Financial Analysis of Business Idea (Overview)
How to evaluate a business idea based upon finances
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What is Financial Analysis of a Business Idea?
This part of the feasibility analysis involves evaluating the potential profitability of the venture. That is, does the proposed business have the potential to return sufficient revenue in excess of costs so that it is financially feasible? So lets take a look at the information you have and the information you will need.
- Within the market analysis portion you acquired sufficient information to estimate the potential revenue from creating a business around your idea.
- The operational analysis provided you with an understanding of the resources required to undertake the business venture.
- In this section you will need to determine the costs associated with operations and compare those against the expected revenue.
If the venture produces a sufficient level of revenue as compared to the operational costs, then the idea may be feasible.
The Analysis Depends Upon Your Intentions?
Many intended business owners, when evaluating the financial possibility for a business idea, evaluate if or how soon a business will produce a profit and how much of a profit. This approach make sense for the lifestyle business owner. She is looking for a business that will provide continued annual earnings and will support her lifestyle.
Startup entrepreneurs evaluate a potential startup venture differently. Note, the last sentence of the introductory paragraph. I write that the business must produce a sufficient level of revenue as compared to the operational costs, rather than, must produce a profit. The reason for this goes back to our initial definition of a startup venture. Remember, startup entrepreneurs (as well as outside equity investors) seek to make money through an exit event (such as selling the business or the equity interest in the business) at a future date. She does not want to report a profit in the early stages of the business if this money would help the business grow more quickly if reinvested in the business. Generally, a business cannot grow to its potential and turn profitable in such a short period of time. For this reason, startup ventures typically report significant losses during the initial stages of operation. The key metric that the entrepreneur must evaluate is whether, once the business has reached its growth plain, will the revenues exceed the costs of operation by a sufficient amount to justify the effort and risk involved in undertaking the venture?
In summary, the entrepreneur must evaluate the potential of the business at later stages of development (devised from the marketing plan) against the costs of operations at different stages of business growth (devised from the operations plan). If the comparison reveals the opportunity to create a business with significant growth potential that outpaces the rise in costs that accompanies such growth, then the idea may be a feasible business opportunity.
How to Financially Analyze an Idea
At this stage, the procedure for analyzing the potential of the idea various with individual entrepreneur and the type or amount of value desired. Below are some general instructions for developing the necessary information.
- Return to the market analysis and calculate the market size.
- Note: This will require using the calculations determining the total revenue generated in the market.
- Provide conservative projections for revenue produced by acquiring a given percentage of the potential target market.
- Note: You will want to determine the immediate addressable market. Be conservative in estimating the size of the market available to you within a given time frame. Here you are assuming that you can acquire some percentage (or fraction of a percentage) of the addressable market. For example, if within the first year you grab 1% of $1,000,000 potential market, then you have $10,000 of revenue.
- Extend these projections out to five years.
- Note: Assuming that your business idea has a given growth target, make projections about the market and your acquired market percentage for a five year period. You may want to break down the early periods quarterly. This is important when determining whether there will be sufficient revenue to sustain operations and growth during the early phases of business development.
- Return to the operational analysis and ascribe costs of to each area of operations.
Note: With a bit of research, determining the cost for most of the equipment, personnel, and other expenses. Two aspects of calculating a dollar value for costs is difficult:
- projecting costs of growth, and
- including the costs associated with available sources of funding.
Growth paths are speculative and often give rise to largely unforeseen expenses. Funding costs are difficult because you cannot assume that identified funding options and terms will be available. Here are some tips for calculating costs:
- Increase the total cost estimates by a nominal percentage (e.g., 5%) each year to account for unforeseen costs that arise as you grow.
- Include the costs to cover interests on money borrowed at various points in the business growth as if it were solely funded by debt.
- Example: Calculate 12% annual cost for all debt outstanding.
- Debt payments often have to be made during the operational life of the business. Even if not, it will allow you to estimate the effect of a balloon payment at the end of debt period. In general, accounting for these payments up front makes certain that revenue is sufficient to cover these costs.
- Also calculate the expected annual rate of return expected by equity investors at different stages of business growth.
- Example: An investment of $100,000 with and expected Internal Rate of Return of 30% would yield a hypothetical $30,000 expense every year.
- Basically, calculate the investors return on equity as if it were debt financing that had to be repaid throughout the business development. Even though these investors dont seek repayment until an exit event, you can compare this amount to the average growth potential calculated for the business. You want to make certain that the growth rate (% growth each year) exceeds the expected percentage return from the investor.
- Note: In any event this calculation will help you estimate whether the revenue will be sufficient to attract later rounds of investment if necessary.
- Note: With a bit of research, determining the cost for most of the equipment, personnel, and other expenses. Two aspects of calculating a dollar value for costs is difficult:
- Extend these costs out to five years in order to match the revenue projections.
Note: Each year your revenue growth (total amount of revenue growth) should exceed your previous years additional costs to grow the business.
- Example: In 2008 the revenue is $100,000 and in 2009 is $150,000. The $50,000 in growth should exceed the differences between the costs in 2007 ($140,000) and 2006 ($100,000).
- As you can see, the business loses money in 2006 and 2007, but the rate of growth in revenue exceeds the costs associated with achieving that growth. This shows the the investment of money is making money.
- Note: These calculations project the ability of the business to grow after the 1st year and generally are only telling for growth after the 2nd year of revenue.
- Note: Each year your revenue growth (total amount of revenue growth) should exceed your previous years additional costs to grow the business.
- Evaluate the profitability of the business at an exist event at some future date.
Note: Startup entrepreneurs (as well as Investors) will want to see an exit event at a future date where they can cash out their interest. You want to determine if, after 3-5 years, that your time, effort, assets, etc., will yield a sufficient return to justify the effort. This brings up 2 very important question:
- If your revenue projections are correct, how much will the business be worth at the end of 3 5 years?
- How much of the business will you need to still own (subtract equity given to the management team and sold to investors) to make your investment in time and effort feasible?
- Example: The end of year revenue at year 5 is $500,000 per year. You look up the given industry multiple for your type of business (look on Yahoo finance) and determine that is 3X or three times revenue. This means that your business is valued at $1.5 million dollars. If you still own 20% of your business, your ownership yields a return of $300,000 upon sale.
- The above example shows the importance of growth in a startup venture. The valuation of the business (and your return) is based upon a multiple of either total revenue or, in some cases, revenue above costs. The gamble for the entrepreneur and investors is the ability to grow the business to a sufficient level of revenue to yield a return that is worth the effort invested over the previous years.
- Note: Startup entrepreneurs (as well as Investors) will want to see an exit event at a future date where they can cash out their interest. You want to determine if, after 3-5 years, that your time, effort, assets, etc., will yield a sufficient return to justify the effort. This brings up 2 very important question:
The above information is a brief overview of the steps involved in projecting the revenues of a business venture. Developing the financial projections used is a more complicated process.
Overview of Financial Projections
Now that you have an operational plan in place, it is time to develop financial projections for your business. Financial projections present a numerical model of your business. They reveal the entrepreneurs basic assumptions about business potential and tell about the expectations for the business future. Perhaps, most importantly, they help the entrepreneur, lenders, and investors evaluate the business potential.
Format for Financial Projections
Unlike the previous, stand-alone business documents discussed in this book, business financial projections have a standard format. The basic portions are as follows:
- Assumptions Assumptions are individual components of logic that are used to build a projection. They detail the individual assumptions about revenues and costs. For example, the assumptions will state the expected sale price as well as the expected cost per unit of a given raw material. These are the details that you will need to devise the financial statements.
- Income Statement The income statement provides a projection about the sources and amount of revenue coming into the business, as well as the costs of operation. The income statement has the primary purpose of showing whether a business is profitable or no.
- Cash Flow Statement The cash flow statement demonstrates the actual flow of cash in and out of the business over a given period. Its primary importance is that it allows for the entrepreneur to adequately plan for the use of cash.
- Projected Balance Sheet The balance sheet is a snapshot in time of what the business owns and owes.
- Break Even Analysis The break-even analysis is a simple calculation that demonstrates at what point the business revenue will cover its costs.
Other Tips About Financial Projections
- Financial projections should look out 5 years, with 1 year in detail.
- This regards the information that is taken for granted about the business.
- Projections may include various metrics, depending upon the use of the financials.
Learn to Create Financial Projections
The process for creation financial projections is covered in greater detail in the Accounting Resources.
Business Valuation (Overview)
Business valuation can be a complicated subject. Numerous methods exist and there is no hard and fast way of arriving at a valuation for a business. Examples of methods employed to value a business include:
Asset-Based (or Cost-Based) Methods
The asset-based approach focuses on the valuation of the firms assets or, in some instances, the cost of replacing those assets. This approach puts emphasis on the total assets and liabilities of the firm. It therefor reflects a whole-firm valuation, rather than simply an equity valuation. To identify the equity value of the firm, one subtracts the market value of any debt held by the company. Determining the valuation may also require adjustment for the intangible assets of the firm that may be incapable of replacement. Asset-based valuation has many variables based upon the purpose or type of company being valued. Common asset-based valuations include:
- Book Value,
- Replacement Value, and
- Liquidation Value.
Market-based approaches value the business based upon the productive characteristics of the business in a given market. These methods focus on comparisons of like businesses, transactions, or industries (known as comparables or comps). Most of these methods focus on identifying a value-based, characteristic of the comparable and comparing it to the total price or value of the firm (i.e., Value-based Characteristic / Total Value of Outstanding Share). The ratio of this value-based characteristic to price is used to value businesses with similar productive output, involved in similar transactions (the reason for valuation), or operating within the same industry. In summary, these methods attribute a value to a business by using ratios (value characteristic to price) to compare the firm being value with other firms whose value is readily determined.
Income-Based Valuation Approaches
Income based approaches value a business based upon the past, current, or expected future cash flows of the business and the risk that the business will not produce the desired return. Estimating and valuing flows of income is done through a process called capitalization. Capitalizing the income streams will produce a so-called present value. Risk is incorporated into this valuation through a discounting process. An applicable valuation formula will discount the present value of cash flows based upon the probability that the firm will not achieve the desired cash flows in the future. The discount rate uses many factors relevant to the individual firm that make the firms projections more or less likely. Below are multiple income-based valuation approaches:
- Earnings Capitalization
- Build-Up Method
- Discounted Cash Flow Method
- Excess Earnings Method
- Economic Value Added Methods
Numerous hybrid methods exist for valuing a business given the situation or scenario. For example:
- Venture Capital Methods - This method combines market-based multiples and discounts on projected cash flows for the the business.
- First Chicago Method - This method uses the venture capital method and employs an averaging function among multiple VC method valuations.
- Options-Based Methods - These methods employ complicated mathematical models to value a business based upon the options that exists for the use of money.
Learn Business Valuation
We cover business valuation in far great detail in our Startup Financing Resources Library.