Profitability analysis cash flows

Economic analysis can determine the discounted profitability criteria in terms of payback period (PBP), net present value (NPV), and rate of return (ROR) from discounted cash flow diagram, in which each of the annual cash flow is discounted to time zero for the LHS system. PBP is the time required, after the construction, to recover the fixed capital investment. NPV shows the cumulative discounted cash value at the end of useful life. Positive values of NPV and shorter PBP are preferred. ROR is the interest rate at which all the cash flows must be discounted to obtain zero NPV. If ROR is greater than the internal discount rate, then the LHS system is considered feasible (Turton et al., 2003). 

Depreciation The Internal Revenue Service allows a deduction for the exhaustion, wear and tear and normal obsolescence of equipment used in the trade or business. (This topic is treated more fufly later in this section.) Briefly, for manufacturing expense estimates, straight-line depreciation is used, and accelerated methods are employed for cash flow analysis and profitability calculations. 

Fixed capital investment Working capital requirements Total capital investment Total manufacturing expense Packaging and in-plant expense Total product expense General overhead expense Total operating expense Marketing data Cash flow analysis Project profitability Sensitivity analysis Uncertainty analysis... 

Accounting Keep the books Record financial transactions Prepare financial statements Manage cash flows Analysis of profitability... 

In profitability assessments, annual cash flows are more meaningful than net profit. The net annual cash flow after taxes (CFxt) is the net profit after taxes less the annual expenditure of capital for additions and modifications. Net annual cash flows are used in discounted cash flow calculations to determine the NPV and the rate of return, which are two key measures used in economic decision analysis. 

The chapter starts by introducing the basic concepts of an economic analysis, as prices, breakdown of the capital and manufacturing costs, profit, as well as the formation of cash flow. Because the time-value of money plays a central role the next section presents some basic elements of financial methods. Two other sections deal with the detailed estimation of capital and operation costs. Simplified equations based on typically cost ratios can be used for quick estimations. These ratios are also helpful for the control of more detailed computations. The chapter ends with a more detailed description of the profitability analysis, both by traditional and modem methods. Note that the methods developed in this chapter can be applied using spreadsheets. 

The common measure of different costs is money. Therefore, a profitability analysis must take into account the time-value of money. The practical way to evaluate the profitability is to forecast the evolution of the cash flow over a longer period of time, theoretically over the plant lifecycle. The next section will discuss in more detail the formation of the cash flow. 

The above representation based on the cash flow analysis over a longer period gives a comprehensive image of the profitability from the point of view of the financial operations incurred by the manufacturing process. An important feature of cash flow is that it takes into account the variability in time of different cost elements, as prices, interest rate, market behaviour, depreciation politics, etc. 

A profitable project should realise a positive NPV for a sufficient high interest rate, say 10%. When several projects are compared, the best is the one bringing the highest NPV. If NPV is negative, the economic analysis should review the elements of the cash flow and identify saving measures. NPV evolution can also indicate when the project does not bring sufficient value, and therefore the plant should be retrofitted or stopped. 

When considering after-tax cash flows, some form of actual dollar analysis must be performed because taxes are paid on profits from actual revenues. This is not to say that constant dollar antdyses cannot be performed, but the actual dollars must generally be estimated before conversion to constemt dollars can take place. 

To initiate the profitability analysis, on the Menu, press the Create Report button to produce the Create Report dialog box. After entering the Report Name, to which the word Report is automatically appended, and the directory into which the report file is to be stored (i.e., the report path), press the Create Report button. The results, which are placed in an EXCEL report file, include sections on the Investment Summary, which presents cost estimates for all entries associated with the total permanent investment, the working capital, and the total capital investment (i.e the entries shown in Table 16.9). Also included are sections on the Variable Costs at design capacity (not production during a specific year) of operations and for the Fixed Costs. These correspond to the entries shown in Table 17.1. Then, a section on the cash flows, and the elements that contribute to them, is displayed for each year during the life of the project. Finally, a section on the NPV and the IRR is provided. Each section is accessed by clicking on the appropriate tab at the bottom of the frame. 

Equipment selection and recommendations are dependent on a proper cash flow analysis that includes costs and price shocks to inputs, capital costs (debt facilities, lines of credit), and products (Aden et al., 2002 Patwardhan and Joshi, 1999 Wooley et al., 1999). The ultimate goal hinges on investment criteria. Operation can be optimized to meet a certain level of output, maximize profit, maximize the return on equity/capital, or a combination of those that would depend on the investors and their priorities. 

It is important for firms to project their cash flow. This ensures that they will have funds on hand to pay their bills and their payroll and to invest in new projects. Cash flow is watched carefully by the finance department, because it is possible for a firm to make a profit on paper and still go broke because they do not have the cash needed to pay bills. When a firm invests in a new plant or new equipment, someone estimates the cash flow to calculate how the investment will influence the firm s ability to pay bills and dividends. In the example above the expenses were shown only as fixed or variable and the calculation was not concerned with the time period in which the expenses had to be paid. Likewise, the sales revenue was calculated on a per unit basis, but the sales may come at different time periods and some of the money for the sales may not be collected immediately. Based on historical records and contracts with suppliers and customers, the firm estimates its cash flow over the relevant time period. The cash flow analysis is shown in Table 3.1 for the example above. The cash flow analysis provides new information that the break-even analysis did not provide. It uses the period-by-period forecast to estimate when the firm will receive money and when it will pay out money. For the first seven months of the project the firm will have negative cash flow of 56,000. Then as sales pick up it will alternate positive and negative cash flows. Part of the reason for this is that revenue will be received 30 days after the product is sold, but the expenses to produce the product will be paid the month earlier. 

The measurements of net profit, cash flow, and ROI tell the manager whether a firm is making money and what its relative performance is. Obviously when managers need to make decisions in the course of daily business, they will try to increase profit, cash flow, and ROI. But, it is not always immediately obvious in many decisions which alternative will maximize this return. The break-even analysis and present value analysis do provide information about investments, but they do not provide insight into decisions about how to schedule the equipment and which orders to accept given certain capacity constraints. 

Commercial profitability analysis is the first step in the economic appraisal of a project from a national view point. It is concerned with assessing the feasibility of an investment based on its likely financial results for the individual firm. This analysis comprises two parts (a) investment profitability analysis and (b) financial analysis. These are complementary and non-subslitutable. Investment profitability analysis is a measure of the return on a capital investment irrespective of tiie sources of hnance. F andal analysis takes into consideration the sources of finance and disposal of the net cash flows that accrue to service the finance in a manner that allows smooth implementation and operation of a project. Figure 21.1 summarizes this dichotomy. 

Both operational and financial cash flows should be estimated on an annual basis for comparative financial analysis over the planning horizon. Financial analysis examines the profitability of an investment both prior to the financing and after financing, using cash flow concepts. 

Monte-Carlo Analysis Using CAPCOST. The CAPCOST program introduced in Chapter 7 includes spreadsheets for estimating the cash flows of a project and the evaluation of profitability criteria such as NPV and DCFROR. In addition, a Monte-Carlo simulation has also been included that allows the following variables to be investigated ... 

The IRR is considerably more difficult to calculate than the NPV without the assistance of a computer, and it represents a sophisticated form of analysis. The IRR is defined as the discount rate that equates the present value of aU cash flows with the initial investment made in a project. The IRR consists essentially of the interest cost or borrowed capital plus any existing profit or loss margin. A project is financially more favorable when the positive difference between IRR and the interest rate charged for borrowing increases. Once all the cash flows have been accounted for over the life of a project, the IRR has to be computed by an iterative procedure. 

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