Project. Management. Finance Basics

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1 Project Management Dave Litten s PMP Primer Workbook (PMBOK Guide V5) Finance Basics Dave Litten The Project Management Framework David Geoffrey Litten PMP Primer

Financial Analysis Techniques for Projects There are two main branches within finance, which you may already have heard of: Financial Accounting Management accounting Both financial and management

2 Financial Analysis Techniques for Projects There are two main branches within finance, which you may already have heard of: Financial Accounting Management accounting Both financial and management accounting rely on accurate and timely data to work effectively. But they have different objectives and a different emphasis. The accurate recording of transactions, preparation of financial reports that are required by statutory and regulatory authorities, for within Financial Accounting. Whereas budgeting, costing and business case is for within management accounting. The following graphics compares on contrasts these main differences: Projex Academy 2017 project_finance_basics V

3 Clarifying financial terminology Accruals Project Finance Basics Finance Demystified Revenue and expenses needs to match in terms of timing, so consider the following as a simple example of what this means: A DIY shop buys 100 cans of paint for $2.00 each In one week, 50 of the cans are sold for $5.00 each The income for the week is $250 (50 times $5.00), And the costs associated with the week s sales are $100 (50 times $2.00) The shop would only show these income and cost centers in its accounts for that accounting periods even though it bought in more stock than it sold. The costs of purchase of remaining cans of paint would not be shown in the accounts Until they were sold. Another example could be where there is a single payment made For Internet Rental butts the payment covers three months rent. The rental amount would be spread across the three months. Consistency Definitions and practices Should be consistent within an organization over time so that trend comparisons can be undertaken periods where there are charges, then these need to be communicated in the form of accounts the prepared. Prudence Losses, for example that debt risk, should be recognized in the accounts as soon as they are identified. Gains should be reflected only when they are definite, that is once the customer is invoiced. This is one of the main reasons for tensions between finance and the sales teams! Separability I need to explain how the figures are arrived at. If we have sales of $100,000 and costs of $101,000, It would not be sufficient to say we made a profit of $1000, we need to know about how all this was arrived at. The accounting rules for a country will define how separable the elements within the financial accounts and needs to be. Projex Academy 2017 project_finance_basics V

4 Going concern This principle means that accounts are prepared on the basis that the organization is going to continue to exist and trade for the for sea of all future. Its assets are shown at the value they provide to ongoing operations, not at the level they might reach on the open market. Asset Something of value that is owned by the business, or to which the business has a right. These are divided into different categories, principally fixed and current assets. Liability Something that is owed, an obligation Expenses Money paid out by the organization Revenue, turnover or income Money earned by the organization Accounts payable (USA) or Purchase Ledger (UK) Record of whom are the organization has bought from and the amount going (payable) to them. Accounts receivable (USA) or Sales ledger (UK) Record of whom are the organization that has sold two and the amount they go to us in other words, what we expect to receive Profit and loss Be summarised record of all the revenues and costs of an organization Over a stated. Of time. A profit is achieved when the revenues exceed the costs. Balance sheet A snapshot of what the organization owns and what the organisation are those at a single point in time Projex Academy 2017 project_finance_basics V

5 Cost center A team, business area or department that only incurs cost Profit center A team, business area or department that incurs cost and generates revenue Financial Accounting Has a focus of external reporting of historical information to fixed timescales in line with statutory or regulatory requirements, and includes the following aspects The recording of accounting transactions The major financial reporting statements, balance sheet and profit and loss The analysis of external financial reports The differences between profits and cash Before a project is even started, a proper financial analysis is vital. Let s keep it simple to start with. Project s cost time and money to deliver the end product into the operational area where it is hoped they will bring benefits. It therefore makes sense to ensure that the total costs of any project are estimated to be less than the total benefits than that same project. Again, keeping it simple, adding that the costs at project end, and your expected revenue increases or cost savings over the next few years then ensuring that the latter exceeds the former. But there s a snag If that is all you do it, you would be ignoring the time value of money. See, most of the costs will be incurred at the beginning of the project, while most of the revenue increases or cost savings will occur much later, possibly even years later. So we need to get smarter. Financial professionals already use what I m about to briefly describe, although most of these ratios are not known or fort about below senior management level. Until now. Projex Academy 2017 project_finance_basics V

If you want to shine out from the crowd, demonstrate that you have a clear head for business, impress the heck out of your boss and senior management, while clearly demonstrating you are in pole

6 If you want to shine out from the crowd, demonstrate that you have a clear head for business, impress the heck out of your boss and senior management, while clearly demonstrating you are in pole position for a career enhancement, then read on I would say might top four picks to fast forward your financial savvy are: payback period analysis accounting rate of return net present value internal rate of return Don t get me wrong, each of these ratios have advantages and disadvantages, so my warning on the bottle says, use with care and a large dollop of common sense Come on them, let s get stuck straight in. Payback Period Analysis This is got to be one of the simplest ways of measuring the financial health of your project endeavor just calculate how long it will take to earn back the money you have invested in the project before you breakeven: Projex Academy 2017 project_finance_basics V

7 As an example, suppose your project cost was 100,000 and the project annual financial returns were estimated to be 250,000, then the payback period would be 100,000 / 250,000 = 4 years. As is often the case, the annual financial returns from a project may vary from one year to the next, in which case just add up the expected returns for each succeeding year until it be called the total cost of the project. If the return from the project is expected to vary from year to year, you can simply add up the expected returns for each succeeding year, until you arrive at the total cost of the project. For example, in our previous cash flow example, the project costs $100,000 and the expected returns were as follows: Year 1 $18,059 Year 2 $25,513 Year 3 $27,951 Year 4 $32,021 Year 5 $40,072 Projex Academy 2017 project_finance_basics V

The project would be completely paid for about 10 1/2 months into the fourth year, because $100,000 (cost of project) is equal to all the first three years' revenues, plus $28,477.

8 The project would be completely paid for about 10 1/2 months into the fourth year, because $100,000 (cost of project) is equal to all the first three years' revenues, plus $28,477. $28,477 is equal to about 10.7/12 of the fourth year's revenues. Cash Flow Analysis A cash flow is one of the most important parts of the financial analysis for a project or a business. It represents a listing of the project cash inflows and outflows divided into time periods. The time periods may be months, quarters or years, depending on the project needs. A cash flow can be created for either the past accounting period (it is called the cash flow statement) or the future accounting period (the cash flow budget). Apart from the cash flow projections, the cash flow budget may contain the actual cash inflows and outflows, allowing you to monitor the accuracy of your projections. The main benefit of cash flow budgeting is that it quickly points out any liquidity problems in the future. It shows when the company would experience cash deficits and allows you to take corrective actions in advance by reducing the outflows, changing the time of certain transactions or borrowing the money. Projex Academy 2017 project_finance_basics V

9 The cash flow budget can also identify the time periods when the company will have excess amounts of cash, allowing you to use this cash to create additional revenue. Choosing Among Competing Projects Under the payback method of analysis, projects or purchases with shorter payback periods rank higher than those with longer paybacks. The theory is that projects with shorter paybacks are more liquid, and thus less risky they allow you to recoup your investment sooner, so you can reinvest the money elsewhere. With any project, the variables grow increasingly fuzzy as you look out into the future. With a shorter payback period, there's less of a chance that market conditions, interest rates, the economy or other factors affecting your project will drastically change. Generally, a payback period of three years or less is preferred. Some advisers say that if the payback period is less than a year, the project should be considered essential. But don't forget the drawbacks of the payback period method. Chiefly, it ignores any benefits that occur after the payback period, so a project that returns $1 million after a six-year payback period is ranked lower than a project that returns zero after a five-year payback. But probably the major criticism is that a straight payback method ignores the time value of money. To get around this problem, you should also consider the net present value of the project, as well as its internal rate of return. Projex Academy 2017 project_finance_basics V

Accounting Rate of Return Project Finance Basics Finance Demystified Net Present Value of Major Purchases The net present value method (NPV) of evaluating a major project allows you to consider the

10 Accounting Rate of Return Project Finance Basics Finance Demystified Net Present Value of Major Purchases The net present value method (NPV) of evaluating a major project allows you to consider the time value of money. Essentially, it helps you find the present value in "today's dollars" of the future net cash flow of a project. Then, you can compare that amount with the amount of money needed to implement the project. If the NPV is greater than the cost, the project will be profitable for you (assuming, of course, that your estimated cash flow is reasonably close to reality). If you have more than one project on the table, you can compute the NPV of both, and choose the one with the greatest difference between NPV and cost. As an example of how NPV works, imagine you're looking at a project costing $7,500 that is expected to return $2,000 per year for five years, or $10,000 in total. At first glance, the project looks profitable. Under the payback method, it looks as if the project will pay for itself in 3.75 years. Projex Academy 2017 project_finance_basics V

However, using NPV analysis, you can determine that if the discount rate on the project was 10 percent, the value of the expected returns would be $12,078.83. In other words, if you had $7,500.

11 However, using NPV analysis, you can determine that if the discount rate on the project was 10 percent, the value of the expected returns would be $12, In other words, if you had $7, today and invested it at 10 percent, after five years you'd wind up with $12,078.83, well above your payback method calculation. Bear in mind, though, that NPV analysis is generally used to evaluate the project's cash flows, rather than the income from the project that would be shown on an income statement. Why? Because the income statement factors in depreciation, but depreciation is not an out-of-pocket expense. For instance, if revenue of $10,000 is reduced to $7,000 of income because of a $3,000 depreciation deduction, you still have the use of the full $10,000. So, the cash flow figure of $10,000 is the more instructive one to look at. However, if you are very concerned about the appearance of your income statement (for example, if you anticipate putting the business up for sale or seeking major financing in the future, or if you're under stockholder pressure to show more income) you may decide that the income figure is more appropriate to use. Discount Rate Projex Academy 2017 project_finance_basics V

12 How can you quickly estimate your cost of borrowing, which is used as the "discount rate," for purposes of analyzing a major purchase decision? If you are planning to finance the purchase and you know what the interest rate on the loan would be, you can use the rate charged on the loan as the cost of borrowing for the project. Therefore, you would use the loan's rate as the "discount rate" in computing the net present value for the project. (If the rate is variable, you may have to take a guess as to the average rate over the loan period, or do the computation under worst-case and best-case scenarios.) If you are not financing your purchase, theoretically, you should attempt to compute an average cost of capital for your business that reflects all your current funding sources, including debt and owner's equity. Computing your true cost of capital can be rather time-consuming and complicated, and you'll probably need your accountant's assistance to do it accurately. The calculation depends on many economic conditions, opportunity costs, and business risks faced by the company. What's more, using this figure assumes that additional capital can be obtained from similar sources in the same proportion, and at the same rates. For many small businesses, this may not be a realistic assumption. Instead, you can use your average cost of borrowing as the discount rate. Internal Rate of Return The internal rate of return (IRR) method of analyzing a major purchase or project allows you to consider the time value of money. Essentially, it allows you to find the interest rate that is equivalent to the dollar returns you expect from your project. Once you know the rate, you can compare it to the rates you could earn by investing your money in other projects or investments. If the internal rate of return is less than the cost of borrowing used to fund your project, the project will clearly be a money-loser. However, usually a business owner will insist that to be acceptable, a project must be expected to earn an IRR that is at least several percentage points higher than the cost of borrowing, to compensate the company for its risk, time, and trouble associated with the project. As an example of how the internal rate of return works, let's say you're looking at a project costing $7,500 that is expected to return $2,000 per year for five years, or $10,000 in total. The IRR calculated for the project would be 10 percent. If your cost of borrowing for the project is less than 10 percent, the project may be worthwhile. If the cost of borrowing is 10 percent or greater, it won't make sense to do the project (at least from a financial perspective) because, at best, you'll be breaking even. Projex Academy 2017 project_finance_basics V

IRR analysis is generally used to evaluate the project's cash flows, rather than the income from the project that would be shown on an income statement

The goals of this phase are to determine whether to take on the project, to calculate its profits and to ensure stable finances during the project.

13 IRR analysis is generally used to evaluate the project's cash flows, rather than the income from the project that would be shown on an income statement (also known as the profit and loss statement). One of the most important parts of the project planning process is the financial analysis. The goals of this phase are to determine whether to take on the project, to calculate its profits and to ensure stable finances during the project. Book your place on my Finance For Non-Financial Professionals online streaming training: Projex Academy 2017 project_finance_basics V

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14 Check out more of my quality downloadable Project Management Video Training Products: (Pass Your PRINCE2 Exam First Time!) (Learn the Art of Advanced PRINCE2 Governance) (Introduction to Project Management) (Introductory Certificate exam for the APM) (Master MS Project 2010!) (Pass the new APM/DSDM Agile Foundation and Practitioner exams) (Conversion course for PRINCE2 Practitioners get take the simpler/reduced APMG exam and become an Accredited Project Manager!) coming soon AnalysisMastery.com I look forward to working with you again. Projex Academy 2017 project_finance_basics V

Chapter 14 Solutions Solution 14.1

Chapter 14 Solutions Solution 14.1 a) Compare and contrast the various methods of investment appraisal. To what extent would it be true to say there is a place for each of them As capital investment decisions