Monday, August 25, 2014

Budding Entrepreneurs should not ignore financial feasibility

A lot of us would like to be entrepreneurs given a choice. However, what is that we must know about finance before setting up the business. This is a question which i have been asked many a times from friends, relatives and even co-passengers while travelling. Here, is my attempt at answering the question.
  1. Every entrepreneur should know the concept of  risk and return.Newspapers frequently talk about individuals who have invested money and believed in their ideas, and this belief has resulted in profits  unheard of. The counry also is seeing a spurt in young entrepreneurs who have jumped into the fray with nothing but intellectual capital. The question is do all these ideas work. According to Bloomberg, around 80% of businesses that start fail. What does it mean in terms of risk? In simple terms, the risk is high. Hence, even though expected returns are on the higher  side the chances are that getting the returns are low. Same was true for most of the software firms that registered loss in 2014.
  2. Profit is a function of revenue and cost. However, good your business idea is if you are not able to earn profits from the business sustaining it in the long run is generally difficult . Being conventional, I would not really look at business idea, which sustain on investments rather than their own internal accruals in medium and long term. Any organisation which has had a life of more than five years should be in black and making profits. The profit can be earned only when revenue is more than cost. If revenue is less than cost for more than five years, for any start up, it should seriously start looking at different avenues of augmenting revenue or controlling cost.
  3. Profit is not equal to cash flow from operations - A lot of start ups face challenges in monetizing their idea and generating revenue out of it. Once revenue is generated, the next big challenge is to realize it in terms of cash, especially if you are a start up in the Business to Business (B2B) space. If your business model is such that you make immediate payment to everyone you owe, but it takes time for you to collect money, there are going to be a severe liquidity crunch in the future. Case in the point, is a digital marketing company I know which went bust because the real estate company which owed them INR 20 lakhs defaulted .
  4. Revenue is a function of selling price and quantum sold. The main aim of any entrepreneur is to maximize revenue and have sustainability in the long run. However, the same cannot be done until and unless the company understands the value proposition it delivers to the consumer. If the consumer is not satisfied with the value proposition, the revenue cannot be maximized. This is true in the case of a lot of intangible services. Case in the point, is the dabbawallahs of Mumbai. Even though dabbawallahs of Mumbai, was a idea that caught up in Mumbai it did not pick up in other cities. It was because it did not provide the same value proposition to the consumers in other cities. The other factor to be considered is the life of your product. In case of technology intensive products, with disruptive technology becoming the buzz word, sustainability is an issue hence generating sustainable and predictable revenue stream is becoming a challenge.
  5. Fixed Cost increases pressure to deliver: Cost can either be categorized as fixed or variable. Fixed Cost does not change with time, while variable cost is proportional to Sales. Hence, if sales are low for a start up and fixed cost is high the pressure to deliver increases and hence the probability of going cashless also increases. An important factor to be kept in mind for any business where salaries is the largest cost driver, is that salaries is a fixed cost. Hence, hiring people who are not required just because you have some idle cash from investors should be strictly avoided. Case in the point is in education digital space which has only 14 employees whereas most of it's competitors have more than 100 employees.
  6. The expected return is always a function of the servicing cost of  raising money for the business. The money for business could be raised from internal accruals (previous years profits), borrowing, preference shares, equity shares, or hybrid instruments comprising two or more instruments.