CBA 101 – Cost Benefit Analyse, Financial Analyse

My upcoming goals in Economics is to learn more about CBA’S and Financial Analyse’s so i’ll be learning what they represent, as I putted it here on the blog for CBA 101, in preparation for future use with economics-experts.

Vaqas Syed, 04-10-09.

Benefits and costs are often expressed in money terms, and are adjusted for the time value of money, so that all flows of benefits and flows of project costs over time (which tend to occur at different points in time) are expressed on a common basis in terms of their “present value.” Closely related, but slightly different, formal techniques include cost-effectiveness analysis, economic impact analysis, fiscal impact analysis andSocial Return on Investment (SROI) analysis. The latter builds upon the logic of cost-benefit analysis, but differs in that it is explicitly designed to inform the practical decision-making of enterprise managers and investors focused on optimising their social and environmental impacts.

It is an analysis of the cost effectiveness of different alternatives in order to see whether the benefits outweigh the costs. The aim is to gauge the efficiency of the intervention relative to the status quo. The costs and benefits of the impacts of an intervention are evaluated in terms of the public’s willingness to pay for them (benefits) or willingness to pay to avoid them (costs). Inputs are typically measured in terms of opportunity costs – the value in their best alternative use. The guiding principle is to list all parties affected by an intervention and place a monetary value of the effect it has on their welfare as it would be valued by them.

The process involves monetary value of initial and ongoing expenses vs. expected return. Constructing plausible measures of the costs and benefits of specific actions is often very difficult. In practice, analysts try to estimate costs and benefits either by using survey methods or by drawing inferences from market behavior.

It can be used to prevent also money-loss in behavior of incidental, accidental and on purpose.

Cost–benefit calculations typically involve using time value of money formulas. This is usually done by converting the future expected streams of costs and benefits with a present value amount.

Cost–benefit analysis is used mainly to assess the monetary value of very large private and public sector projects. This is because such projects tend to include costs and benefits that are less amenable to being expressed in financial or monetary terms (e.g., environmental damage), as well as those that can be expressed in monetary terms. Private sector organizations tend to make much more use of other project appraisal techniques, such as rate of return, where feasible.

The practice of cost–benefit analysis differs between countries and between sectors (e.g., transport, health) within countries. Some of the main differences include the types of impacts that are included as costs and benefits within appraisals, the extent to which impacts are expressed in monetary terms, and differences in the discount rate between countries. Agencies across the world rely on a basic set of key cost–benefit indicators, including the following:

• NPV (net present value)
• PVB (present value of benefits)
• PVC (present value of costs)
• BCR (benefit cost ratio = PVB / PVC)
• Net benefit (= PVB – PVC)
• NPV/k (where k is the level of funds available)

The accuracy of the outcome of a cost–benefit analysis depends on how accurately costs and benefits have been estimated. A peer-reviewed study [13] of the accuracy of cost estimates in transportationinfrastructure planning found that for rail projects actual costs turned out to be on average 44.7 percent higher than estimated costs, and for roads 20.4 percent higher (Flyvbjerg, Holm, and Buhl, 2002). For benefits, another peer-reviewed study [14] found that actual rail ridership was on average 51.4 percent lower than estimated ridership; for roads it was found that for half of all projects estimated traffic was wrong by more than 20 percent (Flyvbjerg, Holm, and Buhl, 2005). Comparative studies indicate that similar inaccuracies apply to fields other than transportation. These studies indicate that the outcomes of cost–benefit analyses should be treated with caution because they may be highly inaccurate. In fact, inaccurate cost–benefit analyses may be argued to be a substantial risk in planning, because inaccuracies of the size documented are likely to lead to inefficient decisions, as defined by Pareto and Kaldor-Hicks efficiency ([15] Flyvbjerg, Bruzelius, and Rothengatter, 2003).

These outcomes (almost always tending to underestimation unless significant new approaches are overlooked) are to be expected because such estimates:

1. Rely heavily on past like projects (often differing markedly in function or size and certainly in the skill levels of the team members)
2. Rely heavily on the project’s members to identify (remember from their collective past experiences) the significant cost drivers
3. Rely on very crude heuristics to estimate the money cost of the intangible elements
4. Are unable to completely dispel the usually unconscious biases of the team members (who often have a vested interest in a decision to go ahead) and the natural psychological tendency to “think positive”(whatever that involves

cost–benefit analysis comes from determining which costs should be included in an analysis (the significant cost drivers). This is often controversial because organizations or interest groups may think that some costs should be included or excluded from a study.

In the case of the Ford Pinto (where, because of design flaws, the Pinto was liable to burst into flames in a rear-impact collision), the Ford company’s decision was not to issue a recall. Ford’s cost–benefit analysis had estimated that based on the number of cars in use and the probable accident rate, deaths due to the design flaw would run about $49.5 million (the amount Ford would pay out of court to settle wrongful deathlawsuits). This was estimated to be less than the cost of issuing a recall ($137.5 million) [16]. In the event, Ford overlooked (or considered insignificant) the costs of the negative publicity so engendered, which turned out to be quite significant (because it led to the recall anyway and to measurable losses in sales).

In the field of health economics, some analysts think cost–benefit analysis can be an inadequate measure because willingness-to-pay methods of determining the value of human life can be subject to bias according to income inequity. They support use of variants such as cost-utility analysis and quality-adjusted life year to analyze the effects of health policies.

Financial analysis refers to an assessment of the viability, stability and profitability of a business, sub-business or project.

It 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. Based on these reports, management may:

• Continue or discontinue its main operation or part of its business;
• Make or purchase certain materials in the manufacture of its product;
• Acquire or rent/lease certain machineries and equipment in the production of its goods;
• Issue stocks or negotiate for a bank loan to increase its working capital;
• Make decisions regarding investing or lending capital;
• Other decisions that allow management to make an informed selection on various alternatives in the conduct of its business.

Goals

Financial analysts often assess the firm’s:

1. Profitability – its ability to earn income and sustain growth in both short-term and long-term. A company’s degree of profitability is usually based on the income statement, which reports on the company’s results of operations;

2. Solvency – its ability to pay its obligation to creditors and other third parties in the long-term;
3. Liquidity – its ability to maintain positive cash flow, while satisfying immediate obligations;

Both 2 and 3 are based on the company’s balance sheet, which indicates the financial condition of a business as of a given point in time.

4. Stability- the firm’s ability to remain in business in the long run, without having to sustain significant losses in the conduct of its business. Assessing a company’s stability requires the use of both the income statement and the balance sheet, as well as other financial and non-financial indicators.

[edit]Methods

Financial analysts often compare financial ratios (of solvency, profitability, growth, etc.):

• Past Performance – Across historical time periods for the same firm (the last 5 years for example),
• Future Performance – Using historical figures and certain mathematical and statistical techniques, including present and future values, This extrapolation method is the main source of errors in financial analysis as past statistics can be poor predictors of future prospects.
• Comparative Performance – Comparison between similar firms.

These ratios are calculated by dividing a (group of) account balance(s), taken from the balance sheet and / or the income statement, by another, for example :

n / equity = return on equity

Net income / total assets = return on assets

Stock price / earnings per share = P/E-ratio

Comparing financial ratios are merely one way of conducting financial analysis. Financial ratios face several theoretical challenges:

• They say little about the firm’s prospects in an absolute sense. Their insights about relative performance require a reference point from other time periods or similar firms.
• One ratio holds little meaning. As indicators, ratios can be logically interpreted in at least two ways. One can partially overcome this problem by combining several related ratios to paint a more comprehensive picture of the firm’s performance.
• Seasonal factors may prevent year-end values from being representative. A ratio’s values may be distorted as account balances change from the beginning to the end of an accounting period. Use average values for such accounts whenever possible.
• Financial ratios are no more objective than the accounting methods employed. Changes in accounting policies or choices can yield drastically different ratio values.
• They fail to account for exogenous factors like investor behavior that are not based upon economic fundamentals of the firm or the general economy (fundamental analysis) ^[1].