For any new venture it can be daunting to answer important financial questions such as when will revenue occur, when will your business become profitable and how much financing will you need.
It is vital for any new company to know the financial numbers that can provide answers to these questions. Generally speaking, knowing your start-up costs, your operating costs and cash flow will put you in a good position to know where your business stands.
Entrepreneurs are generally very optimistic, especially with respect to the rate of sales growth relative to their start-up costs, e.g. product development and marketing costs. Often the rule of two applies; start-up-costs will be twice as high as expected and it will take twice as long as expected for revenue to occur. And upon your first sale, revenue will grow at half the expected pace.
Operating Costs and Break-Even Point
Operating costs, both fixed and variable, are often underestimated. As a result, break-even points are miscalculated and prices are set too low.
The break-even point is the level of sales you need to cover your fixed costs given your contribution margin, which is revenue less variable costs. For example, if your fixed costs are $100,000 in a month and the contribution margin is 50%, you will need to sell $200,000 in that month. But if both the fixed costs and the margin are incorrectly estimated, the product price at which the break even point is anticipated will be wrong.
You should be mindful that fixed costs often increase in a step-wise fashion. Moving from a one-man operation to employees and an office will increase your fixed costs substantially, affecting your break-even point.
When preparing a budget for any business beyond a “one-man-show”, you must include the owner’s salary costs and selling costs, outlined below:
Owner’s salary. A business that cannot accommodate an owner’s salary is not a viable business. Even if the salary is not actually paid out, it must be accounted for as a deferred expense that the business will eventually be able to pay.
Selling costs. Even if the owner initially makes all sales himself, the costs of others performing this function must be included, otherwise the business will never be able to expand beyond what the owner can personally achieve in sales. You also need to ensure that your selling costs include the cost of acquiring new customers. These costs, which include all commissions, salesperson salaries, advertising, concessions, and travel etc., can change over time. Changes in your selling costs and competitive pressures may result in your contribution margin changing over time.
Other operating costs frequently unaccounted for are payroll taxes and employee benefits, various fees on purchased goods such as tariffs and duties, freight, duties, brokerage fees, currency exchange and interest expense.
Cash is king for all companies but especially for start-ups with no or insufficient revenue. Detailed rolling cash flow budgets are essential both in the start-up phase and once full operations begin. These cash flow budgets, if properly implemented, will alert you to cash flow issues, while allowing you time to address them.
The most critical number is the burn rate. The burn rate is the speed at which your cash balance declines and will indicate when your funds are expected to run out if new financing is not obtained. If you are running out of cash, and need new outside financing, you should start seeking it at least six months before it is needed so you do not end up negotiating a deal with a “knife to your throat”.
There are a number of potential working capital financing options available to start-ups.
Lines of credit require security in company assets such as accounts receivable and inventory and often personal guarantees. Factoring, an alternative to a line of credit, allows for a financing company to purchase accounts receivables at a discount. The advantage to factoring is that you can obtain greater financing more quickly, however, you will pay a higher interest rate.
Another option is purchase order financing, which is used for businesses to finance the fulfillment of customer orders. One way this works is for a financing company to pay the required suppliers directly for most or all of the costs. The financing company then invoices the customer directly and payments are returned to the business minus specific fees for the service.
In conclusion, even brand new ventures need to be on top of these key financial numbers right from day one in order to be successful.