Escuela del Desarrollo Integral

Financial analysis is the process of identifying the financial strengths and weaknesses of an institution by properly establishing relationship between the items of the balance sheet and the profit and loss account. Financial analysis provides you with a framework within which all aspects of a proposed project can be evaluated in a coordinated and systematic manner. Careful project analysis will identify unrealistic and questionable assumptions and indicate ways in which a project can be modified to improve its wealth generating capacity or to increase the non economic or nonquantifiable values which we expect to gain from it.

3.1.1 Objective of Financial Analysis:

These objectives include:

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To ensure that there are adequate incentives for project participants.

To assess the financial impact of the project participants. This assessment is based on an analysis of the participants’ current financial position and on projections of their financial positions as the

project is implemented.

To provide a sound financing plan for the project.

To determine whether the financial requirements of the individual participants in the project are properly coordinated.

To assess the financial management competence in order to form a

judgement about how well they will be able to discharge their

responsibilities for project implementation and what management changes may be necessary.

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It is important for you to note that just how elaborate the financial analysis must be for a particular project will depend upon the organisation of the project and its complexity.

The financial projections for the private institutions or project entities may be quite simple while they many be quite complex in projects involving a whole number of different institutions.

3.1.2 CONTENTS OF FINANCIAL ANALYSIS

We are going to highlight the contents briefly.

The contents of financial analysis include:

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audited financial statements for existing organizations.

Statements of total project cost, initial capital required and cash flows relative to the project timetable in the cases of new organizations.

For all projects, financial projections for future time period including

financial statement schedules for the financial projections stating assumptions used.

Financial analysis showing return on investment, equity, breakdown volume and price analysis.

A sensitivity analysis, if necessary.

3.1.3 STEPS IN FINANCIAL ANALYSIS

Things you are expected to learn in a financial analysis are in the following steps:

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Estimated Total cost: Information expected here will include the fixed

investment cost, the working capital requirement, the project start

upcosts, and the project cost summary.

Estimated Financing Needs: This is to determine the forms of financing and the sources of funds

Prepare pro-forma statements: This is an attempt to forecast business operation, over a determined time interval by means of the following profit equation:

Net Profit tax – sales – Returns and allowances – cost of goods sold – operating expenses + other revenue – interest expenses – income taxes.

Prepare cash Flow projections: This is to show movement of cash into

and out of the institution. The statements are useful for financial planning, project evaluation and control.

Prepare pro-forma balance sheet: This represents the financial position of the firm at a given date.

Evaluate project feasibility:

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This is the measure of profitability of the project and the following approaches can be used. Internal rate of Return, pay back period, Net present value, benefit/cost Ratio.

Analyse projections of operating conditions further analysis may be necessary using financial ratios.’

3.1.4 USES OF FINANCIAL ANALYSIS

You have seen that financial analysis is essentially the evaluation of an

institution’s liquidity position. It analyses the institution’s profitability over time and provide financial statement to make analysis about the institution’s future solvency and profitability. Financial analysis also enable the institution to know if it can meet its current obligations. It also explains to the institution if there is any danger to the solvency of excessive debt. Financial analysis confirms if the earnings of the institution is adequate or note and it explains how efficiently the institution uses its finance.

3.1.5 POINTS OF VIEW IN PROJECT FINANCIAL ANALYSIS

The individual financial activities which participate in a project are mainly concerned about the returns on the equity capital they contribute. We may consider this financial return to an equity participation in a project and we determine it through what we will term financial analysis

Financial analysis is important when we turn to a consideration of the incentive structure associated with a proposed project investment. It will do

us no good, for instance, to have a project which is profitable from the standpoint of the whole economy if individuals participating on it are unable

to earn a living from their participation.

The financial aspect of project analysis deals primarily with the revenue earning with whether the project will be able to repay these and whether the

project can become viable.

It is important to note that it is not only crucial to analyse a proposed project to be certain it will be beneficial from the standpoint of the economy, it is also critical to assess whether the project entities which are to participate will have sufficient incentive which will make them willing to participate.

It is financial flows on which this assessment can be based which are the domain of financial analysis. Having looked, in detail into what financial analysis is, we shall now look at the Objectives of Financial Analysis.

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In this section, we shall consider Ratio Analysis as a powerful tool of

financial analysis. In financial analysis, a ratio is used as an index or yardstick for evaluating the financial position and performance of an institution. The absolute accounting figures reported in the financial statements do not provide you with a meaningful understanding of the performance and financial position of an institution. The relationship between

two accounting figures, expressed mathematically is known as financial ratio.

A ratio helps the analyst to make qualitative judgement about an institution’s financial position and performance. It is calculated by dividing current assets

by current liabilities: the ratio indicates quantified relationship between current assets and current liabilities. This relationship is a yardstick which

permits a qualitative judgement to be formed about the institutions’ liquidity.

Therefore, the greater the ratio, the greater the institutions liquidity and vice versa. The ratio therefore indicates a quantitative relationship which can be used to make a qualitative judgement.

3.2.1 SIGNIFICANCE OF RATIO ANLYSIS

We should be able to say that will the help of ratio you can determine:

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The ability of the institution to meet its current obligations

The extent to which the institution has used its long term solvency by borrowing funds.

The efficiency with which the institution is utilizing its various assets in generating sales revenue.

The overall operating efficiency and performance of the institution.

The ratio analysis is also useful in security analysis the major focus of which

is on the long term profitability of the institution. From time to time, management uses ratio analysis to determine the institution’s financial strengths and weaknesses and accordingly take actions to improve the institution’s position. The ratio analysis will reveal the financial condition of

the institution more reliably when trend analysis indicates the direction of change over a period of years in ratios over time are analysed.

Exercises 4.1

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Define project financial analysis

State the objectives of financial analysis Discuss the steps taken in financial analysis

3.2.2 LIMITATION OF RATIO ANALYSIS

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As you have seen, ratio analysis is a widely used technique to evaluate the

financial position and performance of an institution. However, there are certain problems in using ratios. Some of these limitations which the analyst

and you should be conscious of are:

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It is difficult to decide on the proper basis for comparison

The comparison is rendered difficult because of differences in situations of two institutions or of one company over the years.

Price level changes make the interpretations of ratios invalid

Differences in the definition of items in the balance sheet and the income statement make the interpretation of ratios difficult.

The ratios calculated at a point of time are often defective and are therefore no indications for the future.

The ratios of an organisation have meaning only when they are compared with some standards. It is difficult to find out a proper basis of comparison.

Usually, it is recommended that ratios should be compared within the organisation averages.

You will agree that the situations of two institutions are never the same as the factors influencing the performance of an institution in a year may change in another year. Thus the comparison of the ratios of two institutions becomes difficult as the interpretation and comparison of ratios are rendered invalid by the changing value of money. While the financial analyst is more interested in what happens in the future, the ratio indicates what has happened in the past and also while management of the institution has information about the institution’s future plans and policies and therefore is able to predict future happening to ascertain the extent the outside analyst has to rely on the past ratios which may not necessarily reflect the institution’s financial position and performance in future.

Exercise 4.2

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What is the importance of ratio analysis in the light of financial analysis of education projects?

Enumerate the limitation of ratio analysis

What do you understand by trend analysis in to financial analysis of educational projects?