How should I calculate if a project is worth it?
If you’re an entrepreneur without a strong financial background, one of the biggest business challenges you might face is the evaluation of a project’s financial implication. Often new projects are enthusiastically undertaken without proper consideration of the real profit the company stands to make.
A new project or contract always means more revenue, but often it does not end up being profitable in total.
If your business has been growing its revenue, but profit has been going sideways or down, your company is actually only spinning its wheels in terms of bottom line profit.
It might be time to implement a basic financial analysis before a project or contract is accepted.
Considering net present value
Before you roll out that new line of business or accept that project, take the time to consider its net present value. Sure, it generates income and keeps your team busy, but after prudently taking into account all costs and the effect of your cost of capital over time, is it still making you money?
The process to undertake can be broken down as follows:
- First, understand your company’s cost of capital
- Plot your project’s cash flows over its life span
- Calculate the project’s net present value using your cost of capital.
Cost of capital
Cost of capital means the cost of the equity (the owners’ own money) and debt (borrowed funds) of the company. It is calculated as the cost of equity times the weighting of equity in the capital structure, plus the cost of debt times the weight of debt in the capital structure.
Cost of Capital = (cost of debt x weight of debt) + (cost of equity x weight of equity)
A basic example to simplify this mouth-full:
Peter’s company is half-funded by himself, and half by a loan. The weight of equity is therefore 50%, and so is the weight of debt.
The interest on the borrowed funds is 12% per annum. Because the interest is tax deductible, we use the after tax cost of interest. The cost of debt is therefore 12% x 0.72 = 8.64%.
Peter’s expected return on the money that he put in is 30% to compensate for the risk that he is taking in putting money into his business.
Let’s keep it as simple as this for our example. Applying our formula, Peter’s cost of capital can be calculated as:
Cost of Capital = (cost of debt x weight of debt) + (cost of equity x weight of equity)
= (8.64%x50%) + (30%x50%)
Peter now knows that his company will need to generate returns of at least 19.32% in order for him to adequately cover his cost of capital.
Plotting your project’s cash flows
Peter’s financial decision is whether or not to purchase a new line of software with a five year licence for his design company. The new software will enable a new stream of income, as well as add to existing income streams and will cost him R200 000. He has plotted the project income and expenses over five years as follows:
On face value, it looks like the total net inflow for the project over five years coming in at a positive R328 400 is a definite must. But in order to properly analyse this, we need to compute the project’s net present value.
Net present value
The net present value of a project is the current value of all the project’s future cash flows, discounted at the company’s cost of capital.
In basic terms, the R21 200 profit of year one, discounted at the cost of capital rate of 19.32%, is worth only R17 767 at the beginning of that year. Likewise we discount each year’s profit back to its current (year zero) value to get the present value thereof.
The sum of these discounted amounts then make up the net present value:
The project’s NPV comes out negative at -R14 407. As the NPV is smaller than zero, Peter should not accept the project as it will generate less present value profit than the cost of the funds employed in making that profit. Not the same answer as that of the first look at the project’s profit.
Likewise, doing a basic cost of capital calculation for your company and a NPV calculation for each new project, entrepreneurs can make better financial decisions that will drive bottom line profits instead of just spinning the wheels in one place.
What do I keep in mind for financial planning in a business?
In the startup phase of any new business, the profits will usually be quite low. It is therefore important to be wise with every cent in these early stages.
When doing financial planning for the first few months of my new business, what sort of things should I bear in mind?
Below are some financial considerations for the first few months of your new business.
1. Your Personal Salary
In this startup phase, the owner’s personal salary and the business viability will be strongly related. If you are solely reliant on your business to meet your needs, then you may need to reduce your lifestyle to ensure that your business will still break-even, while paying you enough to meet your essential needs.
Related: 6 Steps Of Financial Planning
Don’t start your business hoping to draw a large salary. This may come later, but seldom in the startup phase. Initially, you may have to personally contribute money to the business just to keep it afloat. If possible, work and save up as much as you can before starting your business. The startup phase will often require personal sacrifice.
Consider working a second job in the early months of your business. Your goal in the startup phase should be to take as little as possible from the profits, so that your business can grow as quickly as possible.
Reduce your personal lifestyle and expenses as much as you can. Carefully develop a personal monthly budget. Monitor this budget regularly and ensure that you adhere to it.
2. Separate business finances from personal finances
It is important to have a very clear separation between business transactions and personal expenses. Some owners use business funds for personal costs, often using cash from business sales to buy personal items, then declaring these as business expenses.
Any money taken from business profits for personal use cannot be expended to the business, nor should personal transactions be done through your business accounts. Also avoid business trading using your personal bank account. The only personal cost through your business accounts should be the salary that is paid to you.
3. Startup capital
In most businesses, you will need to invest money, (for stock, machinery, equipment, etc.) before you can trade. When determining your required startup capital, it is wise to start small and gradually scale up.
Avoid debt as much as possible. Focus on sales and begin selling as soon as you can. You don’t need a fancy office with billboards and business cards to start trading. Avoid large rental costs – initially try to work from home. Should you need a loan, try to get low-interest loans from friends and family before approaching institutions.
4. Cash flow forecast for your business
Plan a cash flow forecast for at least 12 months. Take time to realistically list the anticipated monthly cash flowing into your business (Sales, Loans, Investments), and out from your business (Salaries, Suppliers, Loan repayments, Rent, etc.). Regularly review this forecast.
5. Accurately record all income and expenditure – personal and business
In order to draw up a realistic Personal Budget and Business Cash Flow Forecast you will need accurate historical information of all your business and personal transactions for the previous months. Start today: record all income and expenditure, especially cash transactions that do not leave a document trail.
Remember to keep personal records separate from your business records. Develop an effective filing system for all source documents.
6. Don’t give up
Starting a new business is tough, and the financial rewards are seldom seen in the startup phase. You may be tempted many times to just give up. Remember, every large tree started as a small seed and took a long time to grow.
If you give your small “business seed” the care and attention it needs, it will eventually grow and develop into a great tree and bear much fruit.
Which comes first, accounting software or HR software?
Start with accounting software and grow from there.
Which do I need more for my small business – accounting software or payroll software? I can’t afford to buy both. And how do I choose between the plethora of options available?
Generally you should start with an accounting package and then add on others as you need them. That said, businesses are like fingerprints: Each one is unique, and has its own set of needs. You may need accounting or payroll or both.
It depends on details like how many staff you employ, how complex your finances are, and how many companies you’re running.
Choose the right software for your business
In my opinion this is one of the most important choices you will make because your accounting software is one of the most important business management tools you will invest in.
If you’re choosing professional software from a reputable software developer, the particular brand name shouldn’t really matter if they are trustworthy and have a strong local presence.
Goedkoop is indeed duurkoop
Too often I hear horror stories of small businesses buying the cheapest product on the shelf which is fine… until things go wrong.
The package doesn’t work properly, they can’t get support, the phones go unanswered and the company they bought the software from doesn’t have the resources to service its customers.
Take advice from your friends, your accountant, your bank, and then make sure you choose a brand with an established reputation and a local office that provides training, support and after-sales service. Above all, understand that you are making an investment, not a purchase.
How do I implement the youth wage incentive?
We break down the steps required to adopt the ETI.
How do I align my payroll with the newly promulgated Employment Tax Incentive Act?
The government is implementing the Employment Tax Incentive (ETI) scheme to encourage businesses to employ young people.
In practical terms it means that the employer will now receive an incentive for employing youths, subject to certain conditions, which will be in the form of a reduced PAYE monthly liability.
Businesses implementing the incentive will receive substantial financial benefits as it will contribute to an improved cash flow and will reduce the cost of employing young people, especially for smaller businesses and entrepreneurs.
However, the Act has many technical specifications and requirements which will significantly impact on companies’ payroll systems and processes.
Basic principles of the ETI
1. Determine if you are eligible for the incentive as an employer.
An eligible employer is a private sector employer registered for PAYE.
2. Determine which of your employees will allow you to qualify for an incentive (also referred to as qualifying employees).
The following are some basic steps to follow:
- Step 1
Is the employee between 18 and 29 years old?
No – Continue with Step 2; Yes – Continue with Step 3
- Step 2
Is the employee mainly employed in a Special Economic Zone or an industry designated by the Minister in a Gazette?
No – Do not apply incentive; Yes – Continue with Step 3
- Step 3
Is the employee in possession of a SA ID or an Asylum Seeker Permit in terms of the Refugees Act?
The Asylum Seeker Permit is a temporary permit which you are given pending a decision on your application for refugee status or for asylum.
No – Do not apply incentive; Yes – Continue with Step 4
- Step 4
Does the employee earn equal or more than the minimum wage? The minimum wage is stipulated in the bargaining council rules, collective agreement or the sectoral determination.
If the amount of the wage payable to the employee is not subject to any wage regulating measure, the minimum wage will be seen as R2 000 per month.
No – Do not apply incentive; Yes – Continue with Step 5
- Step 5
Is the monthly remuneration of the employee more than R6 000?
No – Continue with Step 6; Yes – Do not apply incentive
- Step 6
Was the employee employed by the employer or the associated person on or after 1 October 2013?
No – Do not apply incentive; Yes – Continue with Step 7
- Step 7
Is the employee a connected person to the employer or a domestic employee?
Yes – Do not apply incentive; No – Calculate the incentive amount
3. Determine the incentive amount
The incentive will be available for a maximum 24-month period per qualifying employee, broken up into a ‘first 12 months’ period and a ‘next 12 months’ period’.
The incentive must be determined every month by identifying who the qualifying employees are and by doing the above calculation.
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