Solving the warnings (5/6): NPV

There are only two warnings left to have a clear guideline on how to solve them. The previous posts were about the Financing, Net Income, Equity and Equity ratio warnings. Let’s get a look deep into the NPV warning.

NPV is short for Net Present Value. You may find more about it at the Financial Analysis Manual. If the warning is triggered it means that your project has a negative NPV (it does not have financial feasibility under the assumptions that you have set).

The NPV is negative, so what can you do?

The NPV is the sum of yearly cash flows of the project (adjusted by the present value) and you can check on the feasibility report how is the Net Present Value being calculated and on which years it is negative.

Remember that CASFLOAPP’s NPV is calculated as a sum of the present value (corresponds to the discounted FCFF) for the first 5 years and a perpetuity (the calculation is explained here).

If you have a negative NPV, you should first investigate your operational results and then your feasibility assumptions. If it is still wrong, then your project may not be as good as you may have thought. As said on the post about the Equity warning, not every project or idea has feasibility and is meant to become a reality.

 

The next and final post about the warnings will be about solving the Debt coverage warning. Stay tuned!

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Solving the warnings (4/6): the equity ratio

The previous posts covered Financing, Net Income and Equity warnings. Let’s have a look at the equity ratio warning.

First, if you are unfamiliar with the equity ratio, you can learn more on it on the Accounting and Reporting Manual.

For as long as equity is positive, the equity ratio can take any value between 0 and 1. Zero means that a company has zero financing with equity and one means that the company is completely funded with equity. There is a threshold that is regarded as the minimum level for a good equity ratio and there are different opinions on what this “safety level” threshold should be. It should be noticed that this threshold is also related to the industry in which a company is at, because there are industries that are more dependent on external financing than others.

We, at CASFLOAPP, decided to set it at 0,2. Notice that a 0,2 equity ratio means that debt of a company is five times the size of its equity, thus meaning that the company is highly leveraged. Therefore, the equity ratio warning is triggered whenever the equity ratio is below 0,2. If you are looking for a different limit, then you should check equity ratio on the graphs or on the indicators report.

The equity ratio is only relevant if the equity warning is not triggered. If it is, you should first look into it and only then try to correct the equity ratio. The correction of the equity ratio warning takes the same steps as that of the equity warning. First look into the forecasts and then assess if more funding is necessary.

Remember that the warnings do not necessarily mean that something is wrong with your forecasting (except the financing warning), but that something might be wrong and needs attention. It will be up to you to decide whether action is needed or not.

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

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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!

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Solving the warnings (2/6): the net income

Continuing the previous post about solving warnings, this post is about the Net Income warning.

Net income is the second warning in the Dashboard. It tells the user that in at least one of the years forecasted, the net result is negative. While that is perfectly reasonable, especially when it comes to entrepreneurship projects, it is something that you should investigate why it is occurring.

If you go to the Income Statement report, the final line is the Net income and you can notice the results of every year. In the following example, the third year has a negative net income, which has triggered the warning.

 

If you expect your project to sustain losses in the first years of activity and all of your forecasting assumptions are correct, then there is nothing wrong with having the net income warning triggered. But if all your forecasting is on the negative side (the net income is negative in every year), maybe you made a mistake in our assumptions; so go look into it. Even if you have only one negative year, you should check if the value of the forecasting can be considered “normal” or if it is exaggerated; if it is different than what you expected, then inspect if your assumptions are correct (again, do not get too overwhelmed, it is normal that the net income might be negative for the first years, or in a particular unusual year).

And do not forget, the net income has revenues on the plus side and costs on the minus side. Therefore, understanding the net income is understanding its own components.

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

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Solving the warnings (1/6): the financing warning

There are 6 warnings at the CASFLOAPP’s dashboard which we have set to help out our users. They are meant to warn you that something might be wrong with your simulation and that you should investigate and understand what is causing the triggering. It does not mean (except for one warning – the financing one) that your assumptions are definitely wrong. As with any business simulation model, it all depends on the context.

The first warning is the “Financing warning”, which is the most important warning of the 6. That is because if it is triggered, your forecasting is incorrect. Well, that is if you are performing a full forecasting (one where your balance sheet and the way you thinking to forecast the project matters, an approach that is more common when starting a new company; it may not be as relevant for a new project within an already existing company), because if you are looking at a plain viability analysis of a project, the financing will not be relevant to you. But in most cases, the balance sheet and the financing are relevant and must be correct; hence you will want to keep this warning untriggered.

So what does the financing warning mean?

This warning is triggered whenever the simulation of the balance sheet has a negative cash. It means that the operational cash flows, investment expenditures and financing have a combined negative cash flow that in total value is above the amount of cash of the previous year.

How is cash calculated?

Operational cash flows

Operational cash flows register payments of the clients to the company (+), payments of the company to suppliers (-), payments of the company to its employees (-) and tax payments of the company to tax authorities (-). Be aware that payments from clients and to suppliers are usually not instantaneous to an invoice. That is particularly true in almost all B2B comercial relations. Therefore, if a company has many days of accounts receivables, it means that will take some time before it gets payed by its clients.

Investment cash flows

Investment cash flows are based on the purchase of assets and on the receivables from assets that the company may sell. In CASFLOAPP it is only possible to forecast the purchase of assets; selling off investment is more uncommon, particularly for entrepreneurship projects.

Financing balance

The financing balance (or financing cash flows) adds the incoming cash from equity, other equity instruments, shareholders loans and financial debt and deducts all cash that was used to redeem any of those items.

Solving a triggered financing

To correct the financing of your project, follow the following steps:

  1. Check if your revenues and costs are well estimated. If these are not adequate, correct them.
  2. Check if your investment is correctly estimated. If it is not, correct it (it may be that you are over-estimating your investment.
  3. Check in which years the financing is negative. If you hover the mouse over the warning it will show in which years it is missing cash.

  1. Increase the financing of your project in the years that have been identified in the dashboard. You can increase it through:
    1. Issued Capital.
    2. Other equity
    3. Shareholder’s loan
    4. Bank debt.

The next post will be about solving the Net Income warning. Stay tuned!

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