing proposed to be tapped in the year

n+1

• The proposed repayment of debt capital (long – term, intermediate

term, and short-term) during the year n+1
 • The outlays and the disposal of fixed assets during the year n+1

• The changes in the level of current assets during the year n+1

• The change in other assets and certain outlays likes preoperative and
preliminary expenses (which are capitalized) during the year n+1

• The cash balance at the end of year n+1

Illustration
_____
The balance sheet of XYZ Enterprises at the end of year n (the year
which is just over) is as follows: (amounts are in thousands)

Assets Liabilities &

Capital
Cash 20 Current liabilities 90
Receivables 80 Secured loans
80
Inventories 80 Unsecured loans 50
Fixed assets 180 Share capital
100
Retained Earning 20
Total Assets 360 total Liab & Capital
360

The projected income statement and the distribution of earnings for

the year n+1 is given below

(in thousands)
Sales 400
Cost 300
Depreciation 20
Profit before interest and taxes 80
Interest 20
Profit before tax 60
Tax 30
Profit after tax 30
Dividends 10
Retained earnings 20
During the year n+1, the firm plans to raise a secured term loan by 20,
repay previous term loan to the extent of 5, and increase unsecured loans by
10. Current liabilities and provision are expected to remain unchanged.
Further, the firm plans to acquire fixed assets worth30 and increase its
inventories by 10. Receivables are expected to increase by 15. Other assets
would remain unchanged, exception, of course, cash. The firm plans to pay
10 by way of equity divided.

Required:- A. Prepare the forecasted cash flows statement of Year

n+1

B. Prepare the balance sheet of year n+1