When business owners have an idea about a new project, they first conduct a feasibility study to determine its viability. A complete feasibility study would examine the market, analyze the technical and production issues, analyze the economic factors and include the preparation of a financial analysis.
Managers prepare feasibility studies to identify the positive and negative issues before making an investment of time and money.
Purpose of a Financial Feasibility Study
Financial feasibility focuses specifically on the financial aspects of the study. It assesses the economical viability of a proposed venture by evaluating the startup costs, operating expenses, cash flow and making a forecast of future performance.
The results from a financial feasibility study determine whether the proposed project is financially possible and make a projection on the rate of return on invested capital.
The preparation of a financial feasibility study has three parts:
- Determining the startup costs.
- Preparing a profit plan and making cash flow projections.
- Assessing the return on invested capital.
Identify the Startup Costs
The first step in the preparation of a financial feasibility analysis is to identify the costs needed to start the project. Typical startup costs are as follows:
- Purchases for land and buildings.
- Acquisition of equipment.
- Licenses and permits.
- Deposits required for office space leases.
- Initial purchases for materials.
- Legal and accounting fees for incorporation.
- Office furniture and supplies.
- Marketing research.
- Employee wages.
- Insurance premiums.
Many of these costs are one-time expenses, but they'll need funding upfront before the business begins operations.
Prepare Profit and Cash Flow Projections
The preparation of projected sales, expenses and cash flow is next and is the analysis that determines if the proposed venture will be financially viable. These projections include the projected sales, costs of production or services and operating expenses separated into fixed and variable categories.
The cash flow projections include the amount of funds needed for startup and identifies where these monies will come from. The amount of equity capital is determined along with the amount and source of all borrowed funds and leases.
Explain Negative Cash Flows
If the project will experience negative cash flows during the early months, this amount should be calculated and explanations provided that show how these cash flow deficits will be financed.
Pinpoint Needs for Additional Funding
Use sales, profits and cash flow projections to calculate periods of negative cash flow and pinpoint when additional funding will be needed to finance growth if internal cash flow generation isn't sufficient.
Determine the Return on Invested Capital
The projected profits will be used to determine the financial feasibility of the project. This part of the financial study assesses the attractiveness of the project to equity investors and the overall financial return on the project.
The financial feasibility of a proposed venture can be estimated using several common methods:
Net present value – The net present value method uses a percentage rate to discount future cash flows to the present. If the NPV of the discounted cash flows exceeds the cost of the initial investment, then the project is feasible and should be accepted.
Internal rate of return – The IRR method uses the same formula for calculating the net present value of cash flows. The IRR is the discount rate that makes the NPV of cash outflows and inflows equal to zero. This IRR can be used to compare the attractiveness of several projects.
Payback period – The payback period is the number of years that it takes for the return from a project to recover the costs of the investment. Shorter payback periods are preferred. The payback method ignores the time value of money that's used in calculating the IRR or NPV of a project.
Financial Feasibility Study vs. Business Plan
A feasibility study isn't a business plan. A feasibility study is intended to determine if the proposed venture is a profitable idea.
A business plan is a detailed plan on how the venture will be implemented and managed successfully.
Start with a Financial Feasibility Study
A financial feasibility study should be conducted at the onset to determine the economic viability of a proposed venture before proceeding to the preparation of a business plan. It identifies the startup costs, makes projections of profits and cash flows and determines the return of the investment.