How can you impress your investor if he is not in your business domain and can’t understand your idea… the only way is to talk with the money language. Financial decision criterion’s are the alphabetic of the money language in this area.
Here i will talk about three important criterion’s, Breakeven point, Pay Back period, and Net present value.
In my business plans, i usually go far for more criterion just like the profitability index PI and Internal rate of return IRR. I encourage the reader to take any free course on financing from any MOOC sites like Coursera.
This is the point in time when your project revenues start to cover your expenses.
When you start your project, you will cover your expenses from your own personal savings or some kind of investment till the project starts to make revenues that can cover your expenses.
In the template we built together in part.1 and part.2, it is the point in time where your gross profit converts from negative to positive value.
why it is important, simply because it gives a clear message on how much time you need till your project becomes independent of any external financial support.
Pay Back period…
It is the point in time where your project net profits reach a value similar to the amount of money invested.
why it is important, simply because it gives the investor some insights about the time needed to get back his investment.
Net Present Value…
If you have a 1000$ now, and you invested it in a project with interest of 10% per year. Then 1000$ today will be 1100$ after a year. and hence to know the present value of a future value, you should discount it with the same interest rate. So the present value of a 1100$ future value after a year with discount rate 10% is 1000$.
But in real life, we have projects that extend over time, may be several years, so we need to discount these values over time to have what we name the net present value.
NPV is the value of specific stream of future cash flows presented in today’s dollars
NPV is based on the concept that money now is more valuable than money later on. … Why, because you can use the money to make more money.
NPV could be the most important decision criteria. it is used to know the approximate value of the project and is also used to compare between two projects.
I will not go in mathematical details on how to calculate the NPV. I Just want you to feel the meaning of it. Rather i will show you how to calculate it using excel on the template we discussed in the Part.1 and Part.2
In part.1 and part.2 we learned together how to build the template and then how to build different scenarios of it. Now i want you to make a summary for each plan you have just like what i did in the figure below:
Y0: represents the first day in your project.
Accumulated cash: represents the cash in hand at the end of each year after deducting all expenses and taxes. you can say it is the net profit of each year.The accumulated cash at Y0, represent the cash in hand at the project start date which is your finance or investment.
The NPV is calculated with the npv formula in excel as in the figure below:
The question here is how to chose the discount rate… actually there is no certain way to calculate it. It could be affected by many factors such as inflation rate, interest rate of another competing project, interest rate on treasury assets, and so on.
So this will depend on the project nature, and the country you live in.
I just finished my series on how to build a financial plan for a start-up that can rock. if you have any questions or suggestion for any enhancements, please mail me or leave your comments.
In a later article, i will talk about “how to valuate your project” especially if you don’t have any assets and the project will result in an intangible assets.