7.1.1. Warnings

There are 6 warnings that alert you to possible errors with your project:

  1. Financing.
  2. Net income.
  3. NPV.
  4. Equity.
  5. Equity ratio.
  6. Debt coverage.

If a warning sign is green it means that no alert has been triggered; if it is red there may be an issue that you should check.

Financing

The  “Financing warning” is the most important warning. 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.

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 CASFLO APP 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.

Advice: your project should always have a positive cash balance so, if you have undertaken any change on your project that triggered this alert, it is advisable to increase the financing.

Net income

The 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.

NPV

This warning alerts you if the Net Present Value (NPV) of your forecasting is negative. It is quite important, as having a negative NPV means that the project is not viable under the assumptions in that version.

Equity

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.

Equity ratio

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 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.

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.

Debt coverage

This warning is triggered if, at any of the forecasted years, the debt coverage ratio is under 1. It means that in that year, the company is not generating enough operational cash to pay its debt service. It may not be too upsetting if the company holds enough accumulated cash on its balance from previous years, but it is an issued to be looked for.

Next Section: 7.1.2. Graphs