How to Create a FINANCIAL JUSTIFICATION for a Project or Business Plan. Practical Template with Sample Data
Quite often, the need to draft a project or business plan arises when seeking investments or advancing business at a particular stage. Apart from the marketing and sales aspects, a key stage is the financial justification and assessment. This often poses challenges, even for skilled strategists, as it has specific nuances.
What is a Financial Justification and What Should It Include?
A financial justification is a crucial element in presenting a project or business plan. It demonstrates financial viability and potential returns, essential for attracting investors and partners. Properly prepared, it not only convinces potential investors of the viability of your idea but also serves as an internal tool for financial management and planning.
What Does Financial Justification Include?
Financial justification includes an analysis of projected revenues, costs, cash flows, and project profitability. The key aim is to show that the project is financially sustainable and capable of generating profit.
Key Elements and Steps for Generating Content:
Revenue and Forecasts:
- Sales Forecasting: Estimate potential revenue based on market research and trends. Study both expected revenue in currency and expected sales volumes.
- Pricing: Determine product or service prices, taking into account projected costs, production volumes, and competitive environment.
- Business Model: For a new business or expansion, it is essential to define the business model - i.e., how the investment will generate revenue.
Cost Estimates and Forecasts:
- Initial Investments: Includes costs for equipment, licenses, installations, and other initial expenses.
- Operational Costs: Ongoing expenses, such as rent, salaries, marketing, and maintenance.
- Financial Planning of Operating Costs: Include production operating costs for a new investment or changes in incremental costs related to process improvements.
Profitability:
- Gross and Net Income: Calculate the difference between revenue and expenses.
- Profit Margin: Assess the percentage of profit relative to revenue.
Cash Flow projection:
- Incoming and Outgoing Cash Flows: Analyze when and how money will flow in and out of the project.
- Liquidity: Ensure sufficient cash reserves to cover current liabilities.
Funding Sources:
- In-house Funding
- External Funding
Think about and identify clear estimations of the funding sources, as well as if they are more than one. For the external sources of funding - research and calculate additional costs for their usage, as well as the conditions and periods of return. For the in-house sources of funding research where are they taken from, are they enough, and whether they will not damage the usual business activities.
Tools and Methods for Analysis:
- Break-even Analysis - defines the minimum sales volume needed to cover costs.
- Net Present Value (NPV) - calculates the present value of future cash flows to assess project profitability.
- Internal Rate of Return (IRR) - indicates the percentage return the project is expected to generate.
- Payback Period - the time needed for the investment to repay itself.
Scenarios and Sensitivity Analysis:
The goal is to assess risks and develop strategies to adapt to changes. To make it credible, it should be prepared in the form of reports with specific figures and forecasted numbers.
This analysis allows the business to understand what the outcomes might be in the best and worst cases, as well as under realistic expectations. It is prepared from three perspectives:
- Optimistic Scenario: Assumes the most favorable conditions for the project, such as high revenues or low costs, and shows the maximum potential outcome.
- Realistic Scenario: Represents the main and most likely case where the project proceeds as expected without major deviations.
- Pessimistic Scenario: Considers the least favorable conditions, such as lower revenues or higher costs, and shows the minimum possible outcome.
Sensitivity to key factors such as changes in raw material prices or demand should also be included and considered.
Practical Case Study and Guidelines:
Below is a basic example with concrete guidelines for developing a financial justification related to a €100,000 partial business digitalization investment. The business that will be digitalized is dealing in a dairy production area.
Financial Justification of the Project: Digitization of the Production Process in the Dairy Industry for €100,000
1. Introduction
The project aims to implement digital technologies in the production process of a dairy company. By introducing an automation and quality control system, cost optimization and efficiency improvements are expected, leading to better financial results.
2. Main Project Components:
- Projected Revenue:
Following digitization, the company expects an increase in the capacity and the quality of the production, which will lead to an increase in sales of 15% in the first year and a 10% increase over the following two years. Also the lower costs will allow better pricing and potential market development.
- Projected Costs:
-
- Direct Investment: €100,000
- Fixed Costs: Annual maintenance and software updates - approximately €5,000.
- Variable Costs: Expected 10% reduction in variable costs through the process automation and this will lower material and labor expenses by about €15,000 annually.
- Capital Structure and Funding Sources:
The project will be financed with €50,000 from internal funds and a €50,000 bank investment credit at a 5% interest rate for three years period.
3. Key Metrics for Financial Justification:
- Net Present Value (NPV):
With projected revenue of €50,000 in the first year (growing by 10% annually) and a 5% discount rate, NPV is approximately €25,000. This give the project positive value.
- Internal Rate of Return (IRR):
The IRR for this project is 12%, significantly above the loan interest rate, suggesting an attractive investment.
- Payback Period:
The investment is expected to pay back in about 2.5 years due to increase revenues and optimized costs.
4. Scenarios and Sensitivity Analysis:
- Optimistic Scenario:
If the demand for milk products increases and the company expands their market share earlier than expected, the annual sales growth could reach 20%. In this case scenario NPV could increase to €35,000.
- Realistic Scenario:
Assumes a 15% revenue increase in the first year and 10% thereafter. This is the basic scenario.
- Pessimistic Scenario:
If the implementation of the digitization is delayed and appeared unexpected costs, revenue growth might be only 5%, which will reduce NPV to €10,000. Never mind the effect from the project will still be positive.
5. Practical Additional Steps for the execution of the Case study example, important for building adequate financial justification:
- Data Collection and Needs Analysis: Specify the systems and software necessary for digitization. The project must be exact and clear to describe what asset will be the investment, what technical characteristics has etc. Not for example - software for improvement. Also clear and punctual expectations about the changes that will follow after the realization.
- Supplier and Contractor Selection: Seek vendors with relevant experience and propose whole decision. Gathering at least three bids of offer and their comparison as well as the products that they offer for sale.
- Implementation and Testing: Implement systems and personal training of the staff before so called go-live stage and immediately after that.
- Monitoring and Results Evaluation: Continuously monitor results and adjust processes as needed.
Each financial justification should include detailed back-up information for each point following the structure above.
If facing challenges in this process, contact us to guide and help you. And why not do all this documentation together for better results?
Author: Galina Vankova, Ethical Finance GV LTD