Capital Budgeting: Evaluating Investments for Long-Term Returns

Introduction

Welcome to the course on economics and finance taught by Sriram Chundi. In this comprehensive video course, Sriram combines theory with practical insights to provide you with a solid foundation in the world of finance and economics. Whether you're looking to make smarter investment decisions or understand the intricacies of global economies, this course has got you covered.

Sriram Chundi is an expert in the field of economics and finance with years of experience. He has taught this course in person and has now put together an excellent video course that covers a variety of topics. Sriram's expertise in economics and finance makes him the perfect instructor for this course.

Throughout this course, you will learn key concepts for business, capital markets, valuation of stocks, business strategies, financial statements, and more. Sriram will guide you through the analysis of financial statements, capital budgeting, cash flow, and the business cycle. You will also gain an understanding of macroeconomics, portfolio diversification, and alternative investment types.

One additional resource that Sriram provides is his YouTube channel, Changemakers Media. On this channel, Sriram shares stories about how teens are making an impact in the world and how you can support them.

Understanding financial statements

Financial statements are crucial tools for understanding and evaluating a company's financial performance. The three main types of financial statements are the income statement, the balance sheet, and the cash flow forecast. Each statement serves a specific purpose and provides valuable insights into a company's financial health.

Income Statement

The income statement, also known as the profit and loss statement, shows a company's revenues, expenses, and net income over a specific period. It highlights the company's profitability and its ability to generate revenue. By analysing the income statement, investors and stakeholders can assess a company's overall financial performance.

Balance Sheet

The balance sheet provides a snapshot of a company's financial position at a specific point in time. It shows a company's assets, liabilities, and shareholders' equity. The balance sheet is essential for understanding a company's liquidity, solvency, and overall financial stability. It helps investors and stakeholders assess the company's ability to meet its financial obligations and manage its resources effectively.

Cash Flow Forecast

The cash flow forecast predicts a company's future cash inflows and outflows. It shows the sources and uses of cash over a specific period, helping companies anticipate their cash needs and plan for future investments or expenses. The cash flow forecast is crucial for managing working capital and ensuring the company has sufficient funds to operate effectively.

Importance of Transparency and Reporting

Transparency and reporting are vital for publicly traded companies. By providing accurate and timely financial statements, companies demonstrate their commitment to transparency and accountability. It allows investors and stakeholders to make informed decisions and evaluate the company's financial health. Transparent reporting also enhances trust and confidence in the company's management.

Purpose and Significance of Financial Statements

Each financial statement serves a specific purpose and provides valuable information for decision-making:

• The income statement helps assess a company's profitability and revenue generation.

• The balance sheet provides insights into a company's financial position and overall stability.

• The cash flow forecast enables companies to plan for future cash needs and manage working capital effectively.

Calculation of Key Ratios

Financial ratios are important tools for evaluating a company's profitability and liquidity. Two key ratios for profitability and liquidity are:

• Profitability ratio: This measure measures a company's ability to generate profits relative to its costs and expenses. Key profitability ratios include gross profit margin, net profit margin, return on assets, and return on equity.

• Liquidity ratio: assesses a company's ability to meet short-term financial obligations. Common liquidity ratios include the current ratio and the quick ratio.

These ratios provide valuable insights into a company's financial performance and help investors and stakeholders make informed decisions.

Analysing Financial Statements

Analysing financial statements is a crucial step in understanding a company's financial health and performance. It involves evaluating various ratios and trends to gain insights into its profitability, liquidity, activity, and leverage. Let's explore some key concepts in analysing financial statements:

Introduction to Ratio Analysis

Ratio analysis is a method of analysing financial statements by calculating and comparing specific ratios. It helps to gauge a company's financial performance and make informed decisions. Ratios provide a standardised way of measuring and evaluating different aspects of a company's financial health.

Explanation of Profitability, Liquidity, Activity, and Leverage Ratios

Profitability ratios measure a company's ability to generate profits relative to its costs and expenses. They include ratios such as gross profit margin, net profit margin, return on assets, and return on equity. Liquidity ratios assess a company's ability to meet short-term financial obligations. Common liquidity ratios include the current ratio and the quick ratio.

Activity ratios evaluate a company's efficiency in using its assets to generate revenue. They include ratios such as inventory turnover and the average collection period. Leverage ratios analyse a company's use of debt to finance its operations and measure its financial leverage. Examples include the debt-to-equity ratio and the interest coverage ratio.

Importance of Comparing Ratios Within the Same Industry

Comparing ratios within the same industry is essential because different industries have different benchmarks and norms. What may be considered a good ratio in one industry may not be the same in another. By comparing ratios within the same industry, you can gain a better understanding of a company's performance relative to its peers and industry standards.

Utilising Horizontal Analysis and Common Size Analysis for Trend Analysis

Horizontal analysis, also known as trend analysis, involves comparing financial data over multiple periods to identify trends and changes. It helps to assess a company's growth and performance over time. Common size analysis is a technique that expresses each line item in a financial statement as a percentage of a base figure. It allows for a better comparison of different items within the same financial statement and helps identify trends and patterns.

Both horizontal analysis and common size analysis are valuable tools for trend analysis and can provide valuable insights into a company's financial performance and future prospects.

Capital Budgeting

Capital budgeting is a crucial process in evaluating and selecting long-term investment projects for businesses and individuals. It involves assessing the potential returns and benefits of significant financial outlays over an extended period. This process helps allocate financial resources effectively, maximising the value of investments and minimising the risk of poor choices.

There are several key reasons why capital budgeting is important:

• Resource Allocation: Capital budgeting helps businesses determine which projects are worth pursuing based on their potential to generate returns. It ensures that financial resources are focused on the most promising investments.

• Long-Term Planning: By considering the long-term impact of investments, capital budgeting allows businesses to plan for the future and manage risk while maximising returns.

• Time Value of Money: Capital budgeting takes into account the time value of money, recognising that a dollar today is worth more than a dollar in the future. This ensures that cash flow predictions are properly discounted.

When considering investment projects, companies can fund them through three primary means: cash flow, debt, or equity. Each method has its own implications and considerations, and it's important for businesses to carefully evaluate the most suitable funding option for each project.

Methods of Evaluating Investment Projects

There are several methods for evaluating investment projects within the framework of capital budgeting:

• Payback Period: The payback period measures the length of time it takes for a company to recoup its initial investment through cash flows generated by the project. It provides a basic assessment of an investment's liquidity and risk.

• Net Present Value (NPV): NPV calculates the present value of an investment's cash inflows and outflows, taking into account the time value of money. If the NPV is positive, it indicates that the investment is expected to generate returns above the required rate of return.

• Internal Rate of Return (IRR): The IRR is the annual growth rate that an investment is expected to generate. It helps assess the profitability of an investment and is compared to the required rate of return. If the IRR exceeds the required rate of return, the investment is considered favourable.

Consideration of cash flows and working capital is also an important aspect of capital budgeting. Cash flows associated with an investment project, both inflows and outflows, must be carefully analysed to ensure accurate forecasting and financial planning. Additionally, changes in working capital should be considered, as they can impact a company's liquidity and cash reserves.