Financial statements are finacial documents published by a company either annually, quarterly or monthly. They reveal the companys’ networth, earnings and operational budget. They are used by accountants and financial planners to decide on product launch, future planning and expansion of the company. They have disadvantages and advantages. One of the disadvantage is that the data focuses on the market at a given period of time.
The numbers may not remain the same throughout, and so the executives should avoid making assumptions. Financial analysts should develop a sales pattern over time since the statement shows the earning of a company. For example, the sales may increase when a product is introduced in the market, and after some time the sales decline and the executive expects a decrease in sales. Another advantage is that they provide enough information for decission making on investments. They are also used to determine if businesses are using accounting standards.
Investment appraisal is a critical and difficult task for an organisation. Firms setting hurdle rate is an approach that is practiced by most companies. Hurdle rates are also the rates of return required by a company when it’s planning its outlay in a longterm (Weston, 1990). It is the minimum rate required before making an investment decission. If the rate of return is higher than the hurdle rate, the project should be accepted. Different companies have diffent interpretation of this term. For this case, if the two or more companies are discussing about the best project to invest in, it is important for them to have a similar understanding of the term.
Debt financing occurs when a company borrows money from outside sources with an agreement of paying back the principal plus an agreed interest after a given time (.Lang & Merino, 1993) This can also be callled Leverage in finance. Although this method of financing has a negative cannotation, most startup companies turn to this method to finance the operations. There are advantages and disadvantages associated to this type of financing.
The advantages may include the maintaining of ownership. When a company borrows money from the outside sources, it is obligated to pay back after a certain agreed time and after the payment that becomes the end of obligation with the lender. After that, the management team can choose to run the company without any outside interference. Another advatage is tax deductions. The principal and interests are mostly classified as expenses, and they are deducted from the income taxes of the business. The government is in a partnership with the business tax rate at stake. It becomes beneficial to the business if the government is cut off from the equation. Effects of tax deductions on the interest rates of the banks should be carefully analysed. If, for example, the bank is charging 10% on the loan and the tax rate is 30%, then it’s advisable to take the loan that is deductable.
There are drawbacks of this type of financing. As mentioned earlier, the only obligation the business has is to pay the lender. The lender has claims even before equity investors if the business is forced in bankruptcy. High interest rates may face the business even after discounted interest rate is calculated from the tax deductions. Interest rates vary with the business’ history with the lender, macroeconomic conditions, the business’ credit rating, and personal credit history. It also has an impact on the credit rating. Every loan is normally noted on credit rating. As an individual borrows more, the risk to the lender increases thus increasing the interest rate to be paid which is expensive for the business. Last but not least, there is cash, collateral or security. To qualify for a loan one has to put up a collateral incase of inability to pay back the loan (Boxwell, 1994).
The word “metrics” is used to define different measurements. Therefore, financial metrics are finacial measurements. They may include net cash flows, earning per share and return on investments (Camp, 1988). They are descriptive statistics since they bring out different things on a body of financial data. It measures the financial strength of a company or performance over a period of time (Schmidt, 2012). The figures used in finance are mostly used by investors who may be interested in buying or selling stocks or bonds in the company.
Most of the financial metrics belong to either of the two families- cashflow metrics or financial statement metrics. Cash flow metrics evaluates investments and cash flow events such as Net Present Value, Internal Rate of Return and Return On Investment (Schmidt, 2012). On the other hand, financial metrics is used to define and describe evaluate the financial performance of a company, such as earning per share, current ratio as well as inventory turns.
In this case, the focus will be on cash flow metric. The payback period, net present value, internal rate of return and modified rate of return will be discussed in details (Merino, 1993).
Payback period is the time required for cost of investment to equal incoming returns and is measuerd in years. A shorter payback period is better for the debtor. They are also less risky. There are points to keep in mind when applying this concept. ” First, it cannot be calculated if the cash outflows outweighs the positive cash inflows. Secondly, there may be more than one payback period for a cash flow stream” (Schmidt, 2012). This may occur when the cash inflow is positive in one year and negative in the next year.
Every cash flow has its time present value. Net present value is the sum of these values for the cash flow streams (Schmidt, 2012). It is affected by the discount period and discont rate. Increase in discount period decreases the net present value while an increase in discount rate also increases the present value. The formular for calculating NPV may be summarised as;
NPV=FV+ FV1+ FV2+ ….FVn
( 1+i)0(1+i) (1+i)1… (1+i)n-0.5
Where:
- FV= net cash flow for the initial present cash flow
- NPV =Net Present Value
- I=annual interest rate
- n= number of periods included
- q=number of pereiods per year
Internal Rate of Return starts with cash flow streams. It answers the question, “What is the discount rate that would give the cash flow stream a net present value of 0?” That rate is the IRR. To decide on if IRR should be included in a business case, one has to consider the following: It cannot be calculated with cash inflows or outflows only (Schmidt, 2012). Secondly, if the initial cash outflow is small, it can be quite misleading. Another point to note is that one can get a negative IRR- a cash stream with more than one IRR. The meaning becomes difficult to interprete in such cases. Finally, it has nothing to say about how much the returns would be.
Modified internal rate of return is measures the attractiveness of an investment. It can be calculated using the followin formular;
MRR= the square root of FV(positive cash flow, re investment rate)-1
-PV(negative cashflow, finance rate)
The answer is multiplied by n
Where n is the number of equal period at the end where cashflow occur, FV is the future value at the end of last period and pv is the present value at the start of first period.
References
Boxwell, R. (1994). Benchmarking for Competitive Advantage. New York: McGraw-Hill.
Camp, R. (1988). Beating the competition: a practical guide to Benchmarking. Washington DC: Kaiser Associates.
Lang, J., & Merino, D. (1993). The selection process for capital projects. NewYork: J. Wiley & Sons.
Schmidt, M. J. (2012). The Meaning of Payback Period. Encyclopedia of Business Terms and Methods, Web.
Weston, J. (1990). Essentials of Managerial Finance. Hinsdale: Dryden Press.