Financial Feasibility Analysis, Part 2

Why This Lesson

After you have forecasted expenses and revenue, it is time to compile the income
statement and analyze whether the venture looks viable. The important thing to
remember about creating a pro forma income statement is that you are making
assumptions. In reality, you have no idea what will happen with the venture next
year, let alone three years from now. The more information you can validate and
verify, the better, but in the end, these are just assumptions.

Breaking Even

A critical reason for estimating revenues and expenses is to understand when the
venture will break even. The break-even point is the point at which revenues equal
expenses. In other words, when the venture generates $0 in profit. After that point, the
venture should start generating a profit.

Break-even point = Total fixed costs / (Sales price per unit − Variable cost per unit)

Evaluation of Assumptions

After you have compiled your pro forma income statement, it is time to evaluate your
assumptions about the attractiveness and viability of the venture. There are several
metrics that you can evaluate as you prepare an income statement. Each of
these metrics will give you a picture of the future profitability and allow you to
compare with competitive or industry averages.

Gross and Net Operating Income

Gross income is also known as gross profit. This is revenue from sales of a product
or service minus the cost to make the product, before deducting expenses such as
overhead and taxes. Cost of goods sold (COGS) is the total expenses that are
directly attributable to making the product, such as materials and cost of labour
to produce the item. Expenses such as distribution or marketing costs are not
typically included in COGS. Net operating income, or net operating profit, is a
company’s total earnings from operations. Net operating income is calculated as
revenue from the sales of a product, minus the cost to make the product (COGS),
minus the costs for all other operating items such as executive salaries and
administrative expenses such as office supplies. Interest expenses, taxes, and other
non-operating expenses are not included in this calculation.

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Gross and Net Margins

Margins are percentages showing the relationship between the revenue of a

venture and the profit. Gross margin is the ratio of gross income to revenue. It is the
percentage of total revenue after accounting for the cost of goods sold.

Net operating margin is the ratio of net operating income to revenue. This
percentage shows how much of each dollar of revenue remains after all
operating expenses have been accounted for. A net operating margin of 5% means
that for every dollar of revenue, the company generates $0.05 in operating profit.

A high net margin indicates that a venture is good at generating significant profit
from revenues. Calculating net operating margins is a way to indicate whether or not
a venture is efficient or will be successful in the industry and is one way to
compare ventures operating in the same industry. Average net operating margins
vary across industries because of several factors. In general, a low net operating
margin means that a venture has little room to make a mistake in pricing,
expenses, or budgeting. To calculate gross and net incomes and margins, use the
following formulas:

Gross income = Revenue − COGS

Net o p e r a t i n g income = Revenue − (COGS + all other operating expenses)

Gross margin = Gross income/Revenue

Net operating margin = Net operating income/Revenue

For example, here is we calculate the gross margin for Falcon Victor a fresh juice
producer using the data from its pro forma income statement.

Falcon Victor Juice

Pro Forma Statement
(RM) Year 1 Year 2 Year 3
Avg. Price Point $2.25 $2.30 $2.50
Demand (units) 15,000 65,000 125,000

Revenue $33,750 $149,500 $312,500

COGS 15,356 68,023 142,500
Gross Income 18,394 81,478 170,000
Gross Margin 54.50% 54.50% 54.40%
Operating Expenses
Rent and equipment 8,000 8,000 26,000
lease
Marketing 2,500 50,000 73,000
Labor and wages 7,000 16,000 39,000

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 General administrative 2,000 5,000 20,000
Total Operating Expenses 19,500 79,000 158,000
Net Operating -1,106 $2,478 $12,000
Income
Net Operating Margin N.M. 1.70% 3.80%

Gross Margin (Year 2)

: $33,750 (Revenue)− 15,356 (COGS) = 18,394

18,394 (Gross income)/33,750 (Revenue)

= 54.5% (Gross margin)

Net Operating Income (Year 1)

: (Gross income)- (Total Operating Expense

Total Operating Expenses = (8,000 + 2,500 + 7000+ 2,000)

= 18,394 -19,500 = -1,106

Risk Assessment

At this point, it is helpful to create d i f f e r e n t scenarios by using what you know

about the industry and market, consider best-case, worst-case, and most likely-case
scenarios, and play around with how they could affect your business model, your
strategy, and your bottom line. This is the kind of information that you will need to have
when you seek financing for your venture.

It is possible that after doing all the research and assessing the financial feasibility,
you will find that the projected profit is insufficient to support the venture and/or
the entrepreneur with the proposed business model. In that case, it is time to decide
whether or not to continue with the plan. To continue, you may have to change
the business model or some other key element of the strategy to make the
venture profitable. If that is not an option, it is better to find out during the planning
process that the venture is not financially viable before investing a lot of time and
resources.

You can learn more about the Financial Feasibility of a startup and cost-cutting
techniques via the following links:

1- Invest Time If You Don't Have Money to Start a Business

2- How to Prepare a Financial Feasibility Study
3- Feasibility Analysis of Entrepreneurship from The Perspective of Financial
Management
4- Conducting a Feasibility Study