This process refers to conditions, estimates and expectations made by organizations regarding future financial variables and events. Financial assumptions that serve as foundations for financial planning and budgeting, may include estimates on the growth rate of sales and expenses, discount rate, weighted average cost of capital (WACC), interest rate, selling prices, sold quantity, operating expenses, and alike. These assumptions show the critical conditions the business will be involved in; however, such estimates shall neither replace any risk analysis nor fix the future dynamics of business influencers. These assumptions play a significant role in judging the decision-making, forecasting and budgeting, viability testing, relocation of resources, performance evaluation, and risk analysis. The more the financial assumptions are reasonable and reflect the actual business situation, the more the financial results will become accurate.
Step-By-Step Process
- Clarify the sales and marketing, technical, and organizational requirements.
- Look into best practices and obtain assumption details.
- Search the company’s internal and external conditions and anticipate variable factors that influence the viability, such as growth rate, discount rate, inflation rate, interest rate, wages and salaries, revenues and expenses, and alike.
- List all current and capital accounts and decide on the most variable accounts that impact the financial viability.
- Identify and list all financial variables relevant to the critical accounts and viability, like revenue drivers, cost components, market factors, interest rates, inflation rates, growth rates, and other factors relevant to your business or industry.
- Describe the future variability for each of the current and capital accounts critical to the financial viability and define trends and scenarios.
- Estimate the variable factors regarding the step before, like growth rate, interest rate, operating cost as a percentage of revenues, gross margin, operating margin, net profit margin, capital structure, and so forth.
- List all financial assumptions and share them with the team and experts.
Example
Here are the financial assumptions of a pharmaceutical manufacturing facility:
- Working capital is estimated based on the third-year operation sales of ($18) million, covering (60) days for receivables, and cost of goods sold of ($7) million covering (90) days for inventory, (90) days for cash, and (30) days for payables.
- Depreciation estimates are calculated based on (5) years of depreciation schedule for the pre-investment cost and capital financing cost, (15) years for the production technology and warehouse equipment, (25) years for the building, and (5) years for the rest of the fixed assets.
- The standard growth rate for revenues, costs, and working capital is set at (5%) for the first five years of production and (3%) afterwards, except for the sales of the first ten years, which follow different paths.
- The cost of materials, packaging, wastes and other direct expenses is estimated as (20%) of factory ex-work prices (Private sales) for the production products and (25%) for the secondary-packaging products.
- The cost of marketing and sales is estimated at (45%) of the revenues.
- The cost of administration is estimated at (10%) of the revenues.
- The financial cost is based on a (75%/25%) leverage ratio (loan/equity), a (3.5%) fixed interest rate, and is repaid over ten years with a two-year grace period.
- The financial costs for the operation debts, other than the initial investment, are based on the fixed interest rate of 3.5% and are repaid over ten years with no grace period.
- The Weighted Average Cost of Capital (WACC) is estimated as 7%.
- We applied no corporate tax.
- The sales program is based on the assumption of private price as (70%) for the first generic medicine, 60% for the second generic medicine, 50% for the third generic one, and so forth of the originator factory ex-work price and (30%) of the public-tender selling prices.
- Dividend pay-outs are assumed to be (0%) for the years (1-4), (10%) for the 5th year, (20%) for the 6th year, (30%) for the 7th year, (40%) for the 8th year, and (50%) for the 9th year and so forth.
Useful Tips
- Brainstorm financial assumptions with your team and experts.
- Make reasonable judgement of the assumptions based on the business’s internal and external conditions.
- Collect relevant information from best practices and published statistics.
Things To Avoid
- Avoid being overly optimistic when setting financial assumptions.
- Avoid basing assumptions on guesswork or unsupported opinions.
- Avoid overcomplicating assumptions.
Final Note
This article is sourced from my new book- Your Guide For Preparing An Industrial Feasibility Study. For more information about the book: https://growenterprise.co.uk/book-your-guide-for-preparing-an-industrial-feasibility-study/To register in our newsletter: http://eepurl.com/ggcC29Or email us at: maldawood@growenterprise.co.ukThe author: Munther Al Dawood- Industrial Enterprise Expertwww.growenterprise.co.uk
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