Solving the warnings (3/6): the equity

At this point we had a simple explanation on how to solve the financing and net income warnings. Today we are going to give some insights about the Equity warning.

The equity warning works in a similar manner to that of the net income. The warning is triggered if in (at least one) of the forecasting years the equity of the project is negative. This is irrelevant if you are only looking to the feasibility of a specific project within an already established company; then you should focus your attention on the income statement and the feasibility analysis. But if you are producing forecasting in which the balance sheet is needed, then the equity warning is relevant. Remember that forecasting the balance sheet is an essential step to assess the financing of a project.

When the warning is red, you should go to the balance sheet (at the reports) and check which are the year(s) with negative equity.

Why does a negative equity occur?

In simple terms, equity combines what the equity holders have invested in the company with accumulated results (the retained earnings and the net income of all previous years). Hence, if a company sustains one or more years of losses it may reach a negative equity level if the equity holders funding was not enough to sustain the losses.

As you can see in the example above, the funding of the first three years is not enough to overcome the losses that the project is expected to sustain in that first year. Hence, it would be reasonable to increase the issued capital or the other equity instruments. Be aware that adding bank debt is inadequate for this purpose, as it will not affect equity value.

Bottom line

If the warning is triggered, check if your operational assumptions are correct. If that is so, then the only option is to adjust the equity items.

But what if it is not feasible to alter equity or the operational assumptions?

You may be reaching a deadlock here… Not every project or idea has economic feasibility and it may well be that yours is in that circumstance. The purpose of a feasibility study is to understand if a project is viable or not; you should not change the assumptions of your project just to have “nice” outputs from your business model. If you carried out a market research for a mobile app and you are expecting that you will have around 100.000 yearly active users, you cannot (should not) change your estimates to 1.000.000 active users just because that is the number that gets your simulation with “good numbers”.

The truth may be hard, but it is better if you know it in advance.

The next post will be about solving the Equity ratio warning. Stay tuned!