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  3. How to Conduct an Initial Financial Analysis

How to Conduct an Initial Financial Analysis

How to Financially Analyze an Idea

At this stage, the procedure for analyzing the potential of the idea various with individual entrepreneur and the type or amount of value desired. Below are some general instructions for developing the necessary information.

  • Return to the market analysis and calculate the market size.
    • Note: This will require using the calculations determining the total revenue generated in the market.
  • Provide conservative projections for revenue produced by acquiring a given percentage of the potential target market.
    • Note:  You will want to determine the immediate addressable market. Be conservative in estimating the size of the market available to you within a given time frame. Here you are assuming that you can acquire some percentage (or fraction of a percentage) of the addressable market.  For example, if within the first year you grab 1% of $1,000,000 potential market, then you have $10,000 of revenue.
  • Extend these projections out to five years.
    • Note: Assuming that your business idea has a given growth target, make projections about the market and your acquired market percentage for a five year period.  You may want to break down the early periods quarterly. This is important when determining whether there will be sufficient revenue to sustain operations and growth during the early phases of business development.
  • Return to the operational analysis and ascribe costs of to each area of operations.
    • Note:  With a bit of research, determining the cost for most of the equipment, personnel, and other expenses.  Two aspects of calculating a dollar value for costs is difficult:
      • projecting costs of growth, and
      • including the costs associated with available sources of funding.
    • Growth paths are speculative and often give rise to largely unforeseen expenses.  Funding costs are difficult because you cannot assume that identified funding options and terms will be available.  Here are some tips for calculating costs:
      • Increase the total cost estimates by a nominal percentage (e.g., 5%) each year to account for unforeseen costs that arise as you grow.
      • Include the costs to cover interests on money borrowed at various points in the business’ growth as if it were solely funded by debt.
        • Example: Calculate 12% annual cost for all debt outstanding.
      • Debt payments often have to be made during the operational life of the business. Even if not, it will allow you to estimate the effect of a balloon payment at the end of debt period. In general, accounting for these payments up front makes certain that revenue is sufficient to cover these costs.
      • Also calculate the expected annual rate of return expected by equity investors at different stages of business growth.
        • Example: An investment of $100,000 with and expected Internal Rate of Return of 30% would yield a hypothetical $30,000 expense every year.
      • Basically, calculate the investor’s return on equity as if it were debt financing that had to be repaid throughout the business’ development. Even though these investors don’t seek repayment until an exit event, you can compare this amount to the average growth potential calculated for the business. You want to make certain that the growth rate (% growth each year) exceeds the expected percentage return from the investor.
        • Note: In any event this calculation will help you estimate whether the revenue will be sufficient to attract later rounds of investment if necessary.
  • Extend these costs out to five years in order to match the revenue projections.
    • Note: Each year your revenue growth (total amount of revenue growth) should exceed your previous years additional costs to grow the business.
      • Example: In 2008 the revenue is $100,000 and in 2009 is $150,000.  The $50,000 in growth should exceed the differences between the costs in 2007 ($140,000) and 2006 ($100,000).
    • As you can see, the business loses money in 2006 and 2007, but the rate of growth in revenue exceeds the costs associated with achieving that growth.  This shows the the investment of money is making money.
      • Note: These calculations project the ability of the business to grow after the 1st year and generally are only telling for growth after the 2nd year of revenue.
  • Evaluate the profitability of the business at an exist event at some future date.
    • Note:  Startup entrepreneurs (as well as Investors) will want to see an exit event at a future date where they can cash out their interest. You want to determine if, after 3-5 years, that your time, effort, assets, etc., will yield a sufficient return to justify the effort. This brings up 2 very important question:
      • If your revenue projections are correct, how much will the business be worth at the end of 3 – 5 years?
      • How much of the business will you need to still own (subtract equity given to the management team and sold to investors) to make your investment in time and effort feasible?
        • Example:  The end of year revenue at year 5 is $500,000 per year. You look up the given industry multiple for your type of business (look on Yahoo finance) and determine that is 3X or three times revenue.  This means that your business is valued at $1.5 million dollars. If you still own 20% of your business, your ownership yields a return of $300,000 upon sale.
      • The above example shows the importance of growth in a startup venture.  The valuation of the business (and your return) is based upon a multiple of either total revenue or, in some cases, revenue above costs.  The gamble for the entrepreneur and investors is the ability to grow the business to a sufficient level of revenue to yield a return that is worth the effort invested over the previous years.

Additional Information

The above information is a brief overview of the steps involved in projecting the revenues of a business venture. Developing the financial projections used is a more complicated process.

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