Financial Fundamentals: Assets, Statements, and Investment Appraisal
Key Financial Definitions
Current Assets
Assets that can be turned into cash within one operating cycle.
Non-Current Assets
Assets that cannot be liquidated quickly.
Company Creation & Financing
To establish a company, it’s essential to determine the required amount of assets and the necessary sources of long-term financing.
Operating Cycle
The process of converting investment in inventory (stocks) back into cash.
Average Period
The duration of the operating cycle; the time it takes for a firm to convert its investment in inventory into cash.
Non-Current Assets (NCA) & Operating Cycle
The operating cycle determines how long it takes for a firm to generate cash from its short-term assets and the cost of its investment in current assets. The amount a firm should invest in current assets depends on the business type, product, and the length of the operating cycle.
Depreciation
A non-cash expense that reduces the value of an asset due to wear and tear, age, or obsolescence.
Financial Statements Explained
Income Statement
A summary of a business’s revenues and expenses over a period, typically one year. It reflects the results of the firm’s operating and financing decisions during that time.
Operating Profit
The difference between sales and the cost of goods sold. This is also referred to as earnings before interest, taxes, and depreciations (EBITDA if no depreciation, EBIT if depreciation is included before tax).
Cash Flow Statement
A summary, over a period, of a firm’s cash flows from operating, investment, and financing activities.
Types of Assets
Real Assets
Assets that produce the firm’s products and services, including both tangible and intangible assets.
Financial Assets
Assets issued by a firm in the financial market to investors to finance its investments in real assets.
Financial Management Roles & Goals
Financial Manager
Their primary function is the management of cash flow to generate profit for the firm’s owners. Key concerns include:
- Investment Decisions: The use of funds, including the buying, holding, or selling of various asset types.
- Financing Decisions: The acquisition of funds.
Financial Method
- Advantages:
- Assessment of the company’s risk.
- Long-term vision of the company’s value.
- Disadvantages:
- Stock prices can be influenced by external factors.
Financial Goal
To maximize the market value of the company, which means maximizing its stock price on the exchange.
Capital
The firm’s resources or funds used to finance its assets.
Stages in Investment Analysis
- Valuation: Determining and calculating the variables for investment analysis.
- Evaluation: Assigning an index of acceptance to the project.
- Comparison: Comparing different projects.
- Selection: Choosing the optimal project.
Financial Calculations & Formulas
Below are various financial calculations and formulas, often used in financial analysis and investment appraisal:
Income Statement Breakdown
A simplified flow from sales to retained earnings:
Sales - Cost of Goods Sold (Raw Materials + Production Expenses + General Expenses) = Operating Cash Flow (before interest & tax) - Depreciation - Interest = Taxable Income - Taxes = Net Income - Dividends = Retained Earnings
Cash Flow Calculation (Specific Context)
Cash Flow = Depreciation - Retained Earnings - Loan Amortization
Liquidation Calculation
Gross Book Values - Accumulated Depreciation (e.g., Year 3, Non-Current Assets = 0) = Net Book Values - Residual Value Before Tax = Capital Gain/Loss Before Tax - Taxes = Residual Value After Tax = Capital Gain/Loss After Tax
Balance Sheet After Liquidation
Assets: Cash (accumulated Year 3), Cash from Assets Sold (Residual Value After Tax)
Equity & Liabilities: Equity, Retained Earnings (accumulated Year 3), Retained Earnings from Assets Sold (Capital Gain/Loss After Tax)
Total Balance After Liquidation - Equity = Gains
Time Investment Calculation
Initial Assets (Year 0) + Cash Flow Before Tax * 0.7 + Depreciation * 0.3 (Tax Shield) + Year 3 Cash Flow + Residual Value After Tax
Time Loan Calculation
Interest * 0.7 (After Tax) + Amortization
Weighted Average Cost of Capital (WACC)
Note: This formula is a simplified representation and may not align with standard WACC calculations.
WACC = (Dividends * Equity + Interest * Loan) / (Equity + Loan)
Net Present Value (NPV)
NPV = -Initial Investment (A) + Cash Flow Year 1 / (1 + Discount Rate (K)) + Cash Flow Year 3 + Residual Value After Tax / (1 + Discount Rate (K))^3
Note: K is the discount rate, often WACC. The phrase “K=wacc/rmin the higher” is unclear and non-standard.
NPV of Cash
NPV Cash = Cash Generated Year 1 / (1 + Discount Rate (K)) + Cash Generated Year 3 + Residual Value After Tax - Shareholder Equity / (1 + Discount Rate (K))^3
Feasibility Cash Flow
Cash Flow + Residual Value (Time Investment) - Interest * 0.7 - Dividends - Loan Amortization - Shareholder Equity (only Year 3) = Net Cash
Profitability Calculation
0 = -Shareholder Equity + Dividends / (1 + Required Return on Stock (Rs)) + Dividends Year 3 + Shareholder Equity + Retained Earnings (accumulated Year 3) / (1 + Required Return on Stock (Rs))^3
Internal Rate of Return (IRR) – Financial
0 = -Equity + Liabilities + Outflow (Total Financing Time) / (1 + WACC)
Internal Rate of Return (IRR) – Investment
0 = -Initial Investment (A) + Cash Flow / (1 + Required Return on Assets (Ra)) + Cash Flow Year 3 + Residual Value After Tax / (1 + Required Return on Assets (Ra))^3
Investment Valuation Techniques
Amount of Investment / Capital Investment
The total funding required to initiate a firm’s investment. This typically includes: Assets = Fixed Assets + Non-Current Assets + Other Expenses
Residual Value (RV)
The expected value of an asset at the end of its useful life.
Time Limit of Valuation
The number of years over which an investment is analyzed. This period can be predetermined by:
- The type of investment.
- An express desire of management.
Interest
Compensation for the opportunity cost of funds. It can be calculated as:
- Compound Interest: Interest earned on both the original principal and accumulated interest.
- Simple Interest: Interest paid only on the principal amount borrowed or invested.
Evaluating Long-Term Investments
Firms use specific techniques to evaluate investments in long-term assets. These techniques should:
- Consider all future cash flows from the project.
- Consider the time value of money.
- Provide objective criteria for project selection.
Net Present Value (NPV)
The present value of future cash flows generated by an investment minus the initial capital investment.
- Positive NPV (+NPV): Indicates that the investment increases the firm’s value; the project is accepted.
- Negative NPV (-NPV): Indicates that the investment decreases the firm’s value; the project is rejected.
- Zero NPV (0 NPV): Means the return equals the return required by owners to compensate for both the risk of the investment and the time value of money.
Advantages:
- Indicates whether the investment will increase the firm’s value.
- Considers all cash flows generated by the project.
- Considers the time value of money.
- Considers the riskiness of future cash flows.
Disadvantages:
- Requires an estimate of the discount rate to calculate the NPV.
- Expressed in monetary terms (e.g., €), which might not be intuitive for comparison across projects of different scales.
Internal Rate of Return (IRR)
The discount rate that results in a zero Net Present Value (NPV). It represents the maximum cost an investment can bear while still being profitable.
Advantages:
- Indicates whether an investment increases the firm’s value.
- Considers all cash flows of the project.
- Considers the time value of money.
- Considers the riskiness of future cash flows.
Disadvantages:
- Requires an estimate of the cost of capital to make a decision.
- May fail to provide a decision of maximum value, especially when selecting projects under capital rationing.
- Cannot be used in situations where the sign of a project’s cash flows changes more than once (multiple IRRs).
Payback Period
The time from when an investment is first made until its cash inflows accumulate to cover the initial cash outflow. It answers: “How long does it take to get your money back?”
Advantages:
- Simple to compute.
- Provides information on the risk of the investment.
- Provides a crude measure of liquidity.
Disadvantages:
- Lacks a specific decision criterion to indicate whether an investment increases firm value.
- Ignores cash flows beyond the payback period.
- Does not consider the time value of money.
- Does not consider the riskiness of future cash flows.