Financial Analysis: Methods, Techniques, and Importance

This document provides an overview of financial analysis, including its methods, techniques, and importance for companies. It covers topics such as the cash conversion cycle, calculation of NPV and IRR, and ways to improve cash flow. The document also includes calculations and interpretations for specific projects.

FINANCIAL ANALYSIS

INTRODUCTION
Financial analysis is characterised as a procedure of assessing financial information of
companies and evaluating each aspect by help of different techniques. In other words, this
can be defined as review of financial material to make strategic decisions. Usually this study
includes a summary of both past and expected productivity, cash flow, and risk. It can result
in the redistribution of personnel to or from an entity or a particular internal process
(Antonopoulos and Hall, 2018). This is crucial for corporations to do proper financial
analyse so that their stakeholders can aware from actual financial condition. This analysis is
useful for both to the internal and external stakeholders. As well as it also contributes in
analysing market trends, develop financial policies, construct long-term economic activity
strategies and classify projects or businesses. In order to do financial analysis of companies,
there are range of plans and methods that are applied by them. Eventually, without proper
financial analysis, this can be difficult for managers to take corrective actions (Tang and
Baker, 2016). It is so because if there will lack of financial information then this will be
difficult for managers to find a suitable framework to take appropriate actions.
The project report is based on different task which covers information about various
aspects. Basically, the report can be categorised into seven tasks in which first, second and
third task consists information about cash conversion cycle, methods to cash flow condition.
As well as in task four, five and six information about calculation of NPV, IRRetc. is done.
In the end of report, limitation of IRR technique is mentioned.
MAIN BODY
Task 1.
(a) What is cash conversion cycle (CCC)?
The term CCC can be defined as a type of matrix which is expressed in terms of time (Banerjee
and et.al., 2016). It calculates time period which is taken by a company in order to convert their
investments in stock and other sources in cash from sales. It is being calculated by including
different aspects such as inventory days, receivable days etc. Mainly it is computed by the
specific formula that is:
Days inventory outstanding + Days sales Outstanding – Days Payables outstanding

A smaller CCC is an indication of a period of better stock-to-sales. A smoother method is
suggested by a higher Cash conversion cycle. A low CCC is generally considered more
favourable, even if it focuses on the respective sector, market and abilities. Thus, it is stated that
CCC provide a valuable information which is helpful in comparing the performance of operation
and activities from the past performances.
(b) Analysis of three components of CCC?
It is based on three key components by which it is being calculated. Herein, underneath analysis
of these components is done in such manner:
 Days inventory outstanding: This is also known as days’ sales of inventory which is
being used by companies to find out days in which a company holds stock before selling
(Brusca, Gómez‐villegas and Montesinos, 2016). In order to calculate the value of DIO
specific formula is used such as:
DIO = (Average Inventory ÷ Cost of Goods Sold) x 365
Average Stock = (Opening stock + closing stock) ÷ 2
Cost of goods sold = Opening stock + Purchases –closing stock.
 Days sales outstanding: DSO is really the total number of hours between days the
receivable balances (the money owed to your business) are expected to be received.
Although cash-only transactions have a zero DSO, customers use company-extended
credit, so that this figure will be good. Thus in case of lower number of DSWO it is
consider to be more favourable. In context to determine the value of DSO specific
formula is used that is:
DSO = (Accounts Receivable ÷ Net Credit Sales) x 365
(Opening Receivables + closing Receivables) ÷ 2
 Days Payable Outstanding: DPO is really the total time frame a corporation takes to
produce its payables from its providers to the companies owes money and to make proper
compensate for them (Siminica, Motoi and Dumitru, 2017). If this could be greatly
increased, the business can keep on to money longer, increasing the investment value;
thus, it is easier to have a longer DPO. Formula for determining the DPO is:
DPO = Closing Accounts Payable ÷ (COGS ÷ 365)

(Beginning Payable + Ending Payable) ÷ 2.
Task 2.
(a) Calculation of days’ inventory outstanding= Average inventory / COGS * 365 days
= 6500/40000*365 days
= 59 days
Analysis: On the basis of above calculation this can be find out that company is taking time
of 59 days in order to transfer their raw material into finished goods. As well as for selling
available amount of inventories to customers.
Working Note:
Average inventory= (Opening stock + closing stock)/2
= (1000+3000)/2
= 13000/2
= 6500
(b) Calculation of days’ sales outstanding= AR/ credit sales* 365 days
= 5000/120000*365 days
= 15.20 or 15 days
Analysis- As per above computed value of days’ sales outstanding, this may be assessed
that company taking time period of 15 days in order to receive debt amount from
different customers. This time period is effective.
Working Note:
Average AR= (Opening AR + closing AR) / 2
= (4000 + 6000)/2
= 5000

(c) Calculation of days payable outstanding= Accounts payable / cost of goods sold*365
days
= 1500/40000*365 days
= 13.68 or 14 days
Analysis- As per the above calculated value of days payable outstanding, this can be find
out that its value is of 14 days. It means company is taking this time period in order to
make payment to their creditors.
(d) Calculation of cash conversion cycle= Day inventory outstanding + Days sales
outstanding – Day payable outstanding
= (59 + 15 – 14) days
= 60 days
Analysis- The CCC is of 60 days, that is prepared by making addition of days’ inventory
outstanding and days sales outstanding.
Task 3.
Ways to improve cash flow condition of company in accordance of above scenario.
The term cash flow can be defined as flow of cash during a particular time frame. It is
beneficial for companies if there is inflow of cash and higher outflow shows negative condition
of a company. Due to which, it becomes essential for corporations to enhance cash flow in a
better manner. Herein, underneath way to improve cash flow are mentioned in such manner:
 By improving inventory- This is an effective way to improve cash flow condition for a
company. It is so because if inventory will have managed in an efficient way then it
becomes easier to companies to minimise cost of storage (Cantillon, Maître and Watson,
2016). Such as in the aspect of above calculated value of days’ inventory, it can be find
out that it is of 59 days. It is indicating that this is too higher. Hence, this is essential for
above company that they should minimise it as soon as possible.
 Send out invoices immediately- In addition, sending invoices immediately to customers
so that company can recover payment on time is also important. It is so because if
companies will send invoices on right time then customers will be liable to pay before

due date. By doing so, companies will get cash on time and before due date. Such as in
the aspect of above calculation, it can be find out that days’ outstanding sales is of 15
days which is impressive. Hence, companies should try to minimise days of outstanding
sales so that they can recover fund from creditors on time.
 Paying less to suppliers- The suppliers are those who sell raw material and other form of
goods to companies on debt or cash. In order to enhance cash flow of companies, this is
essential to pay less to suppliers. It means company should buy raw materials from those
suppliers who are providing discount as well as ready to get payment in instalments. By
doing so, this will be easier for companies to protect funds as reserve. So this is also an
effective way to improve cash flow position of companies (Engel and et.al., 2016).
 Liquidate old inventory- In the business firms purchasing of inventories is a huge
expense. Herein, it is important to know that all types of inventories are not used in
operations. Thus, companies should try to sell out those inventories which are old and
cannot be used. By doing so, level of cash flow will enhance and because selling of old
assets will produce cash and as a result cash flow condition will be better.
So, these are the ways which can be helpful for companies in order to enhance their cash flow as
well as the above mentioned methods can contribute to increasing efficiency in other operations.
Task 4.
(a) Calculation of NPV and IRR:
NPV- The net present value method is a process of computing PV of a project. Under this,
variation between DCF and initial investment is calculated (Ferguson and Morton-
Huddleston, 2016). The value of discounted cash flow is calculated by help of present value
factor. Herein, below calculation of NPV is done of project X in such manner:
Year Cash
flow
PV
factor
at 10%
DCF
1 100000 0.9091 90910
2 150000 0.8264 123960
3 200000 0.7513 150260

4 250000 0.683 170750
5 300000 0.6209 186270
722150
NPV= DCF –investment
= 722150-250000
= $472150
IRR- IRR is a sort of technique that is related to calculation of rate of return from a project. Due
to this technique, managers take correct decision for investment in any financial proposal (Lewis,
2018). In regards to above project X, calculation of IRR is done below in such manner:
Lower discount rate= 9%
NPV at lower discount rate:
Year CF PV at
9% DCF
1 100000 0.9174 91740
2 150000 0.8417 126255
3 200000 0.7722 154440
4 250000 0.7084 177100
5 300000 0.6499 194970
744505
NPV= 744505-250000
= $494505
Higher discount rate= 18%
NPV at higher discount rate:
Year CF PV at
18% DCF
1 100000 0.8475 84750
2 150000 0.7182 107730
3 200000 0.6086 121720

4 250000 0.5158 128950
5 300000 0.4371 131130
574280
NPV= 574280-250000
= $324280
IRR= 9+494505/ (494505-324280) *9
= 9+494505/170225*9
= 9+26.14
= 35.14%
(b) Calculation of NPV and IRR for project A:
Initial investment= $400000
Cost of capital= 15%
Year Cash
flow
PV
factor
at 15%
DCF
1 50000 0.8696 43480
2 100000 0.7561 75610
3 150000 0.6575 98625
4 200000 0.5718 114360
5 250000 0.4972 124300
456375
NPV= 456375-400000
= $56375
IRR:
Lower discount rate= 12%
NPV at lower discount rate:

Year Cash
flow
Present
value
factor
at 12%
DCF
1 50000 0.892 44600
2 100000 0.797 79700
3 150000 0.711 106650
4 200000 0.635 127000
5 250000 0.567 141750
499700
NPV= 499700-400000
= 99700
Higher discounted rate= 18%
NPV at higher discount rate:
Year Cash
flow
Present
value
factor
at 18%
DCF
1 50000 0.847 42350
2 100000 0.718 71800
3 150000 0.608 91200
4 200000 0.515 103000
5 250000 0.437 109250
417600
NPV= 417600-400000
= 17600
IRR= 12+99700/ (99700-17600) *6
= 12+99700/82100*6
= 12+7.28

= 19.28%
Task 5.
Interpretation on the basis of above calculations:
NPV- According to above analysis it can stated that both projects are producing different present
value. Such as in the aspect of project X, this can be find out that value of NPV is of $472150
and in project A, the value of NPV is of $56375. This is indicating that project X is much better
as compare to project A. Though, this is important to know that both projects have different
amount of initial investment and cash flows. Like project X has initial investment of $250000
while project A has investment of $400000. So as per the above discussion, company should go
with project X, because its’ net present value is too higher.
IRR- As per above computed value of internal rate of return of both projects, this can be find out
that project X will generate return with rate of 35.14% which is very effective. While in the
aspect of project A, it can be find out that this project will produce return with rate of 19.28%. It
is showing that project X is too effective as compare to project A. It is so because there is a huge
difference in the rate of return. If respected company will make invest in project X, then it will
be beneficial for them and they will be able to get higher amount of return. So company should
make invest in project X as instead of project A.
In regards to analysis of projects with both techniques, it can be suggested to company that they
should accept project X and project A should be rejected. Herein, underneath comparison of both
projects is done below in such manner:
Particulars Project X Project A
Net present value $472150 $56375
Internal rate of return 35.14% 19.28%
This table is clearly indicating difference between both of projects and it can be estimated that
which project needs to be selected and which one needs to be rejected.
Task 6.
a) Outline what is the significance of “sensitivity analysis”.

It determines how different values of a variable which is independent can affect
the values of a variable which is dependent under a given set of assumptions (Michalak,
2016). It is important because it understands the relationship between inputs and outputs
and helps in identifying whether the output would be available even under uncertainty
when optimum parameter settings are provided there for a model. For instance, a study
may yield a p-value of 0.02 for a primary analysis but when sensitivity analysis is done it
results in 0.03 then the outcomes are robust. Apart from it some key significance of
sensitivity analysis is done below in such manner:
The main function of sensitivity analysis is to demonstrate the simulation's exposure to
fluctuations in the model's input variables (Siekelova and et.al., 2017).
 Sensitivity analysis is a tool for forecasting a proposal's result if a thing turns out to be
unique from the main forecasts.
 Makes it easier to identify how dependent a specific input function is on the output.
Analyses whether the vulnerability in turn helps to determine the risks involved.
 It contributes in better judgement making (Mitchell and Calabrese, 2019). This is
beneficial for assessment of risk which is included in a particular project.
 In addition, it helps in taking informed and corrective actions in order to right decisions.
So, these are some common benefits of sensitivity analysis which contribute in effective
comparison of two projects with each other. As well as for taking suitable decisions.
(b) Compute sensitivity analysis to analyse the new NPV assuming a change in WACC from
10% to 15% for project X.
In this task of report, sensitivity analysis is needed to be done of financial project X by
changing rate of PV factor from 10% to 15%.
Net present value at 10%:
Initial investment= $250000
Year Cash
flow
PV
factor
at 10%
DCF
1 100000 0.9091 90910
2 150000 0.8264 123960

3 200000 0.7513 150260
4 250000 0.683 170750
5 300000 0.6209 186270
722150
Net present value= 722150-250000
= $472150
Net present value at 15%:
Year Cash
flow
PV
factor
at 15%
DCF
1 100000 0.8696 86960
2 150000 0.7561 113415
3 200000 0.6575 131500
4 250000 0.5718 142950
5 300000 0.4972 149160
623985
NPV= 623985-250000
= $373985
Sensitivity analysis:
Best case NPV-
Net cash
flow
(250000) 100000 150000 200000 250000 300000
Present
value at
10%
1 0.9091 0.8264 0.7513 0.683 0.620
NPV= 472150
Worst case NPV-

Net cash
flow
(400000) 100000 150000 200000 250000 300000
Present
value at
15%
1 0.8696 0.7561 0.6575 0.5718 0.4972
NPV= 373985
So as per the above mentioned sensitivity analysis of project X, under present value of 10% and
15% this can be find out that project will be more beneficial at the rate of 10%. It is so because at
the rate of 10%, the value of project is $472150 but at 15% the NPV of project is of $373985.
Thus project will be suitable at the rate of 10%.
Task 7.
Explain the 3 (three) limitations of the IRR.
 This is used in Capital Budgeting enabling the company to see whether a particular
project is suitable for it to invest in among different projects available (Muneer, Ahmad
and Ali, 2017)
. Thus, it can be used for an overall comparative analysis and relies on same formula like
NPV.
Limitations of IRR-
Ignores Size-This method does not consider project size as it compares cash flows with
capital outlay of project which can yield different results (Munge, Kimani and Ngugi, 2016).
This method can calculate higher returns for a plan with lower investment and lower return
for a plan with higher outlay which can affect decision-making. It ignores the fact that a
product with high investment can generate significantly more profits than those with lower
expenditure. Thus, it does not take into account this factor which is quite important.
Decision-Making can also be affected due to overstated IRR and a wrong project may be
selected.
Results in over-Estimation-It overstates the rate of return of a project whose cash flows are
reinvested at lower rates than the IRR. Thus, a wrong project may be selected by firm

because of the over-projected IRR which may harm its prospects in the long-run by leading
to a decrease in profits (Nkundabanyanga and et.al., 2017)
Overstates annual rate of return- Another issue of IRR is that it overstates the rate of
return for a project whose internal cash flows are re invested on lower rate.
CONCLUSION
In accordance of report, it has been articulated that financial analysis is a key element for
companies that contribute in effective judgement making. The report concludes about
computation of cash conversion cycle as per the given data as well as about ways to enhance
cash flow condition. In accordance of further part of report, this can be concluded that
company should accept project X, because of its higher efficiency in both NPV and IRR
method. In the end of report limitations of IRR method is mentioned.

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