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Financial IntelligenceFinancial Intelligence
Ayman El-Najjar
Aiming to become Financially Intelligent person – 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
The Art of Finance & Why it MattersThe Art of Finance & Why it Matters
Aiming to become Financially Intelligent person – Ayman El-Najjar
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
• Accruals
• Allocations
• Depreciation
• Valuation
Simple but critical Questions:
• What were the assumptions in this (االفتراضات)number?
• Are there any estimates in the (التقديرات)numbers
• What is the bias (الميل) those assumptions and estimates lead to?
• What are the implications ?(التضمينات)
Aiming to become Financially Intelligent person – Ayman El-Najjar
Accruals• 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
Allocations• 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
Depreciation (االستهالك)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
Valuation (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
Income StatementIncome Statement(( الدخل قائمة الدخل بيان قائمة ((بيان
Aiming to become Financially Intelligent person – Ayman El-Najjar
• Income statement shows revenue (المبيعات), expenses (المصروفات), and profit (الربح) for a period of time, such as a month, a quarter, or year.
• It’s also called profit & loss statement ( بيانوالخسارة P&L, statement of earning ,(الربح
• The bottom line of the income statement is Net Profit ( الربح also known as net ,(صافيincome ( الدخل or net earning (صافي
Aiming to become Financially Intelligent person – Ayman El-Najjar
Operating Expenses (Opex)
• Operating Expenses ( المصاريف are costs that are required (التشغيليةto 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 is the purchase of an item (الرأسماليةthat’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)
• Cost of Goods Sold ( المبيعات (تكلفة• Gross Profit ( الربح (إجمالي• Expenses (مصروفات)
• Operating Profit (EBIT)
• Taxes (ضرائب)
• Net Profit ( الربح (صافي
$100
50
50
30
20
5
$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 ExpensesOperating 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
• COGS 5,000
• Gross Profit 5,000
• Expenses 3,000
• Depreciation* 1,000
• Net Profit $1,000
* 3 years depreciation
• Revenue $10,000
• COGS 5,000
• Gross Profit 5,000
• Expenses 3,000
• Depreciation* 3,000
• Net Profit - $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 profitsGross 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 ( العمليات من الربح(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) ( الربح (صافي= 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?How to fix it?
1. Increase profitable Sales زيادةالربحية ذات المبيعات
1. Find new markets, or2. new prospects,3. Work through sales cycles, 4. 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 بكفاءة … والعمل االنتاج تكاليف تخفيضأعلىTakes 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 ( تقليصالتشغيلية (المصروفات
which almost always means cut the headcount! … layoffs! موظفين تسريحShort-term Solution! It makes earning looks better fast! نتائج له تظهر قد المدى قصير حل سريعة
But it backfires! ولو المرجوة النتائج عكس يعطيحين بعد
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!
Balance SheetBalance Sheet المركز المركز بيان بيانالماليالماليAssets = Liabilities + Equity
Aiming to become Financially Intelligent person – Ayman El-Najjar
Understanding BasicsUnderstanding Basics• The balance sheet reflects the assets
( الموجودات أو أو ) liabilities ,(األصول المطلوباتأو ) and owner equity ,(المديونيات المالك حقوق .at a point in time (المساهمين
• 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 حكمه في وما النقد– Machinery & equipment ومعدات مكائن– Buildings مباني– Land أرض
Aiming to become Financially Intelligent person – Ayman El-Najjar
• Current Assets المتداولة : الموجوداتanything that can be turned into cash in less than a year
• Long Term Assets طويلة الموجودات : المدىhave 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 متداولة : مطلوبات
to be paid of in less than a year
• Accounts payable الدفع مستحقة ديون amounts the company owes للموردينits vendors
• Long-term liabilities طويلة ديون will come due over a longer time :األجلframe; 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
Cash StatementCash Statementالنقدية التدفقات النقدية قائمة التدفقات قائمة
Aiming to become Financially Intelligent person – Ayman El-Najjar
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
8,000 12,000 18,000
Expenses 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
Sales $ 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
Net Profit $ (15,000) $ (7,500) $ (1,500)
Aiming to become Financially Intelligent person – Ayman El-Najjar
Jan Feb Mar
Beginning Cash
$ 10,000 $ 30,000 $ 75,000
Collection (cash sales)
50,000 75,000 95,000
Payment (COGS)
0 0 (35,000)
Payment (expenses)
(30,000) (30,000) (30,000)
Net Cash $ 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
RatiosRatios
Aiming to become Financially Intelligent person – Ayman El-Najjar
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-to-equity 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 RatioProfitability 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 RatiosLeverage 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 Efficiency Ratios (making the most of your assets)(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
Inventory Days and Turnover
• 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 Which Ratios are most important to your Business?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
Return on InvestmentReturn on Investment
Aiming to become Financially Intelligent person – Ayman El-Najjar
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
1. finding out the expected cost of its debt (interest rate),
2. estimating the return expected by the shareholders, and
3. 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 MethodOn 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 MethodOn 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)Net Present value (NPV):Net Present value (NPV):
It’s called Discounted Cash Flow (DCF) method It’s called Discounted Cash Flow (DCF) method
Pros:Pros:
It takes into account the time value of moneyIt takes into account the time value of money
It considers business cost of capital or other hurdle rateIt considers business cost of capital or other hurdle rate
It provides answer in today’s dollarsIt 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)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
1. A: PB=3 years2. B: PB=1 year 3. 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 StoryJohn 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?
Working CapitalWorking Capital
Aiming to become Financially Intelligent person – Ayman El-Najjar
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