So, as 2023 approaches, you are contemplating Starting a New Business. But how do you know whether you have Feasible Business Ideas? This article explores how to prepare a Financial Feasibility Study. We will first explain what a financial feasibility study is, the meaning of a feasibility study, why you need one, in which situations to prepare one, its importance, and who typically prepares such a study.
Financial Feasibility Study 101
The article will explain the main elements of a thorough financial feasibility study and suggest a process when preparing such an analysis. Our goal is that after reading this article, you will know everything you need to know when preparing your next financial feasibility study.
What is a Financial Feasibility Study?
A Financial Feasibility Study is a certain type of study conducted to assess the financial viability of a new investment project. To assess this, we must develop financial projections based on well-researched assumptions. These financial projections are then used to determine if a new project can generate sufficient returns to primarily satisfy the requirements of capital providers such as banks or investors.
For this article, we can use the following definition of financial feasibility:
Feasibility Study Meaning: A financial feasibility study explores aspects such as the total investment costs required to do such a project. It analyses the ability to generate income, profits, and cash flows by preparing detailed financial projections about revenues, costs, profits, and cash flows.
Financial viability is determined after evaluating the financial attractiveness and a project’s financial risks. Therefore, a project needs not only to cover its cost but generate a decent return to become financially attractive to invest in by investors or banks.
A financial feasibility study can come in a variety of forms. It can be in the form of a written report, a presentation, or a spreadsheet model. However, in most cases, transparency on the calculation is required. Therefore, a spreadsheet model will be very handy as it allows us to understand the detailed calculations for such an analysis.
Why do we need to analyse Financial Feasibility?
So, why do we need to do a financial feasibility study? Wouldn’t it be sufficient to go without one, especially if we know the market well?
Many new investment projects require a significant upfront investment. When asked to invest in such a project, any capital provider will have their money at stake, and they will naturally be worried that the proposed investment might not work or investors might even lose all their money.
Therefore, before spending any money, we will need to find out and analyse thoroughly if a project makes financial sense ― or, in other words ― if a project is financially viable. We must assess if a project can create sufficient returns to compensate capital providers for the risk.
The study’s financial viability analysis evaluates a new project’s financial prospects. We will need to evaluate the required investment amount, the start-up costs, net working capital requirements, projected production and sales volumes, expected prices, revenues, and variable and fixed costs and seek to protect the project’s estimated future profits and free cash flows. Based on the forecasted financials, we will now be able to calculate select financial metrics, such as the payback period or the internal rate of return, to better assess the financial attractiveness of the proposition better.
Furthermore, a financial feasibility analysis allows for a solid check if the proposed project leads to a sustainable business model. Something very important to avoid losing money or becoming obsolete soon. Financial feasibility analysis also evaluates how much debt financing can be obtained from banks or other lenders. Considering all these points allows us to conclude whether such a project is financially doable ― viable ― or not.
Apart from the potential upside, we will also need to understand the (financial) risks involved and determine if the offered return by the project will be sufficient to compensate for such risks.
A financial feasibility study should help prepare the groundwork for the following situation:
- Evaluating the financial projects of a new investment opportunity
- Assessing the profitability and financial viability
- Making rational instead of emotional investment decisions
- Recommending to go ahead or decline opportunities
- Finding risk-mitigation strategies
- Getting approvals from boards or investment committees
- Serve as a basis for capital raisings
The focus of a feasibility study lies in studying the financial prospects for a project which does not exist yet, which is new. Therefore, not all assumptions that might be required are available yet and first need to be carefully studied where they could lie within.
Conducting such a study seeks a solid understanding of the financial implications of starting a new project. This also leads to a more solid understanding of the risks involved, allowing for identifying risk mitigation strategies.
When to do a Financial Feasibility Study?
When do we exactly require a financial feasibility study? As outlined above, a solid justification should be provided under best management practices whenever a large amount of capital is required.
Capital providers (investors or banks) often require a thorough financial feasibility study to serve as a basis for financial decision-making. In such cases, the quality of the study decides the fate of such a project. Preparing a thorough financial feasibility study demonstrates professionalism and preparedness to mitigate the risk enhancing trust among investors.
Therefore, typical situations that require to prepare of a financial feasibility study are the following ones:
- When you are unsure if a project will lead to financial success, a thorough financial analysis will be required for something that does not exist yet.
- When a large investment amount is required, that can expose a company or investor to great financial risk or even the potential loss of his investment.
- When suggesting complex projects whose financial implications are difficult to understand.
- When seeking ways to mitigate financial risk, studying a project in detail often allows preparing for such risks and even finding ways to mitigate them.
- When you don’t want to rely on the opinion of somebody and seek a second opinion from somebody else.
- As a basis for financial decisions, the Board of Directors or an Investment Committee takes.
- When capital providers ask for thorough documentation to justify their decisions.
Whenever you deal with the question of how to finance a new project with large amounts of capital, be prepared that the involved investors or bank will expect you to prepare a thorough financial feasibility analysis.
What is the Difference between a Business Plan and a Financial Feasibility Study?
You might now think a feasibility study sounds similar to preparing a business plan. Well, not exactly. There are some differences in terms of the approach and focus when you consider their objectives. The following illustration explains the main differences between a business plan and a financial feasibility study:
The Financial Feasibility Study focuses on the Financial Viability and Risks
- Financial feasibility analysis seeks to prepare financial projections based on well-researched and educated assumptions, mostly for new projects to be built. The objective is to evaluate a new investment opportunity’s financial attractiveness and risks.
- Especially capital-intensive projects, such as new infrastructure projects or manufacturing plants, require a careful financial feasibility study because they require millions of dollars of investment by banks and investors. Those capital providers want to see a responsible approach to managing their funds and avoid losing their money at all costs.
- They want to study the project themselves, and the easiest way is to ask the project promoters to present such a study they can now review and critique. Many projects rely on important assumptions, e.g., that a wind farm can produce and sell a certain amount of electricity. So they want to understand how the electricity will be produced, how much wind will be required, how it will be generated and distributed to the electricity grid, and who pays for it.
- Many risks are involved in such projects, from the choice of location and wind generation potential to the credibility and financial situation of the electricity distributor who will purchase all the electricity produced. As the name implies, the focus here lies on studying all the important aspects of such a project and concluding whether this project is financially attractive. Therefore, a financial feasibility analysis looks at a project mainly from an investor’s point of view.
The Business Plan focuses on Traction and Execution.
- Business plans focus mainly on Execution and lay out the plan on how the business should be run and grow. Business plans rely on the excellence of execution, which requires somebody to assume responsibility and take ownership. Therefore, a business ideally should be prepared by the Entrepreneurs wishing to launch a new company. Business plans where there is no team behind typically have less value.
- A business plan should be prepared for any new Startup project, also less capital-intensive projects such as developing a mobile app or launching a service-based business. For those businesses, the initial investment required is manageable. Sometimes only a first prototype is required to test the market and see if there is demand for a new product and service or not.
- The success of the new business depends now if traction in the market can be obtained. Traction means demand from real customers asking to be served and are interested or have even already bought the products of the new Startup as first buyers. Execution typically will focus on gaining such traction and seeking ways to grow the business. Therefore, in many cases, marketing will be the key to success.
- As less capital is required, investors at this stage will only invest small amounts, typically first as seed investors and larger amounts only later once traction is proven. Therefore, a desktop study is less relevant as it all comes down if customers are demanding a new product or service introduced into the market.
The Importance of Financial Feasibility: Avoiding Unnecessary Risk-Taking!
As Warren Buffet famously once said, as an investor, there are two rules to live by:
This is more or less what a financial feasibility study seeks to achieve, protection against unnecessary mistakes or bad investment decisions. Studying the financial feasibility helps investors to make rational and – in theory – better decisions as emotions do not influence them and, therefore, should avoid unnecessary risk-taking.
Three groups of stakeholders typically require financial feasibility studies. They mainly for purposes of enhancing their decision-making process or preparing the required documentation for capital providers for fundraising exercises:
- Startups and Entrepreneurs ― Whenever a new capital-intensive project is started that involves much capital, like a solar park or a new ethanol plant, a financial feasibility study should be conducted to figure out if such a project can generate sufficient returns to cover its costs and compensate capital providers for the risk.
- Existing Companies ― The question of financial feasibility arises whenever businesses are looking into an expansion that requires significant capital investment – like buying a new machine to automate certain production processes. In such cases, the company’s management typically prepares a study and presents the project to the board for approval and/or to banks for financing. The financial feasibility study serves as an important document to justify the spending of company resources as it can demonstrate that there will be a financial return from it aiming to maintain or enhance the value of a business.
- Investors ― Companies are often not formed for new projects, and their Promoters will be tasked to prepare the financial feasibility analysis. Such a study can then serve as a basis for whether to start and fund a new project. The study must also bring co-investors and other capital providers on board and demonstrate that they can profit from it. Their investment and credit committees will appreciate having a solid financial feasibility study that can serve as a basis for any new investment.
The Elements of Financial Feasibility
A financial feasibility study typically consists of various important elements, allowing us to decide whether a project makes financial sense or not. Before we go into the elements of financial feasibility, we need to recap what type of questions our financial feasibility study needs to answer:
- What are the total project costs?
- Multi-year projections (Financial Model) for Income Statement, Balance Sheet, and Cash Flow Statement
- How profitable will that project become?
- Can the project cover its cost of capital?
- How much funding will be required?
- How much debt financing can be obtained from banks?
- What will be the return for shareholders?
- What are the most likely scenarios, and where are the risks?
- A project is financially feasible when the project can create a profit, cover its cost of capital and compensate all capital providers with sufficient returns for the risk they take.
As you can see from the questions above, the task is to develop financial projections from which we can run all required calculations to determine if a project is financially feasible. To come up with such projections, we need to develop them based on a set of assumptions.
Therefore, a financial feasibility analysis should ideally investigate and clarify the following elements:
- Revenue Projections
- Cost Projections
- Net Working Capital Requirement
- Fixed Asset and Depreciation Schedules
- Debt Financing
- Tax Analysis
- Financial Statement Forecast
- Financial Ratios Forecast
- Free Cash Flow Forecast
- Uses and Sources of Funds
- Financial Metrics
- Break-Even Analysis
- Scenario analysis and Risk Identification
A financial feasibility study is only as good as the assumptions used. Therefore, it is very important also to review the other types of feasibility studies ― market, technical, phasing, costing, environmental, social impact, pricing, and others as they are a prerequisite to preparing a solid financial feasibility study. If the other studies are not yet completed, we would still speak of pre-feasibility.
A financial feasibility study should contain all the required details and disclose the calculations on which a conclusion regarding financial viability is reached. For this reason, typically, calculations in the form of a detailed spreadsheet are needed to provide all the details and full transparency on the calculations.
Financial feasibility analysis also serves to identify the main risks and prepare for eventualities. This helps to avoid unnecessary risks and makes a project more attractive to capital providers.
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