Financial Feasibility is Key to Success!
Financial feasibility is the process of evaluating the financial viability of a proposed new project or a new business venture. The analysis entails a comprehensive study of the expected financial performance of such a project by examining the projected investments, running costs, sources of revenues, profits, and cash flows to evaluate if the expected returns provide sufficient compensation for capital providers for the project’s risk.
In the context of setting up a new manufacturing plant which typically requires a large amount of capital, financial feasibility is a very important factor to consider because it helps to determine whether the plant is likely to be financially successful. Studying the financial feasibility entails a deep dive into many details to understand important details such as the cost of labor, raw materials, overhead expenses, and the initial investment cost into equipment. The analysis of the revenue side covers the anticipated demand for the goods or services being produced; how much volume is demanded in the market and the expected selling price at which the products will be sold. In the following, we will shortly explain the important aspects when studying the financial feasibility of such a project.
8 Key Factors when Evaluation the Financial Feasibility of a Manufacturing Plant
There are several key factors that need to be considered when evaluating the financial feasibility of a new manufacturing plant, including:
1. Market demand for the products that will be manufactured — This involves conducting market research to learn more about the target market, including the size and characteristics of the potential customer needs and preferences, and the competition.
2. Competition in the market — There are several ways to assess the competition in the market. One common method is to analyze the competitive advantage of the business, including its cost structure, the effectiveness of the production process, and the special qualities or advantages of the items it produces, which is a popular technique.
3. Capital Expenditures expenses (CAPEX) — CAPEX items are expenses that a company incurs to acquire, maintain, or improve its fixed assets, such as buildings, land, machinery, and equipment. These expenses are typically one-time, large expenditures that are expected to provide long-term benefits to the company.
4. Direct expenses — Direct expenses are costs that are directly related to the production of a company’s products or services. Examples of direct expenses include raw materials, direct labor, and commissions paid to sales staff.
5. Operating expenses (OPEX) — OPEX items are the costs that a company incurs in order to run its business on a day-to-day basis. Examples of operating expenses include salaries, rent, utilities, and supplies.
6. Potential profit margins — Profit margins represent the amount of money that a company expects to earn after all of its expenses have been paid. Forecasting the anticipated demand for the products being produced and the accompanying sales volume, as well as figuring out the costs related to creating and selling those products, are necessary to determine the prospective profit margins for a new manufacturing facility.
7. Potential revenue — Potential revenue refers to the amount of money that a company expects to earn from the sale of its products or services before any expenses have been deducted. There are several potential sources of revenue for a new manufacturing plant which include:
a. Sale of Manufactured Products — The manufacturing plant’s main source of income comes from the selling of manufactured products to its customers[CH1] .
b. Licensing and royalties — Often manufacturing plants developed unique technologies for their processes and are able to license those technologies to other plants. So a manufacturing plant potentially can create an additional income stream by licensing its technology[CH2] to other companies or by receiving royalties from the use of its intellectual property rights.
c. Services — Sometimes manufactured goods such as e.g. a boiler or heater might require annual maintenance and service in order to keep functioning properly. This can open up new a new revenue stream and offers valuable insights into customers’ problems and allows us to form a long-term relationship.
8. Potential risks and uncertainties
An important element of financial feasibility analysis is not only to study the merits of a project but also to have a good look at all the risks and uncertainties involved in such an operation. For a manufacturing plant, some of the risks may include:
a. Changes in market demand — A number of variables, including shifts in customer preferences, shifting economic situations, and competition, can all affect how much demand there is for the products being produced over time.
b. Supply chain disruptions — Supply-chain disruptions, such as raw material shortages or delivery delays, can have an effect on the production process and may result in lower sales or higher expenses.
c. Technological changes — Technology advancements might also bring opportunities or threats to a manufacturing facility. For instance, the introduction of new manufacturing methods or materials could interfere with the current production process and necessitate large expenditures for new tools or training.
Financial Metrics to look at when evaluating the Financial Feasibility of a new Manufacturing Plant
Here are several methods for evaluating the financial feasibility of setting up a new manufacturing plant:
1. Internal Rate of Return (IRR) — A financial metric that is used to evaluate the investment’s profitability and which takes into account the time value of money. The internal rate of return is the discount rate which leads to a net present value (NPV) being equal to zero. The NPV discounts the future net cash flows to their present value to take into account the fact, that positive cash flows in the near future are more valuable than positive cash flows years into the future. The IRR for such a project should lie above the opportunity cost of capital.
2. Payback Period — A simple metric that analyzes the time required so that a project’s cash flows should be able to repay the initial investment made. For a manufacturing plant, a good payback period should lie within 7–10 years.
3. Annual Cash yield — Opposite to IRR, the cash yield looks at the annual yield a project can generate and is not exit driven. A good way to look at the profitability of a project is from a buy-and-hold perspective by dividing the annual free cash flows (levered or unlevered) by the required investment.
4. Break-even analysis — Conducting a break-even analysis will tell us how much volume of a project needs to be produced to achieve break-even (meaning profits are zero). This can give us a good grasp of the riskiness of such a project. For example, if your fixed costs are $100,000, your variable cost per unit is $10, and your selling price is $20, your break-even point would be:
Break-even point (in units) = $100,000 / ($20 — $10) = 10,000 units
This means that you need to sell at least 10,000 units in order to break even. If you sell more than 10,000 units, you will start to make a profit. So if your business plan foresees selling 10,500 units, then such a plan is riskier than if your business plan foresees selling 20,000 units.
5. Debt-to-EBITDA Ratio — The Debt-to-EBITDA ratio measures the amount of debt a company has relative to its profits at the level of Earnings before Interest, Taxes, Depreciation, and Amortization (EBITDA). A debt-to-EBITDA ratio of 3.0x means that the company would require 3 years of annual EBITDA to fully repay its debt. Typically, banks view Debt to EBITDA ratios higher than 3 times as quite risky and indicate excess use of leverage.
For example, a company estimates that the total cost of building and equipping the plant will be $20 million. The company has $10 million in available equity to fund a portion of the project. The company is thinking about getting a loan to finance the remaining $10 million.
Let’s assume that the business anticipates having $5 million in EBITDA in its first year of operation and $7 million in its second. With these, the company would have a debt-to-EBITDA ratio of 2.0x in the first year ($10 million in debt / $5 million in EBITDA) and 1.4x in the second year ($10 million in debt / $7 million in EBITDA). These ratios are below the desired limit of 3.0x, indicating that the company may be able to properly manage its debt levels.
Please note, there are many other aspects from a bank’s point of view which need to be taken into account when determining if obtaining bank financing will be feasible or not. E.g. a manufacturing plant might need to offer collaterals, guarantees by its shareholders, compliance with other covenants such as the Loan to Value Ratio, Debt Service Coverage Ratio (Free Cash Flow / Debt Service), or Interest Coverage Ratio (EBIT/Interest) during the forecast period.
Studying Financial Feasibility reduces Risk and prepares for Success
Financial feasibility is a crucial factor to take into account when opening a new manufacturing facility, especially when thoroughly studying all aspects which impact the financial feasibility. The analysis is based on forecasting the expected financial performance of a new project and apart from studying its merits also should focus on identifying and mitigating the risks. New projects should generate sufficient returns so that the capital providers receive adequate compensation for carrying out the financial risk of such projects. Also, proposals to receive debt financing need to take into account market terms in order to be acceptable to banks or other lenders.
There are several key factors to consider when evaluating financial feasibility, including market demand, competition, potential revenue, capital expenditures, direct expenses, operating expenses, potential profit margins, and risks. Feasibility analysis typically summarizes all the considerations in select key metrics which then can be easily compared and understood by capital providers.
If you are interested to learn more about this topic, kindly read the full article about how to prepare a financial feasibility study.
