A financial analysis is performed by professionals who prepare reports
using ratios that make use of information taken from financial statements and
other reports. These reports are usually presented to top management as one of
their bases in making business decisions. Financial analysis may determine if a
- Continue or discontinue its main operation or part of its business;
- Make other decisions that allow management to make an informed selection on
various alternatives in the conduct of its business.
Basically, a business or project is
financially viable if the revenues exceed the funding cost and project/business
costs. The relationship between project revenues and expenses comprising both
funding cost and project costs for any business or project can be captured as
in the figure below:
When the blue area - project revenue - is
smaller than the funding and project costs, the business is financially not
viable. A financially viable project/business has higher revenues than project
cost and funding cost.
Projected revenue refers to the estimated
money a project/company will generate during a specific period. These
projections may be monthly, quarterly or annual. Revenues or sales is the amount of money that is brought into a project/company
by its business activities. There are two main ways of calculating revenue.
These depend on the accounting method a business employs.
Accrual accounting includes sales
made on credit as revenue, as long as the goods or services have been delivered
to the customer. In accrual accounting one needs to look at the cash flow
statement too, to assess how efficiently a company collects the money it is
Cash accounting only count sales
as revenue if the payment has been received. When cash is paid to a company,
this is known as a "receipt" to distinguish it from revenue. It is
possible to have receipts without revenue. For example, if the
customer paid in advance for a service that has not been rendered or goods
that have not been delivered, this activity leads to a receipt, but not
Revenue can be divided into operating
revenue or sales from a company's core business, and
non-operating revenue which is derived from other secondary sources. As
these non-operating revenue sources are often not predictable or recurring,
they can be referred to as one-time events or gains.
In the case of government, revenue
is the money received from taxation, fees, fines, inter-governmental grants or
transfers, securities sales, mineral rights and resource rights, as well as any
sales that are made.
Debt and equity are the two main
components that constitute a project’s capital funding. Lenders and equity
holders will expect to receive certain returns on the funds or capital they
have provided. Since cost of capital is the return that equity owners (or
shareholders) and debt holders will expect, so WACC indicates the return
that both kinds of stakeholders (equity owners and lenders) can expect to
To help understand WACC, try to think
of a project/company as a pool of money. Money enters the pool from two
separate sources: debt and equity. Proceeds earned through project/business
operations are not considered a third source because, after a company pays off
debt, the company retains any leftover money that is not returned to
shareholders (in the form of dividends) on behalf of those shareholders.
Suppose that lenders require a 10%
return on the money they have lent to a firm, and suppose that shareholders
require a minimum of a 20% return on their investments to retain their holdings
in the firm. On average, then, projects funded from the company’s pool of money
will have to return 15% to satisfy debt and equity holders. The 15% is the
WACC. If the only money in the pool was $50 in debt holders’ contributions and
$50 in shareholders’ investments, and the company invested $100 in a project,
to meet the lenders’ and shareholders’ return expectations, the project would
need to generate returns of $5 each year for the lenders and $10 a year for the
company’s shareholders. This would require a total return of $15 a year, or a
Risk identification and allocation is a key component of project funding. A
project may be subject to several technical, environmental, economic and
political risks, particularly in developing countries and emerging markets. Financial
institutions and project sponsors may conclude that the risks inherent in project
development and operation are unacceptable (unfinanceable).
Project cost is the operating cost of the project, which is required for
smooth operation and maintenance of the project.