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5. Financial Analysis of Processing Industries
Agricultural projects requently include processing facilities such as packing sheds, preserving and canning plants, oil extraction mills, rice mills, sugar refineries, and the like. For these agriculturally based industries (or "agroindustries"), we must project and analyze financial statements to judge efficiency, incentive, creditworthiness, and liquidity and to determine the costs and benefits that are to be included in the overall project. Whether such enterprises are publicly or privately owned, there is the same need to analyze their financial structure.
Analyzing and projecting financial statements for these enterprises requires a considerable, specialized expertise that those responsible for agricultural project analysis often do not possess. The purpose of this chapter is thus twofold. First, for those who do not consider themselves experts in financial analysis, it provides an analytical pattern to apply to less complex agricultural industries included in their projects. Second, for an accountant or financial analyst, it indicates the kinds of financial information needed for agricultural projects. Then, when a project analyst turns to these specialists for their help, they can adapt the pattern formats in this chapter to develop appropriate financial statements for a particular agricultural project.
The treatment here of these issues is necessarily brief; project analysts may want to consult Upper (1979), a collection of teaching materials that expands many of the elements only summarized here. Much of the following discussion is drawn directly from these materials. Those interested in more detail may also wish to consult a standard accounting textbook such as Niswonger and Fess (1977), which uses the U.S. accounting conventions, or Bigg and Perrins (1971), which uses the British conventions. In the discussion here, we will generally follow the accounting conventions of U.S. practice and note some of the important ways that it differs from British practice. Both conventions, however, are essentially identical; differences are almost entirely limited to conventions of presentation and to a few specialized terms used for accounting concepts.
We will illustrate the kinds of accounts that are appropriate for the financial analysis of a processing enterprise that is a part of an agricultural project with examples adapted from the sugar mill included in the South Nyanza Sugar Project in Kenya. We will reproduce the figures for selected years; the original accounts were projected for sixteen years.
The overall South Nyanza project included establishment of a nucleus sugarcane plantation; development of a network of small farmers, or outgrowers, who would supply additional cane; and a processing component-a sugar mill initially capable of crushing 60,000 tons of cane a year, 90,000 tons of cane after later expansion. The accounts presented contain all the elements necessary for analysis of much simpler enterprises but are also complex enough to be useful as a pattern to be adapted by those with specialized knowledge of financial analysis.
For an agriculturally based industry included in a project, three basic financial statements should be prepared: balance sheets, income statements, and sources-and-uses-of-funds statements. If the project represents an expansion of an existing facility, then these accounts should include historical information for, say, about five years previous to the beginning of the project. Both for enterprises that are to be expanded and new enterprises, these statements would be projected over the life of the project.
The balance sheets give a view of the assets and liabilities of the processing enterprise at the end of each accounting period, which is usually a year-a kind of still photograph of the financial state of the enterprise at a given moment. The income statements summarize the revenues and expenses of the enterprise during each accounting period and give a kind of cinematic picture of activities over time. The sources-and-uses-of-funds statements are a summary of the financial transactions taking place during each accounting period. In essence, they convert the income statement to a cash (or funds) basis. They highlight large transactions, such as the purchase of assets and creation of new obligations (both debt and equity), that appear as changes in the balance sheets for the opening and closing of each period.
On the basis of these financial statements, the project analyst can form a judgment about the efficiency of current operations and about how efficient proposed new facilities are likely to be. He can assess the returns to investors if the project is to be financed by private funds or by accountable public enterprises. The statements may reveal losses that will have to be made up through a subsidy if the enterprise is to remain financially solvent; from them the analyst can examine the creditworthiness and liquidity of the enterprise during the project life as a basis for arranging its financing. In general, the project analyst will make use of three sets of ratios, which are derived from the financial statements and which give him insight to help form his financial judgments-efficiency ratios, income ratios, and creditworthiness ratios.
The financial data essential to analyze any new project are, of course, based on incremental expenses and revenues. The South Nyanza example for our discussion was a new project, and virtually the whole sugar mill was incremental. (There were a few existing assets.) Many projects, however, will entail expansion of existing facilities. In these instances, the analysis centers on incremental growth in the parent enterprise, the situation with and without the expansion that the parent enterprise will carry out. Costs and revenues that would be realized by the parent enterprise whether or not a particular project is undertaken are not considered in the estimate of the incremental contribution. On the one hand, the potential future effects of a proposed project must be isolated from the overall accounts of the parent enterprise. On the other hand, the project analyst will be concerned not only with the financial dimensions of a proposed expansion alone. He must also be satisfied that the parent enterprise is financially able to carry out the expansion, and that may require projecting financial statements for the enterprise as a whole, including the expansion envisioned by the project.
Accounts are kept for operating entities rather than for the persons who own, manage, or are otherwise employed by them. The enterprise represents a group of resources subject to common control. In financial analysis, it is the operating entity that is viewed as controlling the resources and receiving the income. The entity is, in turn, owned by its proprietors or shareholders. The management of the enterprise acts on behalf of the owners, whether private or government.
Accounts for operating enterprises are kept on an accrual basis. That is, revenues are recorded in financial statements for the period in which they are earned, and expenses are recorded in the period incurred, regardless of when the corresponding cash transactions took place. In contrast, cash accounting shows transactions only when cash payments are actually made. Governments generally keep their accounts on a cash basis, as do some small businesses. Public sector enterprises, however, normally follow the accrual principle because it is more useful for managerial decisionmaking.
The most common and generalized categories of items included in the accounts of the South Nyanza project appear in italic type in the text of this chapter. If the analyst takes the italicized items and the illustrative tables as a general pattern and adapts them to the particular project he is working on, he will arrive at a satisfactory account for most simple processing enterprises. Conceptual errors would probably be limited and have little effect on the overall project investment decision, although the analyst may wish to verify his projected financial statements by consulting an accountant. Consultation with a financial analyst early in project preparation will probably be necessary when the financial statements for the processing plant become more complex.
Balance Sheet
The most well-known financial statement is the balance sheet. It is a snapshot of an enterprise at a particular point of time. In the South Nyanza example in table 5-1, the assets of the sugar mill are listed above and its liabilities and equity below. Assets and liabilities are listed according to the U.S. convention of showing the most liquid, or current, first and then progressing through less and less liquid forms to end with fixed assets and long-term liabilities. British usage shows the least liquid first,
KSh Kenyan shillings.Note: Parentheses indicate negative numbers.Source: Adapted from World Bank, "Kenya: Appraisal of the South Nyanza Sugar Project," 1418-KE (Washington, D.C., 1977; restricted circulation), annex 20, table 12.a. Represents the net value of services and inputs provided to outgrowers (small farm-ers), including company overhead cost allocated to outgrowers.b. Includes investment in sugarcane (current value less production cost of sugarcane; excludes value of land).c. Includes spare parts, tools, and operating materials.
working through to the most current. (Also, if assets and liabilities are listed in parallel columns instead of at the top and bottom of a page, U.S. custom is to show assets on the left-hand side, whereas British usage is to put the liabilities on the left.) Assets and liabilities plus equity are defined so that they must always be equal. Thus we have the identity: assets - liabilities + owners' equity. Assets must be owned by the enterprise and be of measurable value. There are three principal kinds of assets: current, fixed, and other. Current assets consist of cash, including checking accounts in a bank; accounts receivable, which are amounts owed to the firm by customers and are expected to be converted into cash in the reasonably near future, usually in less than a year; and inventories intended for rather prompt sale. In the South Nyanza example, the standing crop of sugarcane on the nucleus plantation is treated as an inventory. Fixed assets include durable goods of relatively long life to be used by the enterprise in production of goods and services rather than to be held for sale. Property, plant and equipment, and land are the most common fixed assets. Often, as in the South Nyanza example, buildings
Source: Same as table 5-1 (annex 20, table 11).a. Valued at KSh3,050 per ton.b. Valued at KSh350 per ton f.o.b. Mombasa.c. Represents total cost of production of sugarcane on the nucleus estate.d. Value of sugarcane purchased from outgrowers at KSh155 per ton.e. Includes excise tax of KSh6 per ton and transport charges of KShl0 per ton from factory to dockside in Mombasa.
and equipment at cost are shown at their original cost, and then the accumulated depreciation allowances are deducted. Land, by convention, is never depreciated. In the South Nyanza example, construction in progress is shown separately as a fixed asset. A third kind of asset, called simply other assets, is not needed in the South Nyanza balance sheet. This category would include investments in other companies or long-term securities; deferred expenses, such as start-up expenses for a new project, to be charged over several accounting periods; intangible assets such as patents and trademarks that have no physical existence but are of value to the enterprise; and miscellaneous additional assets peculiar to particular types of enterprises.
Liabilities are the claims against the assets of the enterprise that creditors hold-in other words, the outstanding debts of the enterprise. There are two principal kinds. Current liabilities comprise debts falling due within a year, such as accounts payable, short-term loans, and the current portion of long-term loans and suppliers' credits that must be paid within the coming accounting period. Taxes payable but not yet paid are also a current liability. Long-term liabilities are the debts that become payable after one year from the date of the balance sheet. They may consist of medium- and long-term loans and suppliers' credits.
Owners' equity consists of claims against the assets of the enterprise by its owners-in other words, what is left after all liabilities have been deducted from total assets. In the case of public sector enterprises, the owner is generally the government, although some public sector firms may have nongovernment shareholders. Owner's equity generally takes the form of share capital paid in by owners of the enterprise and retained earnings ("reserves" in British usage). Various other kinds of reserves may also appear under equity that do not fit precisely into the description of capital and retained earnings.
Income Statement
The income statement is a financial report that summarizes the revenues and expenses of an enterprise during the accounting period. It is thus a statement that shows the results of the operation of the enterprise during the period. Net income, or profit, is what is left after expenses incurred in production of the goods and services delivered have been deducted from the revenues earned on the sale of these goods and services. In other words, income (profit) = revenues - expenses. Thus, in the South Nyanza example in table 5-2, the net income is the sales revenue less all expenses.
Revenue in most processing enterprises will come from sales of goods and services in the South Nyanza example, sugar and molasses. Sales are shown net of sales discounts, returned goods, and sales taxes.
The cash operating expenses list all the cash expenditures incurred to produce the output. Important among these are expenditures for labor (which in the South Nyanza example is included in factory variable cost) and for raw materials, in this case largely sugarcane purchased from outgrowers. Subtracting these direct costs incurred in the production of the goods sold from the revenue gives the gross income (or gross profit).
Selling, general, and administrative expenses are shown next. These include a number of overhead items-in the South Nyanza example, general administration, training, research, and the management fee to be paid the firm that will operate the sugar mill. Maintenance costs are often included as a separate entry in this category.
We now reach the funds from operations, also called the operating income before depreciation. This is the net benefit or cash flow of the enterprise that arises from operations. If the account is built on an incremental basis, it is the incremental net benefit from operations. (It is not the incremental net benefit or cash flow for the enterprise as a whole during each year over the life of the project, since we must deduct the investment costs that come from the sources-and-uses-of-funds statement discussed in the next section. This expense is shown as depreciation in the income statement. See the last section of this chapter, on financial rate of return.) Funds from operations are sometimes also called the internally generated funds. Funds from operations becomes the first element in the sources-and-uses-of-funds statement and is also the basis for transferring the net benefits of the enterprise to the summary project accounts from which the estimated economic return of the project is derived. Before this is done, however, any element in the revenues, cash operating expenses, and selling, general, and administrative expenses that is a direct transfer payment or that has an economic value different from its market price must be omitted or revalued along the lines given in chapter 7.
Next we list the noncash operating expenses, of which the primary element is depreciation. In accounting, depreciation refers to the process of allocating a portion of the original cost of a fixed asset to each accounting period so that the value is gradually used up, or written off, during the course of the useful life of the asset. Allowance may be made for the resale value of the fixed asset-its residual value at the end of its useful life to the enterprise. The most common depreciation method is "straight-line depreciation," which allocates an equal portion of the value of the fixed asset to each accounting period; in contrast, various methods of accelerated depreciation allocate more of the depreciation to earlier accounting periods than to later. The principal other noncash operating expense is amortization, the gradual writing off of intangible assets such as royalties or patents.
Deducting the noncash operating expenses gives us operating income (or operating profit), also called the profit before interest and taxes. Nonoperating income and expense are subtracted next. When an enterprise will receive interest payments, as is the case of the South Nyanza example, it is convenient to include interest received at this point, so that all interest transactions will appear at one point in the income statement. Interest received is thus shown as a "negative expense." In most enterprises, interest paid is among the most important nonoperating income and expense items. Duties and indirect taxes are also included among the nonoperating income and expenses unless they have been allowed for elsewhere. Duties, for instance, may appropriately be included among the expenses. In the South Nyanza example, duties on imported machinery were included in the purchase price of the machinery and thus were not shown separately under this entry. Indirect taxes also may not appear separately in income statements. In the South Nyanza example, we noted earlier that sales taxes were deducted before entering the sale revenues in accord with normal practice. In effect, the enterprise is simply acting on behalf of the government when it collects a sales tax, and the amount of the tax does not enter the income statement. In the South Nyanza example, the excise tax on molasses also was not shown separately but is properly included as part of the expenses. Among the indirect taxes that might be shown are franchise taxes and a value added tax-a tax levied as a proportion of the increased value generated at each stage in the processing and handling of a product up to the final sale. Finally appear subsidies. Again, subsidies may not appear at this point in the income statement. They may be incorporated elsewhere (for example, in the price that an enterprise pays for a subsidized input), or they may be shown as a revenue (as in the case of export incentive payments).
Thus we reach income (profit) before income taxes. Now, deducting the income taxes, we obtain the final entry, the net income (profit) after taxes. This is the return to the owners of the enterprise and is available either for distribution to them or for reinvestment in the enterprise.
Financial accounts must be linked to all other accounts. As the accountants put it, accounts must be "articulated." We noted that the funds from operations in the income statement becomes the first element in the sources-and-uses-of-funds statement. The income statement is also a bridge between successive balance sheets. The net income, after payment of dividends to shareholders, is transferred to the balance sheet as retained earnings and thereby increases the owners' equity. To trace this transaction, a reconciliation statement, such as a retained earnings statement, would be required to show any distribution of earnings as dividends before the retained earnings are added to the owners' equity in the balance sheet. In the South Nyanza example, it was assumed that all earnings would be retained by the enterprise throughout the sixteen years for which the projected accounts were prepared. Looking at years 9 and 10 reproduced in tables 5-1 and 5-2, we can see the articulation between the balance sheet and the income statement. The net income in year 10 given in the income statement in table 5-2 is KSh53,890 thousand. Adding this amount to the retained earnings at the end of year 9, shown in the projected balance sheets in table 5-1 to be -KSh43,355 thousand, gives a retained earnings in year 10 of KSh10,535 thousand ( -43,355 + 53,890 = 10,535). Table 5-3 shows projected retained earn-ings statements for the South Nyanza example. Reconciliation accounts are uncommon for government-owned operating entities that retain all earnings in the enterprise.
Sources-and-Uses-of-Funds Statement
The sources-and-uses-of-funds statement highlights the movements of investment funds over the life of the project. It is a vehicle for measuring the total flow of financial resources into and out of an enterprise during an accounting period and for projecting this total flow into the future. The sources-and-uses-of-funds statement is also called the sources-and-applications-of-funds statement, the funds statement, the statement of change in working capital, or sometimes simply the cash flow, since the flow of funds is reflected in the final analysis by changes in the cash position of an enterprise. This accounting definition of cash flow, however, differs from that used in project analysis to measure the return on the resources engaged in the project.
The most common sources of funds are outlined in the first part of table 5-4. The first of these is funds from operations (or the operating income before depreciation). When the accounts are laid out following the pattern given here, this can be taken directly from the income statement as illustrated in the South Nyanza example. Often, however, the funds from operations does not show as a separate item in a set of accounts and will have to be constructed by adding depreciation and other noncash charges back to the operating income.
To the funds from operations are added the increase in equity, the long-term loans received, and the increase (decrease) in short-term loans. In the South Nyanza example, equity and loans come from a wide variety of sources. The government of Kenya contributes part of the equity financing that, in turn, it is to obtain from the proceeds of a World Bank loan, and part of the equity comes from a private firm. Long-term loans come from a variety of international financing institutions and from suppliers' credits. The capital structure of the firm is such that it does not need short-term loans in the years we have chosen as illustrative examples,
Source: Same as table 5-2.but in many agricultural processing enterprises short-term loans would be needed to enable the enterprise to carry inventories of raw materials purchased at harvest time and stocks of processed goods that will be sold during the year.
Interest received is the next source of funds; in the South Nyanza example, it comes from short-term loans made to outgrowers. The increase (decrease) in accounts payable and other short-term liabilities (except current portion of long-term loans received) follows. An enterprise might obtain part of its funds by increasing the amounts purchased on terms from its suppliers or by postponing payment to its suppliers. If it reduces the amount purchased on terms or the average time it takes to pay its suppliers from one year to the next, this would cause a decrease in accounts payable and a reduction of the funds available. Because we are looking, in general, at an expanding firm that will be increasing its accounts payable in the normal course of widening the scope of operations under the project, an increase in accounts payable will usually be found in the sources-and-uses-of-funds statement. When a decrease occurs, however, it is convenient to enter it as a "negative source" in the accounts rather than as an additional line among the uses of funds. In some agricultural projects, the processing enterprise may be expected to operate at a loss to increase the income of farmers. If so, the firm may expect direct subsidies to be one source of its funds.
Among the major uses of funds (second part of table 5-4) in the projected sources-and-uses-of-funds statements for a project with an expanding processing enterprise will likely be the increase (decrease) in gross fixed assets. This item shows the investment in fixed assets during each year; in the South Nyanza example, this is principally investment in new milling capacity. In other cases an enterprise may decrease fixed assets by selling them. If this transaction exceeds the purchase of fixed assets, the net result would most easily be shown as a "negative use" among the uses of funds rather than as a separate entry for the proceeds from the sales of fixed assets among the sources of funds.
A major item in the projected sources-and-uses-of-funds statements for an enterprise included in an agricultural project will most likely be repayment of long-term loans. (Recall that among the sources of funds shown is the increase or decrease in short-term loans. Since this is shown on a net basis, there is no need for a separate entry among the uses of funds for repayment of short-term loans.) Only the principal repayment is included under the repayment of long-term loans. Interest payments on long-term loans and interest payments on short-term loans are segregated and shown separately. (In the South Nyanza example, the analyst assumed that the repayment of the short-term loans, shown as a decrease in short-term loans among the sources of funds, would be made at the very beginning of the accounting period; hence, there is no short-term interest shown in the account for year 9.) An enterprise that has borrowed for expansion, such as the South Nyanza Sugar Company, may have to pay loan commitment fees for undisbursed amounts of loans that have been made to it.
The increase (decrease) in inventories shows the change in the inventory position of the enterprise. Because most projected accounts are for expanding enterprises, it is likely that this entry will reflect an increase in inventories; the entry is therefore included among the uses of funds. Sometimes, however, there may be a decrease in inventories. Rather than have an additional line under sources of funds, it is convenient to treat a reduction in inventory as a negative use. In the South Nyanza example, the major inventory is the standing cane crop on the nucleus
Source: Same as table 5-1 (annex 20, table 13).a. Includes investment in the factory, agriculture, administration, housing, and company-related research.b. Includes spare parts, tools, and operating materials.
plantation. As indicated in table 5-4, this inventory does decrease during years 9 through 11-thus it is shown as a negative entry in the account. The increase (decrease) in accounts receivable appears next. If a firm is expanding, it will likely be extending credit to an increasing number of customers, and its accounts receivable will expand. But if it is able to reduce the average length between delivery and payment or be more restrictive in extending credit, its accounts receivable may decrease during the year and be shown as a negative use. The increase (decrease) in other short-term assets except cash would allow for changes in holdings of such short-term assets as notes, certificates of deposit, or treasury bills.
Income taxes paid are an obvious use of funds for an enterprise, and there may be dividends paid by the enterprise to its equity owners.
Finally, an entry for adjustments for items not covered above comprises those items that for various reasons do not fit well into one of the pattern categories. Any items of substance in this entry should be fully disclosed in footnotes to the accounts.
What remains is the net funds flow, of which the first element is the current surplus (deficit). Adding the opening cash balance to the surplus or deficit gives the cumulative surplus (deficit). If the projected accounts indicate a cumulative cash deficit-a deficiency of funds-then some arrangements will have to be made to sustain the enterprise during this period. It may be necessary to reduce planned dividends, arrange for additional loans or equity, or in some other way plan to provide the necessary funds.
Projecting the sources-and-uses-of-funds statements enables the analyst to be certain that the available financing for the enterprise will be sufficient to cover the investment program-including increases in inventories, other permanent working capital, and all cash expenditures for operations-and to cover obligations of interest and the principal repayment on all outstanding loans. Projecting the sources-and-uses-of-funds statements year by year makes it possible to check the timing of inflows from various sources to be certain that these inflows will be available as the need arises. Credit agencies can assess the total flow of funds from operations before debt service to determine how adequately the debt service is covered. Owners will be looking at the projected flow of funds after debt service to judge what their returns will be. For private investors, the funds generated after debt service and the projected dividends will be important elements in their decisions about whether to participate in the project.
Financial Ratios
From the projected financial statements for an enterprise, the financial analyst is able to calculate financial ratios that allow him to form a judgment about the efficiency of the enterprise, its return on key aggregates, and its creditworthiness. We will discuss several of the most significant of these ratios, but there are many others that financial analysts use and that are particularly appropriate for specific kinds of enterprises. For each ratio we will discuss, the means of computation is summarized in table 5-5. Two examples of the application of the ratios are given in the table, based on years 10 and 11 of the South Nyanza Sugar Company accounts reproduced in tables 5-1, 5-2, and 5-4.
In general, it is not possible to give ranges within which financial ratios should fall. Instead, the analyst will have to form a judgment about whether the ratio indicates an acceptable situation for the kind of enterprise that is the subject of the projected accounts. For more information about the use of financial ratios, the project analyst may consult a standard accounting text or Upper (1979), from which this discussion draws heavily.
The ratios given here have all been computed using the figures at the end of each year. This weights the analysis toward the last months of operations; as long as clarity and consistency are maintained, this usually poses no problem. If the activities of an enterprise are highly seasonal, as is often the case in agricultural projects, calculating the ratios on a year-end basis could easily be misleading. In that instance, the analyst may want to examine the pattern of seasonal fluctuations within the accounting period and make a judgment about whether the seasonal variation would affect his conclusions about the efficiency, return, or creditworthiness of the proposed enterprise.
Efficiency ratios
The first group of ratios (first part of table 5-5) enables the analyst to form a judgment about the efficiency of the proposed enterprise. They provide measurements of asset use and expense control.
Inventory turnover measures the number of times that an enterprise turns over its stock each year and indicates the amount of inventory required to support a given level of sales. The ratio can be computed in several ways. In the form given here, the cost of goods sold is divided by the inventory. In the South Nyanza example in table 5-5, for year 10 this amounts to 3.94 times a year. In agricultural processing industries, this ratio may be low compared with that of many manufacturing enterprises; this lower ratio reflects the highly seasonal nature of agricultural processing. The inventory turnover can also relate to the average length of time a firm keeps its inventory on hand. In the South Nyanza example, the firm has about ninety-three days of inventory on hand at the end of year 10. We determine this by dividing the days in the year by the inventory turnover ratio (365 _ 3.94 = 93). We could also state this in months-the firm has about three months of inventory on hand-by dividing the months of the year by the inventory turnover ratio (123.94 = 3). A low turnover ratio may mean that a company with large stocks on hand may find it difficult to sell its product, and this may be an indicator that the management is not able to control its inventory effectively. A low turnover ratio may, however, also mean that large stocks must be held to ensure that production schedules are met. A low ratio means a sizeable amount of funds are tied up. A high turnover ratio may mean that the enterprise is able to recover its inventory investment rapidly and that there is a good demand for its products. On the one hand, when the ratio is much higher than the industry average, it may mean that the enterprise is very efficient in managing its inventories. On the other hand, it may mean that the enterprise is starved of funds and cannot afford to maintain a sufficient inventory; as a result, it may be forced to forgo sales opportunities.
The operating ratio is obtained by dividing the operating expenses by
the revenue. In the South Nyanza example, for year 10 the operating ratio is 71 percent. The operating ratio is an indicator of the ability of the management to control operating costs, including administrative expenses. This ratio is most useful when operations of the same enterprise are compared year by year or when the enterprise is compared with similar industries. If the ratio is increasing, it may mean that the cost of raw materials is increasing, that the management is having problems controlling labor costs, that there is waste in the production process, or, when sales decline, that expenses have not been trimmed proportionately. It may also mean that there is substantial competition and that it is necessary to reduce prices. If there is uncertainty about whether the increase in the ratio is due to increasing costs or decreasing sales prices, the answer can usually be found by taking the operating expenses and dividing that by the company sales volume on a unit basis (for instance, the number of tons of refined sugar sold in the South Nyanza example). In general, the larger the capital investment is relative to sales volume, the lower will be the operating ratio. If a company has made a large investment, it must be able to recover it with a high cash flow, which can only be accomplished generally through a low operating ratio. If an enterprise has a high operating ratio, say in the neighborhood of 90 percent, it may have difficulty making an adequate return. If it is abnormally low, say 50 percent, then some costs have likely been omitted or underestimated.
Income ratios
The long-term financial viability of an enterprise depends on the funds it can generate for reinvestment and growth and on its ability to provide a satisfactory return on investment. We will look at three ratios (second part of table 5-5) that can be used to judge net income or profitability-return on sales, return on equity, and return on assets. Because of their importance in project analysis and because they are somewhat more difficult to calculate, we will defer to the next section consideration of three other income measures-the rate of return on all resources engaged, the rate of return on equity before income taxes, and the rate of return on equity after taxes.
Income ratios are calculated on a year-to-year basis and may be noted in the projected statements for an enterprise. That will provide some idea of the changing income ratios over the life of the project. If a company is granted a tax holiday for the first years of its operations, it is necessary to forecast its accounts through the end of the tax holiday period to determine the full effect of taxes on the company.
The return on sales shows how large an operating margin the enterprise has on its sales. This is determined by dividing the net income by the revenue. In the South Nyanza example, the return on sales in year 10 is 21 percent. The lower the return on sales-hence, the operating margin-the greater the sales that must be made to make an adequate return on investment. The ratio is most useful when comparing companies in the same sector or industry or when analyzing the results of past operations and comparing projections for future expansions. Comparisons among industries may have little meaning because of the widely varying structure of different industries.
One of the most important ratios is the return on equity. It is obtained by dividing the net income after taxes by the equity. In the South Nyanza example, for year 10 this is 26 percent. This ratio is frequently used because it is one of the main criteria by which owners are guided in their investment decisions. It can also be used to weigh incentives for individual owners if the enterprise is to be in the private sector.
The earning power of the assets of an enterprise is vital to its success. A principal means of judging this is to determine the return on assets, which is the operating income divided by the assets. In the South Nyanza example for year 10, this is 20 percent. The return on assets is the financial ratio that comes closest to the rate of return on all resources engaged (for more detail, see the next section). A crude rule of thumb is that, once the enterprise is operating at normal capacity, the return on assets should exceed the cost of capital in the society as measured by, say, the bank lending rate to industries-provided that there is no interest subsidy. Public sector enterprises usually should also be able to realize a return of this order, since if they do not, it is evidence that public funds would be better employed in other enterprises.
Creditworthiness ratios
The purpose of creditworthiness ratios (final part of table 5-5) is to enable a judgment about the degree of financial risk inherent in the enterprise before undertaking a project. They are also a basis for the project analyst to estimate what financing an enterprise will need and what will be suitable terms. Some firms, especially those in the private sector, attempt to finance their projects with as much debt as possible so they may realize maximum return on their own equity contribution. This can be risky, especially in an unstable industry or in an economy subject to substantial business cycles. An enterprise should be financed in such a way that it is able to survive adverse circumstances without emergency measures.
The current ratio is the current assets divided by the current liabilities. In the South Nyanza example, for year 10 the ratio is 4.41. From the standpoint of the credit agency, the current ratio is an indication of the margin that the enterprise has for its current assets to shrink in value before it faces difficulty in meeting its current obligations. In the South Nyanza example, in year 10-even if the current assets are worth only one-fourth the value given in the accounts-the sugar mill could still pay its creditors from these assets.
A rule of thumb sometimes applied to the current ratio is that it should be around 2. As with all rules of thumb, this figure should be used with caution. If the company has a rapid inventory turnover and can easily collect its receivables, the current ratio can be lower. If the ratio drops to near 1, then the enterprise will be in a potentially unstable position. If the ratio is low, it may mean that the enterprise is undercapitalized, and consideration will have to be given to providing more capital, either through increased equity or more long-term debt. Faced with a low current ratio, an enterprise will have to exist on a day-to-day basis, and thus it may have to adopt uneconomic practices. Its products may have to be sold at lower prices to receive payment in cash, or it may lose sales to competitors that can offer better credit terms. It may not be able to carry sufficient inventories to meet its sales needs. Inventories of raw material may be so low that its production efficiency is impaired. It may have to buy from importers in high-cost, small lots instead of buying large, low-priced shipments of inputs direct from overseas suppliers, and it may be forced to buy on credit instead of being able to take advantage of cash discounts. With a low current ratio, an enterprise may be forced to defer preventive maintenance, and this drives up costs later.
An important financial ratio for credit agencies is the debt-equity ratio. The amount of equity in an enterprise can be described as a "cushion" by which a company can absorb initial losses or weather bad times. Because debt carries a fixed rate of interest and fixed repayment of principal, too much debt may saddle a company with obligations it cannot meet when conditions are unfavorable. (A better measure of the cushion is the debt service coverage ratio, discussed below.)
The debt-equity ratio is calculated by dividing long-term liabilities by the sum of long-term liabilities plus equity to obtain the proportion that long-term liabilities are to total debt and equity, and then by dividing equity by the sum of the long-term liabilities plus equity to obtain the proportion that equity is of the total debt and equity. These are then compared in the form of a ratio. In the case of the South Nyanza example, for year 10 the long-term liabilities divided by the sum of the long-term liabilities plus the equity is 0.40. The equity divided by the sum of the long-term liabilities plus equity is 0.60. The debt-equity ratio, therefore, is 40 to 60. This may be interpreted as saying that, of the total capitalization in the enterprise, 40 percent is debt and 60 percent is equity. There is no good rule of thumb for the debt-equity ratio. In newly established enterprises, equity ideally should exceed the debt, but in many developing countries equity capital may be scarce, and such a conservative rule may not be sensible given the national objectives. If the enterprise is in the public sector, with a high proportion of the debt held by public sector agencies, the debt-equity ratio may lose some of its importance because of the presumption that, if the company falls on hard times, it will be possible to renegotiate some portion of the debt held by public agencies. In agricultural projects, enterprises are likely to need a strong equity base because they process or sell commodities that may sharply fluctuate in price and that are subject to adverse weather conditions or a fall in crop or livestock production.
The most comprehensive ratio of creditworthiness is the debt service coverage ratio. This is the net income plus depreciation plus interest paid divided by interest paid plus repayment of long-term loans. In the case of the South Nyanza example, for year 10 the debt service coverage ratio is 2.23.
The debt service coverage ratio could also be calculated on a before-tax basis, in which case it is simply the funds from operations divided by the interest plus repayment of long-term loans. In the case of the South Nyanza example, for year 10 (not shown in table 5-5) this would be 2.30 [117,078 _ (17,008 + 33,796) = 2.30]. Financial analysts who use the after-tax basis argue that taxation is a routine and unavoidable aspect of doing business. But analysts who prefer the before-tax basis argue that debt service coverage should be seen as the ability of funds from operations to satisfy debt obligations before such tax shields as depreciation and other noncash charges are applied to reduce taxable profits. The viewpoint of the analyst will be affected by whether the company is in the public or private sector.
Again, it is hard to give a rule of thumb for the debt service coverage ratio. One way of looking at it is that, in the case of the South Nyanza Sugar Company in year 10, the net income plus depreciation plus interest paid could drop by half and the enterprise could still meet its debt obligations. The analyst would have to look at each of the elements making up the ratio and form a judgment about how likely it is that any element could vary from the projected amount. A declining trend in the debt service coverage ratio in a projected account might indicate overly ambitious expansion. A persistently low debt service coverage ratio might indicate that consideration should be given to changing the credit terms to lengthen the repayment period.
The debt service coverage ratio interpreted alone can be misleading. There are many requirements that a successful enterprise must satisfy in addition to simply covering its debt service obligations. A full analysis of the sources and uses of funds for the enterprise is needed. The true buffer for debt service is only the pool of funds remaining after meeting all requirements for maintenance and improvement of current operations and orderly expansion.
Financial Rate of Return
A useful financial measure that is very important in project analysis is the financial rate of return. We will discuss three variations that differ only in the standpoint from which the calculations are made-the financial rate of return to all resources engaged, the financial rate of return to equity, and the financial rate of return to equity after taxes.
Calculations of rates of return are based on an incremental net benefit flow. This is the "cash flow" that is meant by references to discounted cash flow measures of project worth such as the net present worth, the internal rate of return, or the net benefit-investment ratio (all are discussed in detail in chapters 9 and 10). In this section we will discuss only derivation of the incremental net benefit; the discussion of discounting and of the measures based on incremental net benefit flows will be found in chapter 9.
In rate of return calculations we want to determine the actual cash inflows and outflows of the project each year and incorporate them in the incremental net benefit. Noncash receipts and expenditures are omitted (except for items in kind such as those we discussed in chapter 4 in connection with the farm budgets). Thus, the year an investment is made it reduces the net benefit for that year; when a revenue is realized, it too is reflected in the same year it is received. Because we are preparing the projected accounts over the life of the project, it is unnecessary to include depreciation (which is the major noncash expenditure in most accounts) to allow on an annual basis for the capital value consumed during the year.
From the projected income statements and sources-and-uses-of-funds statements for an enterprise as we have laid them out, we can determine the incremental net benefit streams we need to calculate the financial rate of return. The general format is given in table 5-6 and is illustrated by the South Nyanza Sugar Project accounts examined in tables 5-2 and 5-4. All the relevant entries are included in table 5-6 for illustrative purposes, even if the South Nyanza example did not use a particular entry. The entries appear in the order they are found when consulting
Source: Tables 5-2 and 5-4.a. Calculated from the incremental net benefit before financing. For details about methodology of the computation, see chapter 9.b. Calculated from the incremental net benefit after financing.c. Calculated from the incremental net benefit after financing and taxes.
the first the income statements and then the sources-and-uses-of-funds state-ments. Only the rate of return is usually reported. Were the table itself to be used in a project report, it might be desirable to group the entries so that related items are not separated.
The first financial rate of return to be determined is the financial rate o f return to all resources engaged, which is a measurement of the financial viability of an enterprise. It is based on the incremental net benefit before financing. In the South Nyanza example, the rate of return to all resources engaged, assuming a thirty-year life for the project, is 14 percent. When all the elements that enter into the derivation of the incremental net benefit before financing are revalued to reflect economic values (as discussed in chapter 7) and any transfer payments are taken out, the incremental net benefit before financing becomes the basis for aggregating the net economic benefit from the enterprise and carrying it into the economic accounts for the project.
To obtain the incremental net benefit before financing, we begin with the revenue and direct subsidies received; these are taken from the income statements, which total to give the total inflow. The first two entries among the outflows are the cash operating expenses and the selling, general, and administrative expenses, also taken from the income statements. (At this point, if there were no direct subsidies, we would have the funds from operations; an alternative calculation of financial rates of return would therefore be to begin with the funds from operations, add any direct subsidies, and deduct any of the other elements of the outflow that are relevant.) Continuing with the outflow entries, we add duties and indirect taxes as shown in the income statements and add or subtract, as appropriate, the increase (decrease) in gross fixed assets and the increase (decrease) in inventories as shown in the sources-and-uses-of-funds statements. The result is the total outflow. Subtracting the total outflow from the total inflow provides the total net benefit before financing. Subtracting what would be the net benefit without the project (which, in the South Nyanza example, is nothing), we now reach the incremental net benefit before financing.
The financial rate of return to equity before income taxes will be an important consideration to any potential private investors. It is also of concern if the enterprise is to be a financially responsible public sector enterprise that must demonstrate the good use it makes of resources put at its disposal. The return to equity before income taxes will help the project analyst judge the attractiveness of the proposed enterprise to potential investors and to determine if the financing plan will give rise to undue windfall profits. It may also help in deciding what special tax holiday or other exemption may be justified. For the South Nyanza example, the return on equity before income taxes is 16 percent. To determine the return to equity before income taxes, we need to calculate the incremental net benefit after financing, and to reach this we add or subtract the financing elements shown in the sources-and-uses-of-funds statements, indicating the sign in the account as we proceed. Note the inclusion of accounts payable and accounts receivable as part of the financing. Because a decrease in accounts receivable increases the funds available to the enterprise, it is decreases that are added to obtain the net financing. The heading on these entries has been reversed from that in the sources-and-uses-of-funds statements to indicate that decreases are to be added and increases subtracted. Finding the algebraic total gives the net financing, and subtracting that from the net benefit before financing gives the total net benefit after financing. Subtracting the without-project net benefit after financing (in this case, nothing), we reach the incremental net benefit after financing.
Finally, we determine the financial rate of return to equity after taxes, which is based on the incremental net benefit after financing and taxes. For the South Nyanza example, it is 13 percent. To determine the incremental net benefit after financing and taxes, we deduct income taxes from the net benefit after financing and subtract the without-project amount (in this case, nothing). This is the flow that will accrue to the equity owners after the enterprise has met its tax obligation. It is, of course, this flow that is of most concern to potential investors, and so the rate of return to equity after taxes is an important measure on which to base judgments about the incentives to invest in an enterprise.
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