Understanding Financial Reports - Basic Course

Financial Intelligence Ayman El-Najjar

Outline • • • • • • •

Introduction; the art of Finance and why it matters Income Statement; the many peculiarities of IS Balance Sheet; it reveals the most Cash Statement; cash is king Ratios; what the numbers are really telling Return on Investment; how to calculate ROI Working Capital Management; applied financial intelligence

Aiming to become Financially Intelligent person – Ayman El-Najjar

What’s Financial Intelligence? • Everyone in a company does better when they understand how financial success is measured and how they have impact on the company’s performance ...

Aiming to become Financially Intelligent person – Ayman El-Najjar

• FI; set of skills that must be, and can be, learned • For most senior executives, they come out of finance or pick up the skills during their rise to the top • It’s tough to run a business unless you know what the financial folks are saying

Aiming to become Financially Intelligent person – Ayman El-Najjar

4 skill Sets • Understanding the foundation • Understanding the art • Understanding Analysis • Understanding the big picture

Aiming to become Financially Intelligent person – Ayman El-Najjar

• Financial intelligence need to be learned, practiced, and applied – Learn the Language – Ask Questions – Use the information

Aiming to become Financially Intelligent person – Ayman El-Najjar

The Art of Finance & Why it Matters

You can’t always trust the numbers!! • Accounting and Finance, like all other business disciplines, really are as much art as they are science. – When is a sale a sale? (revenue recognition game) … • Xerox case – improperly recognized $6 billion!

– Determining whether a given cost is a capital expenditure or operating expenditure!

Aiming to become Financially Intelligent person – Ayman El-Najjar

• If you don’t have a good working understanding of the financial statements and don’t know what those folks are looking at or why, you are at their mercy!!

Aiming to become Financially Intelligent person – Ayman El-Najjar

Spotting Assumptions, Estimates, and Biases Examples of the art of Finance

Simple but critical Questions:

• Accruals

•

What were the assumptions (‫ (الفتراضات‬in this number?

• Depreciation

•

Are there any estimates (‫ (التقديرات‬in the numbers

• Valuation

•

What is the bias (‫(الميل‬ those assumptions and estimates lead to?

•

What are the implications (‫?(التضمينات‬

• Allocations

Aiming to become Financially Intelligent person – Ayman El-Najjar

Accr ual s • The portion of a given revenue or expense item that is recorded in a particular time span – e.g. Development Cost

Aiming to become Financially Intelligent person – Ayman El-Najjar

Al locati ons • apportionment of costs to different departments or activities within a company – e.g. allocation of CEO salary to operating units

Aiming to become Financially Intelligent person – Ayman El-Najjar

workshop – Group Discussion • In June, you worked on a new product line, which was introduced in July. How much of your salary should be matched to product cost and how much to development cost … Imagine that The accountant determined that all your salary should go to development cost in June …

Aiming to become Financially Intelligent person – Ayman El-Najjar

Depr eci ati on (‫(الستهلك‬ The method accountants use to allocate the cost of equipment and other assets to the total cost of products or services as shown on the income statement At attempt to spread the cost of the expenditure over the useful life of the item

Aiming to become Financially Intelligent person – Ayman El-Najjar

Example – for discussion • Accountants of Airline industry some years back realized that their planes were lasting longer. So, they changed their depreciation schedules … (assumptions, estimates, bias, implications)

Aiming to become Financially Intelligent person – Ayman El-Najjar

Val uati on (‫(التقييم‬ • Methods of Valuation – Price-to-Earning Ratio Method – Discounted cash flow Method – Asset Valuation Method Each method entails a whole passel of assumptions and estimates

Aiming to become Financially Intelligent person – Ayman El-Najjar

Why Increase your Financial Intelligence?

• To understand what the numbers really mean … • As a leader, manager, employee, you need to understand what’s happening in the company from a financial perspective, and use that information to work and manage more effectively … simply stated, to improve your decision making Aiming to become Financially Intelligent person – Ayman El-Najjar

For you: – Increased ability to critically evaluate your company – Better understand the bias in the numbers – The ability to use numbers and financial tools to make and analyze decisions

For the company: – better decisions, – greater alignment, – strength an balance throughout the organization

Aiming to become Financially Intelligent person – Ayman El-Najjar

Roadblocks to Financial Savvy • Hate Math! • Finance and accounting department • Your boss • No Time!

Aiming to become Financially Intelligent person – Ayman El-Najjar

The Players • Chief Financial Officer (CFO): management and strategy of the organization from financial perspective. Oversees all financial functions

• Treasurer: building and maintaining banking relationship, managing cash flow, forecasting, equity and capital-structure decisions, investors relations

Aiming to become Financially Intelligent person – Ayman El-Najjar

• Controller: Financial reports, general accounting, business analysis, financial planning, asset management, internal control

Aiming to become Financially Intelligent person – Ayman El-Najjar

Part 1 - Recap • We know “What’s Financial Intelligence?” • Why we need to be financially intelligent? • We learned about the art of Finance? • We are ready to ask 4 simple but critical questions to spot assumptions, estimates, biases and their implications

Aiming to become Financially Intelligent person – Ayman El-Najjar

Income Statement (‫(بيان قائمة الدخل‬

• Income statement shows revenue (‫المبيعات‬,( expenses (‫ )المصروفات‬and profit ,(‫( الربح‬for a period of time, such as a month, a quarter, or year. • It’s also called profit & loss statement (‫بيان الربح‬ ‫والخسارة‬P&L, statement of earning ,( • The bottom line of the income statement is Net Profit (‫(صافي الربح‬, also known as net income (‫صافي الدخل‬or net earning ( Aiming to become Financially Intelligent person – Ayman El-Najjar

Operating Expenses (Opex) • Operating Expenses (‫(المصاريف التشغيلية‬ are costs that are required to keep the business going day to day. – e.g. salaries, benefits, insurance costs, etc..

• Operating Expense shows up on the income statement and thus reduce profit Aiming to become Financially Intelligent person – Ayman El-Najjar

Capital Expenditures (Capex) • Capital expenditure (‫(المصاريف الرأسمالية‬ is the purchase of an item that’s considered a long term investment – E.g. computer system, equipment, car • Capex shows up on the balance sheet; only depreciation of a capital equipment appears on the income statement

Aiming to become Financially Intelligent person – Ayman El-Najjar

• So, operating expenses reduces the bottom line immediately, and a capital expenditure spreads the hit out over several accounting periods

Aiming to become Financially Intelligent person – Ayman El-Najjar

Profit

(‫(الربح‬

• “Profit is a sovereign criterion of an enterprise” Peter Drucker • Profit is not Cash; beware! • Profit is an estimate! And you can’t spend estimates! • It’s a promise to pay! • Profit will turn into cash (hopefully!) Aiming to become Financially Intelligent person – Ayman El-Najjar

Matching principle • A fundamental accounting rule for preparing an income statement • It says “match the sale with its associated cost to determine profit in a given time” • Accountants have to make assumptions and come up with estimates

Aiming to become Financially Intelligent person – Ayman El-Najjar

The Purpose of the Income Statement

• In principle, it tries to measure whether the products or services are profitable when everything is added up.

Aiming to become Financially Intelligent person – Ayman El-Najjar

A sample Income Statment • Revenue (‫(مبيعات‬

$100

• Cost of Goods Sold (‫(تكلفة المبيعات‬

50

• Gross Profit (‫(إجمالي الربح‬

50

• Expenses (‫(مصروفات‬

30

• Operating Profit (EBIT)

20

• Taxes (‫(ضرائب‬

5

• Net Profit (‫(صافي الربح‬

$15

Aiming to become Financially Intelligent person – Ayman El-Najjar

Revenue • Revenue recognition; when to record or recognize a sale – When a product delivered; a commonly used rule. – Beware: this is an area for accountants judgment and thus manipulation – Most common source of accounting fraud; revenue recognition!

Aiming to become Financially Intelligent person – Ayman El-Najjar

Costs & Expenses • Cost of Goods Sold (COGS) or Cost of Services (COS): to measure all costs directly associated with making the product of delivering the service – The material. The labor.

Aiming to become Financially Intelligent person – Ayman El-Najjar

Operating Expenses • Also referred to as “Overhead” or “SG&A” i.e. Sales, General, & administrative expenses – Utilities, rent, telephone, research, management, staff salaries, HR, accounting, IT, and so forth – Depreciation is included … the way it’s calculated affects the bottom line

Aiming to become Financially Intelligent person – Ayman El-Najjar

• Revenue

$10,000

• Revenue

$10,000

• COGS

5,000

• COGS

5,000

• Gross Profit

5,000

• Gross Profit

5,000

• Expenses

3,000

• Expenses

3,000

• Depreciation* 1,000

• Depreciation* 3,000

• Net Profit

• Net Profit

$1,000

* 3 years depreciation

- $1,000

* 1 year depreciation

Aiming to become Financially Intelligent person – Ayman El-Najjar

Forms of Profits • Profit is the amount left over after expenses are subtracted from revenue.

Aiming to become Financially Intelligent person – Ayman El-Najjar

3 basic types of profits Gross Profit (GP) = Sales – COGS

GP can greatly be affected by decisions about when to recognize revenue and decisions about what to include in COGS

Aiming to become Financially Intelligent person – Ayman El-Najjar

Operating Profit, EBIT (‫(الربح من العمليات التشغيلية‬ = Gross Profit – operating expenses

• It’s the profit a business earns from the business it is in – from operations • It measures both the overall demand for the company products (sales) and the company’s efficiency in delivering those products (costs) Aiming to become Financially Intelligent person – Ayman El-Najjar

Net Profit Net Profit (the bottom line) (‫(صافي الربح‬ = Operating profit – (interest expense + taxes, any other expenses not included in operating profit)

Aiming to become Financially Intelligent person – Ayman El-Najjar

How to fix it? 2. Increase profitable Sales ‫زيادة المبيعات‬ ‫ذات الربحية‬ 1. 2. 3. 4.

Find new markets, or new prospects, Work through sales cycles, So on so forth

Aiming to become Financially Intelligent person – Ayman El-Najjar

2. Lower Production Cost and run more efficiently – i.e. reduce COGS … ‫تخفيض تكاليف النتاج والعمل بكفاءة أعلى‬ Takes time; you need to study production processes, find inefficiencies, and implement changes

Aiming to become Financially Intelligent person – Ayman El-Najjar

3. Cut Operating Expenses (‫تقليص‬ ‫(المصروفات التشغيلية‬ which almost always means cut the headcount! … layoffs! ‫تسريح موظفين‬ Short-term Solution! It makes earning looks better fast! ‫حل قصير المدى قد تظهر له نتائج سريعة‬ But it backfires! ‫يعطي عكس النتائج المرجوة ولو بعد حين‬

Aiming to become Financially Intelligent person – Ayman El-Najjar

For most companies, it’s better to manage for the long haul and to focus on increasing profitable sales and reducing costs. Sure, operating expenses may have to be trimmed. But if that your focus, you’re probably postponing the day of reckoning!

Aiming to become Financially Intelligent person – Ayman El-Najjar

Balance Sheet ‫بيان المركز المالي‬ Assets = Liabilities + Equity

Understanding Basics • The balance sheet reflects the assets (‫الصول‬ ‫ أو الموجودات‬,(liabilities (‫المطلوبات أو المديونيات‬and ,( owner equity (‫( حقوق الملك أو المساهمين‬at a point in time. • It’s simply a statement of what a business owns and what it owes at a particular point in time. The difference represents equity • All financial statements ultimately flow to the balance sheet Aiming to become Financially Intelligent person – Ayman El-Najjar

Equity • Equity is the shareholders’ stake in the company. * Equity = Assets – Liabilities * Equity = sum of all capital paid in by shareholders + profits earned – dividend paid out

• Increasing equity is a company’s goal. • Profitability & Equity are related Aiming to become Financially Intelligent person – Ayman El-Najjar

What’s the relationship? • Profitability is like the grade you receive for a course • Equity is like your overall GPA • Your GPA always reflects your cumulative performance at one point in time. Any grade affects it, but doesn’t determine it • Over time, the equity section of the BS shows the accumulation of profits or losses Aiming to become Financially Intelligent person – Ayman El-Najjar

• Balance sheet (like income statement) in many respects is a work of art not only a work of calculation; understand the assumptions, decisions, and estimates that go into it

Aiming to become Financially Intelligent person – Ayman El-Najjar

Assets • Assets are what the company owns; – Cash & Cash Equivalent ‫النقد وما في حكمه‬ – Machinery & equipment ‫مكائن ومعدات‬ – Buildings ‫مباني‬ – Land ‫أرض‬

Aiming to become Financially Intelligent person – Ayman El-Najjar

• Current Assets ‫ الموجودات المتداولة‬: anything that can be turned into cash in less than a year • Long Term Assets ‫ الموجودات طويلة المدى‬: have a useful life of more than a year

Aiming to become Financially Intelligent person – Ayman El-Najjar

Types of Assets • Cash & Cash Equivalents Money in banks & money-markets

• Accounts Receivable (A/R) – Amounts customers owe the company. It’s like a loan form the company to its customers – Important for managers to watch it closely Aiming to become Financially Intelligent person – Ayman El-Najjar

• Inventory; ‫المخزون‬ – Finished goods; ready to be sold – WIP goods; work-in-process – Raw materials Inventory

• Property, Plant, & Equipment (PPE) – Includes buildings, land, machinery, trucks, cars, computers, etc – Recorded at Purchase price Aiming to become Financially Intelligent person – Ayman El-Najjar

• Less: accumulated depreciation – Land doesn’t wear out

• Goodwill ‫الشهرة‬ – Like land; not amortized!

• Intellectual property & other Intangible assets – Patents, brand names, customer lists, strategic strength, employees, reputation, and so on. – Most are not found on the balance sheet unless an acquiring company pays for them!

• Prepaid asset

Aiming to become Financially Intelligent person – Ayman El-Najjar

Liabilities & Equity • The other side shows how the assets were obtained

Aiming to become Financially Intelligent person – Ayman El-Najjar

Liabilities • Current liabilities ‫ مطلوبات متداولة‬: to be paid of in less than a year • Accounts payable ‫ديون مستحقة الدفع للموردين‬ amounts the company owes its vendors • Long-term liabilities ‫ديون طويلة الجل‬will : come due over a longer time frame; mostly loans

Aiming to become Financially Intelligent person – Ayman El-Najjar

Workshop Example • Pp 102-103

Aiming to become Financially Intelligent person – Ayman El-Najjar

• A change in one statement nearly always has an impact on the other statements. • The effect of Profit on Equity; net profit adds up to equity unless paid out as dividend – See other examples pp 104-105

Aiming to become Financially Intelligent person – Ayman El-Najjar

‫‪Cash Statement‬‬ ‫قائمة التدفقات النقدية‬

Why cash? • It’s cash that keeps a business alive, and cash flow is a critical measure of its financial health. You need people to run the business, you need a place, you need electricity, telephones, computers, supplies, etc. you can’t pay for all these things with profits because profits aren’t real money. Cash is!

Aiming to become Financially Intelligent person – Ayman El-Najjar

• Profit is different than Cash • Companies need both Profit & Cash • Understanding the difference is a key to increasing your financial intelligence.

Aiming to become Financially Intelligent person – Ayman El-Najjar

1st Scenario: Profit without Cash Jan

Feb

Mar

Sales

$20,000

$30,000

$45,000

COGS

12,000

18,000

27,000

Gross Profit Expenses

8,000

12,000

18,000

10,000

10,000

10,000

Net Profit

$(2,000)

$ 2,000

$ 8,000

Aiming to become Financially Intelligent person – Ayman El-Najjar

Jan

Feb

Mar

Beginning Cash

$ 10,000

0

($22,000)

Cash in (Collection)

0

0

20,000

Cash out (vendors)

0

(12,000)

(18,000)

Cash out (expenses)

(10,000)

(10,000)

(10,000)

Net Cash

0

($ 22,000) ($ 30,000)

Aiming to become Financially Intelligent person – Ayman El-Najjar

2nd Scenario: Cash without Profit Jan

Feb

Mar

$ 50,000

$ 75,000

$ 95,000

COGS

35,000

52,000

66,500

Gross Profit

15,000

22,500

28,500

Expenses

30,000

30,000

30,000

$ (15,000) $ (7,500)

$ (1,500)

Sales

Net Profit

Aiming to become Financially Intelligent person – Ayman El-Najjar

Beginning Cash Collection (cash sales) Payment (COGS) Payment (expenses) Net Cash

Jan

Feb

Mar

$ 10,000

$ 30,000

$ 75,000

50,000

75,000

95,000

0

0

(35,000)

(30,000)

(30,000)

(30,000)

$ 30,000

$ 75,000

$ 105,000

Aiming to become Financially Intelligent person – Ayman El-Najjar

• Understanding this foundational concept opens up a whole window of opportunity to ask questions and make smart decisions

Aiming to become Financially Intelligent person – Ayman El-Najjar

The language of Cash Flow • Cash from or used in operating activities • Cash from or used in investing activities • Cash from or used in financing activities

Aiming to become Financially Intelligent person – Ayman El-Najjar

Ratios

The Power of Ratios • They offer a quick shortcut to understanding what the financial statements are saying • Ratio indicate the relationship of one number to another

Aiming to become Financially Intelligent person – Ayman El-Najjar

• Senior managers watch ratios such as gross margin to be aware of rising costs or inappropriate discounting • Lenders examines ratios such as debt-toequity to give them an idea of whether the company will be able to pay back a loan • Credit managers assess potential customers’ financial health by inspecting the quick ratio

Aiming to become Financially Intelligent person – Ayman El-Najjar

• The power of ratios lies in the fact that numbers in the financial statements by themselves don’t reveal the whole story • Ratios offer points of comparison

Aiming to become Financially Intelligent person – Ayman El-Najjar

• Compare Ratios with themselves over time (trend analysis) • Compare Ratios with what was projected • Compare Ratios with industry averages

Aiming to become Financially Intelligent person – Ayman El-Najjar

• Is net profit of $ 10 million healthy for a company?

Aiming to become Financially Intelligent person – Ayman El-Najjar

4 Categories of Ratios • Profitability Ratios • Leverage Ratios • Liquidity Ratios • Efficiency ratios

Aiming to become Financially Intelligent person – Ayman El-Najjar

Profitability Ratio • The higher the better • Evaluate a company’s ability to generate profits • Are most of common of ratios

Aiming to become Financially Intelligent person – Ayman El-Najjar

• Gross Profit Margin (or Gross Margin): = Gross Profit / Revenue

Trend line in gross margin is important as it indicates potential problem. If it is heading down it means that the company is under sever price pressure or its raw material and labor are rising or both Aiming to become Financially Intelligent person – Ayman El-Najjar

• Operating Profit Margin (Operating Margin) = Operating Profit (EBIT) / Revenue

A key metric indicating how well managers as a group are doing

Aiming to become Financially Intelligent person – Ayman El-Najjar

• Net Profit Margin (net margin) = net profit / revenue

To be compared with the company performance in the previous years & to similar companies in the same industry

Aiming to become Financially Intelligent person – Ayman El-Najjar

• Return on Asset (ROA) = net profit / total assets

ROA tells what percentage of every dollar invested in the business was returned to you as a profit. It shows how effective the company is at using those assets to generate profit Aiming to become Financially Intelligent person – Ayman El-Najjar

• An ROA considerably above industry average norm may indicate that the company is not renewing its asset base for the future – not investing in new machinery and equipment --its long term prospect will be compromised • Another possibility is that the company executives are playing fast and loose with the balance sheet, using accounting tricks o reduce the asset base to make ROA look better Aiming to become Financially Intelligent person – Ayman El-Najjar

• Return on Equity (ROE) = net profit / shareholders’ equity

It tells us what percentage of profit we make for every dollar of equity invested

Aiming to become Financially Intelligent person – Ayman El-Najjar

Leverage Ratios • ‘Leverage’ is the financial analyst’s word for ‘debt’. Two kinds of leverage: • Operating leverage: the ratio between fixed costs and variable costs. Increasing operating leverage means adding to fixed costs with the objective of reducing variable costs • Financial Leverage: the extent to which a company’s asset based is financed by debt

Aiming to become Financially Intelligent person – Ayman El-Najjar

• Debt-to-Equity Ratio: = Total Liability / Shareholders’ equity

Aiming to become Financially Intelligent person – Ayman El-Najjar

• Interest Coverage = Operating Profit / annual interest charges

The ratio shows how easy it will be for the company to pay its interest.

Aiming to become Financially Intelligent person – Ayman El-Najjar

• What happens when either of these two ratios heads too far in the wrong direction (i.e. too high Debt-To-Equity and too low Interest Coverage)?

Aiming to become Financially Intelligent person – Ayman El-Najjar

Liquidity Ratios • Current Ratio measures the company’s current assets against its current liabilities Current Assets

= ________________ Current Liabilities

Aiming to become Financially Intelligent person – Ayman El-Najjar

• Quick Ratio known as the “Acid Ratio” Current Assets - Inventory

= __________________ Current Liabilities

Aiming to become Financially Intelligent person – Ayman El-Najjar

Efficiency Ratios

(making the most of your assets)

• Efficiency ratios help you evaluate how efficiently you manage certain key balance sheet assets and liabilities • For instance, if you can reduce inventory and speed up collection of receivable, you will have a direct and immediate impact on your company’s cash position Aiming to become Financially Intelligent person – Ayman El-Najjar

Invent ory D ays and Turnov er • Days-in-inventory (DII) Average Inventory

= ____________________ COGS/360days

Aiming to become Financially Intelligent person – Ayman El-Najjar

• Inventory Turns 360

= _______________ DII

Aiming to become Financially Intelligent person – Ayman El-Najjar

• Days Sales Outstanding (DSO) known as “Average Collection period” and/or “Receivable Days” • It is a measure of the average time it takes to collect the cash from sales (or it measures how fast customers pay their bills)

=

Ending A/R

________________ Revenue / 360 days

Aiming to become Financially Intelligent person – Ayman El-Najjar

• DSO is a key ratio for those doing a due diligence on a potential acquisition. • High DSO may be a red flag • Due diligence folks need to look at the aging of receivables, how old specific invoices are & how many there are

Aiming to become Financially Intelligent person – Ayman El-Najjar

• Days Payable Outstanding (DPO) it shows the average number of days it takes a company to pay its own outstanding invoices Ending A/P

= ___________________ COGS / 360 days

Aiming to become Financially Intelligent person – Ayman El-Najjar

• Property, Plant, & Equipment (PPE) Turnover It tells how many dollars of sales the company is getting for each dollar invested in PPE. It measures how efficient you’re in generating revenue from fixed assets.

Revenue

= __________________ PPE

Aiming to become Financially Intelligent person – Ayman El-Najjar

• Total Asset Turnover It compares revenue to total assets not just fixed assets.

Revenue = _______________ Total Assets

Aiming to become Financially Intelligent person – Ayman El-Najjar

Which Ratios are most important to your Business? • Depends on the industry, competition, and company specific circumstances • Example: Retailers watch Inventory turnover

Aiming to become Financially Intelligent person – Ayman El-Najjar

Two things … • The power of percent-of-sales figures to be tracked over time to establish trend lines • Each line item of the income statement can be expressed as a percent of sales • The percent-of-sales figure gives a manager more info than the raw numbers alone Aiming to become Financially Intelligent person – Ayman El-Najjar

Ratios Relationships • Example:

ROA (Return on Assets)= Net income/ total assets • Expressed differently: ROA= net income/revenue * revenue/assets = net profit margin * asset turnover

Aiming to become Financially Intelligent person – Ayman El-Najjar

Return on Investment

Fundamentals • Time Value of Money simply says ‘a dollar in your hand today is worth more than a dollar your expect in the future’ • Simply because of the risk involved. You may not collect it tomorrow. • The longer time period, the higher the risk, the larger the interest charges are likely to be Aiming to become Financially Intelligent person – Ayman El-Najjar

• Three key concepts when analyze capital investment: 1) Present Value, 2) Future value, 3) required rate of return (or hurdle rate)

Aiming to become Financially Intelligent person – Ayman El-Najjar

•

Financial analyst figure a company’s Cost of Capital by

2. finding out the expected cost of its debt (interest rate), 3. estimating the return expected by the shareholders, and 4. taking a weighted average of the two. Aiming to become Financially Intelligent person – Ayman El-Najjar

• Example: A company borrow at 4%, Shareholder expect a 16% return. It’s financed 25% by debt and 75% by equity. What’s the cost of capital?

Aiming to become Financially Intelligent person – Ayman El-Najjar

Figuring ROI • Capital expenditures, Cap-ex, Capital Investments, Capital Budgeting, ROI … companies use these terms loosely or interchangeably to mean .. • The process of deciding what capital investments to make to improve the value of the company.

Aiming to become Financially Intelligent person – Ayman El-Najjar

The process of calculating ROI 1. Determine the initial cash outlay 2. Project the future cash flows generated from the investment 3. Evaluate the future cash flows; typically using 3 different financial methods; payback, NPV, IRR.

Aiming to become Financially Intelligent person – Ayman El-Najjar

Learning the threee methods • Payback Method: It measures the time required for the cash flow form a project to return the original investment Initial Investment

= ___________________ Yearly cash flow

Aiming to become Financially Intelligent person – Ayman El-Najjar

Payback Method On the Plus side: • It’s simple to calculate ad explain. • It provides easy and quick reality check. If the payback period is longer than he project life, then no need to look any further • It’s a project used in meetings to quickly determine if a project is worth exploring. Aiming to become Financially Intelligent person – Ayman El-Najjar

Payback Method On the minus side: • It doesn't tell you much. • It doesn’t consider the cash generated beyond the breakeven • It doesn’t give you an overall return • It doesn’t consider the time value of money Aiming to become Financially Intelligent person – Ayman El-Najjar

Payback - Conclusion • Payback method should be used to compare projects (those will recover their initial investment or reject projects (those that will never recover their initial investment) • So, if payback looks promising, go on to the next method to see if the investment is really worth making Aiming to become Financially Intelligent person – Ayman El-Najjar

Net Present value (NPV) Net Present value (NPV): It’s called Discounted Cash Flow (DCF) method

Pros: It takes into account the time value of money It considers business cost of capital or other hurdle rate It provides answer in today’s dollars

Aiming to become Financially Intelligent person – Ayman El-Najjar

NPV – Acceptance Criterion • If NPV of a project is greater than zero, it should be accepted because the return is greater than the company’s hurdle rate.

Aiming to become Financially Intelligent person – Ayman El-Najjar

Internal Rate of Return (IRR) • IRR calculates the actual return provided by the projected cash flows. • That rate of return can then be compared with the company’s hurdle rate to see if the investment passes the test • It can be looked at as the hurdle rate that makes NPV equals to Zero Aiming to become Financially Intelligent person – Ayman El-Najjar

IRR – cons • IRR doesn’t address the issue of scale. • Example: an IRR of 20% doesn’t tell anything about the dollar size of the return

Aiming to become Financially Intelligent person – Ayman El-Najjar

IRR – Acceptance Criterion

Aiming to become Financially Intelligent person – Ayman El-Najjar

• Example: Initial Investment: $ 3,000 Cash flow by yearend: $ 1,300 Duration: 3 years

Aiming to become Financially Intelligent person – Ayman El-Najjar

Comparing the Three methods • Example: A company has $ 3,000 to invest, its hurdle rate is 9%, has three investments of the same risk level – Investment A: returns cash flow of $1000 per year for 3 years – Investment B: returns cash flow of $3600 at the end of year one – Investment C: returns cash flow of $4000 at the end of year 3

If you could select one of these investment, which would it be?

Aiming to become Financially Intelligent person – Ayman El-Najjar

1.

Payback method • • •

•

A: PB=3 years B: PB=1 year C: PB=3years

NPV method • • •

•

A: NPV= -$469 B: NPV= +$303 C: NPV=+$552

IRR method • • •

A: IRR= 0 % B: IRR= 20% C: IRR= 15%

Aiming to become Financially Intelligent person – Ayman El-Najjar

• What’s the right decision? if we go by IRR, B will be chosen. However, C has a higher NPV, which shows that C is worth more in today’s dollar than B. With C, we get a lower return but we get it for three years at 15%, which is better than one year at 20%. Aiming to become Financially Intelligent person – Ayman El-Najjar

• An important step: revisit the cash flow estimates, make sensitivity analysis to check, for instance, the calculations using future cash flows that are 80% of original projections, and see if the investment still makes sense.

Aiming to become Financially Intelligent person – Ayman El-Najjar

• Although the process entails a lot of calculating, you would be surprised how intuitive the whole process can be

Aiming to become Financially Intelligent person – Ayman El-Najjar

A Story John was running a financial review meeting for XYZ. A senior manager in a company suggested to invest $80,000 in a new machine center that could produce certain parts in-house rather than relying on an outsider. Before John could speak up, a shop floor technician asked the manager the following questions: Aiming to become Financially Intelligent person – Ayman El-Najjar

• Did you figure out the monthly cash flow return we will get on this new investment? $ 80,000 is a lot of money! • Do you realize that we are in the spring, and the business is typically slow, and cash is tight during the summer?

Aiming to become Financially Intelligent person – Ayman El-Najjar

• Have you figured in the cost of labor to run the machine? We are all pretty busy in the sop; you will probably have to hire someone to run this machine • And are there better ways we could spend that cash to grow the business?

Aiming to become Financially Intelligent person – Ayman El-Najjar

Working Capital

Managing the Working Capital • Learn to manage working capital better to impact the company’s profitability and cash position • Working Capital = Current Assets – Current Liability

Aiming to become Financially Intelligent person – Ayman El-Najjar

• Elements of Working Capital – Cash to buy Raw material to make goods (inventory) to sell (AR) which t be collected (Cash)

Aiming to become Financially Intelligent person – Ayman El-Najjar

Cash Conversion Cycle • it’s the timeline relating the production to the company’s investment in working capital • How many days all this takes? How many days a company’s cash is tied up?

Aiming to become Financially Intelligent person – Ayman El-Najjar

• Cash Conversion Cycle = DSO + DII – DPO This tells how fast a company recovers its cash, from the moment it pays its payable to the moment it collects its receivable

Aiming to become Financially Intelligent person – Ayman El-Najjar

• The Cash Conversion Cycle gives you a way of calculating how much cash it takes to finance the business: you just take sales per day and multiply it by the number of days in the cash conversion cycle

Aiming to become Financially Intelligent person – Ayman El-Najjar

• Example: DSO = 54 days, DII= 74 days, DPO= 55 days Sales per day = $ 241,360 How much working Capital this business would require to finance its operations? Aiming to become Financially Intelligent person – Ayman El-Najjar

• CCC = 54 + 74 – 55 = 73 days • 73 days * 241,360 Sales/day = 17,619,280

Aiming to become Financially Intelligent person – Ayman El-Najjar

Financial Literacy • By introducing these concepts, it’s aimed to increase your financial intelligence and helping you becoming a better manager. • By understanding financial aspects of the business, we believe you will make more effective decision in your business and in your whole life Aiming to become Financially Intelligent person – Ayman El-Najjar

• There’s a simple antidote to politics; sunlight, transparency, and open communication • When people understand a company’s objectives and work to attain them, it’s easier to create an organization built on a sense of trust and a feeling of community Aiming to become Financially Intelligent person – Ayman El-Najjar