How does an entrepreneur find out whether his business project will succeed financially? To answer this question, the business plan requires evaluation by financial and marketing specialists.
Alternatively, preliminary evaluation of business plan could be done by entrepreneur himself. If basic checks show negative results, the entrepreneur may tweak his business plan and evaluate it again or pursue other business ideas.
What elements requires evaluation?
The business elements that an entrepreneur should evaluate to know viability of his business are:
- Capital and operating cost requirement;
- Net Cash flow;
- Breakeven sales;
- Net Present Value and;
- Potential problems.
How to evaluate these elements?
Capital and operating cost: First and fore most ensure all possible items are considered while estimating capital expenses and recurring operating costs. Be conservative in your estimation. Identify the events that may escalate the costs. Now review the estimates by asking questions.
How will be the capital sourced? What is the interest rate if borrowed? How will be the escalated cost funded?
Net Cash Flow: Prepare monthly net cash flow for 24 months. Net cash flow for a month is the sum of all incomes (sale revenue, borrowed money, miscellaneous receipts etc.) in that month minus sum of all payments (raw material, salary, rent, utility, loan repayment, govt. fee etc.) in that month.
Net Cash Flow in Month X = Sum of All Income in Month X – Sum of All Payments in Month X
How many months will have negative cash flows? How do I fund the negative cash flow period? Am I willing to wait though the negative cash flow period to reach the positive cash flow or profitable period?
Breakeven Sales: Breakeven Sales quantity tells the minimum number of units that must be sold in a month or year to balance the costs with revenue.
At Breakeven point, Cost For Production – Revenue From Sale = 0
When sales in a month or year is below breakeven point the business will have loss and when sales are above breakeven point the business will have profits.
Estimation of breakeven point requires iteration; so it is easier when the templates available in MS Excel is used.
Are there enough customers or market size to exceed breakeven sales? How much production capacity is required to exceed breakeven sales?
Net Present Value: NPV tells you whether it is financially sensible to invest in particular business. If NPV is more than 0 then that the business is profitable. Also, NPVs of different business plans can be compared to find out which would be more profitable.
Steps for calculating NPV is given here. Alternatively, one can use the templates available in MS Excel .
Step 1: Estimate annual net cash flow (ANCF) for each year over project life. Say for 5 or 10 years.
Step 2: Find out the profit rate (D) from other lower risk use of the capital. Example: If the capital is deposited with bank, instead of investing in business, then profit rate will be 3 %. i.e. D = 3% = 0.03
Step 3: Estimate the Present Value (PV) of net cash flow in each year over project life.
PV First Year = ANCF ÷ (1 + D) 1 , PV Second Year = ANCF ÷ (1 + D) 2, PV T4hird Year = ANCF ÷ ( 1 + D) 3
Step 4: To get NPV, add all PVs and minus the initial investment.
NPV = PV First Year + PV Second Year + PV Third Year etc. – Initial Investment
What can be done to improve NPV? Are there other business opportunities with better NPV?
What if Analysis: It is important for the entrepreneur to ask himself questions on possible undesirable scenarios and identify his strategy to overcome them. These questions could be framed in ‘What If An Event Happen’ format. Some examples are:
What if a competitor opens shop in same area?
What if Government implements new rules?
What if an employee leaves or falls sick?
What if the rent increase steeply in second year?
What if the internet platform, that the business is depending on shuts down or lose popularity?
With some patience and basic MS Excel skills any entrepreneur can evaluate his business plans himself. Moreover, it is necessary for every entrepreneur to have the skills to conduct above evaluation to have proper control and understanding of his business.
MS Excel have readymade formulas and templates to calculate net cash flow, net present value and breakeven sales.
All The Best.
Article by Mr. Sumesh Soman for First Business Mate