Art of Challenging Assumptions in Business Plans

Evaluating the credibility of operational assumptions or challenging assumptions of projects is an art that should be mastered for anyone in a position to validate business plans: banker, investor, member of the investment selection committee. It must be able to rely on points operational and financial benchmarks. Below this post is all about the Challenging Assumptions in Business Plans.

Challenging Assumptions in Business Plans

Return rates or fair net discounted values, cash flow curves and very short payback periods are based on operational assumptions whose credibility needs to be verified. The proponent of a project tends to make optimistic assumptions, either because of his or her natural enthusiasm and in good faith, or more consciously to facilitate the adoption of the project. The credibility of a project’s cost-benefit assessment can be accessed from operational action plans, key economic sector indicators, or project financial data.

Evaluate the Credibility of Operational Action Plans

As part of the selection of projects within the company, the members of the investment committee are a prior professionals in the business able to evaluate the operational aspects.

Illustration: In an SME, investment projects are presented to the board of directors. The production manager realizes that the questions put to him have become much more precise since an engineer has integrated this advice.

Investors and bankers often use specialists by sector. For example, to evaluate mining projects, an investment bank hires as a financial analyst a geological engineer who has worked for seven years in mining and quarrying before obtaining a degree in finance.

• Have expenditure items been forgotten?

Illustration: As part of the project to implement a computer-aided production management (CAPM), the project manager has only one license fee to use the ERP while four computer stations are planned. However, the billing of the operating license which is of a significant amount is proportional to the number of computer stations!

Be Familiar with the Key Economic Indicators of the Sector

Depending on the sector of activity, the profitability of the project is often based on the control of some key economic indicators: hotel sector, transport, distribution, the knowledge of these key indicators is shared by the actors of the sector. For example, in distribution, three years are usually required to reach the goal of the number of customers in a store.

Illustrations

Several indicators condition the success of a hotel project, including:

• The occupancy rate of the rooms;
• Average revenue per available room
• For hotel restaurants, the hotel’s hotel intake rate determines the proportion of hotel guests visiting the restaurant. It is a priori higher in small provincial towns where the catering offer is low.

These indicators are modulated according to the project: size, level of range, geographical location,

In 2015, the Macron law opened interregional bus transport to competition. Some private companies that launched the “Macron bus” lines displayed in their business plan a record seat occupancy rate of around 80%. In reality at the end of the first year, this rate did not generally exceed 30%!

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Evaluate the Credibility of the Financial Forecast

To assess the credibility of sales forecasts, you need to know the dynamics of the market: Is the expected growth rate of turnover consistent with the growth rate of the sector, if it is higher how to justify it? Is the turnover forecast credible in relation to the size of the market; is the market share consistent with the competitive position of the company?

To evaluate margins in the business plan of an existing business, it is necessary to compare the forecast data with the actual data of the past, any differences to be explained. In the income statement below, the company will have to justify:

• Improvement of the gross margin rate: development of products with higher margins, improvement of the product mix, negotiation of purchases,
• The reduction in the weight of personnel costs expressed as a percentage of sales: increased sales allowing better absorption of structural expenses, productivity investments, outsourcing of non-strategic activities.

It is also important to identify any anomalies with respect to balance sheet items:

• An increase in sales that is not accompanied by a corresponding increase in working capital requirements (WCR). It is advisable to show in the forecast, not only the BFR in amount but also the time of flow to facilitate the analysis;
• An increase in sales without corresponding investment of capacity. A significant improvement in the fixed asset turnover ratio (Net Sales / Fixed Assets) over time may reveal that capacity or renewal investments have been missed.

 

• Does the Forecast Incorporate Safety Mattresses?

Are safety mattresses corresponding to the identified operational risks integrated into the forecasts? Are these risks taken into account in the baseline scenario or analyzed as part of a sensitivity analysis or alternative scenarios?

Illustration: The business plan of a tannery company of calfskins includes an assumption of 15% increase in the purchase price of skins spread over two years. As the consumption of veal decreases, skins are consequently rarer. However, this increase in the purchase cost is not effective so far, it remains at the contingency stage. In all cases, it is worth mentioning the existence of this safety mattress in the interpretation of the profitability indicators.

• Integrate the Law of Diminishing Returns

According to this law, it is difficult for a company to maintain in the medium term an economic profitability higher than the average profitability of the companies of the sector.

At some point, the company may have a competitive advantage that gives it a higher rate of return than the industry. In the long run, however, competitors will try to copy it, the product may become commonplace, the needs of the market to evolve towards other products,

• Evaluate a Posteriori the Reliability of the Hypotheses

The European financial department of an industrial group studies a posteriori the credibility of the revenue assumptions of the business plans from the various national subsidiaries. It was able to establish the “prudent” or “optimistic” profile of each of the subsidiaries based on the average difference between forecast and actual sales.

The business plan is also increasingly used as a tool for monitoring and steering the project. Each year, it is necessary to compare the actual data with the forecast data, analyze the differences and, if necessary, update the forecasts for the remaining period. It is a way of empowering project managers in advance.