Tuesday, February 28, 2012

Small Business and Entrepreneurship - To Startup or Not To Startup Part V - Profit Loss and Break-even

"Remind people that profit is the difference between revenue and expense. This makes you look smart." -- Scott Adams

In this section of our look into the decision of whether or not to start a new business, we will look at compiling the results of our financial projections. We've taken a look at collecting our expected costs, and predicting our future sales. Now we will combine the two but first we should note that there are many ways to format a cash flow projection spreadsheet. We will make some general recommendations that may help with analyzing the results but these are by no means the only way to do things.

For your columns, a typical dating format may begin with monthly figures (Month 1, Month 2, etc) for the first year, go quarterly for year two, and yearly for the remainder of the projection. Financial statements will typically be compiled for 3, 5 or 10 year periods.

As far as formatting the rows it is usually helpful to arrange figures categorically, and to help analyze your results later it is best to put in as much detail as you can. Remember, this set of figures is to help you make a decision on starting a business (as opposed to presenting an idea to an investor, or convincing a boss to authorize a project), we are not looking to hide anything from ourselves, we want information and functionality. Typically you would start with revenue figures, then costs, then totals, and it is helpful to try to list your assumption in the first column after your descripion, something like:

If you are able to list your assumption this way and tie your monthly or yearly figures to the assumption using formulas then changing the assumption should update all the fields in the forecast allowing for quick updates or easy sensitivity studies.

When listing your revenue figures it could be helpful later to embed in your projections the process used to determine your numbers. If you are using a salesman/marketing effort based calculation perhaps your revenue section will look something like:

  • Number of Sales Staff
  • Number of Potential Customers Reached per Staff Member
  • Amount of Advertising Budget
  • Number of Potential Customers Reached per $10,000 in Advertising
  • Total Number of Customers Reached
  • Percentage of Reached Customers Converted to Sales
  • Total Unit Sales
  • Price
  • Total Forecasted Sales
Of course we can abbreviate them in our spreadsheet, but laying out all the detail will allow us to play with the assumptions and analyze changes once we are done.

When listing costs it is helpful to be organized by categories perhaps by listing up-front costs first (these may only show up in month 1 but it is nice to have the total easily identified). We can further organize our costs into variable and fixed monthly expenses. Variable would contain things that vary with the level of production (such as materials, shipping, packaging, manufacturing labor, etc); while fixed costs are monthly expenses that are expected to be roughly the same despite the current level of production (such as rent, salaries, insurance, utilities, office supplies, etc).

Now that we've compiled our revenues and costs we will want monthly (or quarterly or yearly depending on your date formatting) totals for:

  • Total Cash In
  • Total Cash Out
  • Net Cash Flow

In addition to this we will want a running total of our cumulative cash flows. Totals should look something like the simplified example below:

Once we've compiled all our figures and totals we can look for some key points. One is the cash-flow positive point. This is the point where your net income exceeds your net outflow, when you have more money coming in than you expend. At this point your company will start making back some of the money it needed to get started. In the simplified example above, this occurs at Month 8 of Year 1, with a Net Cash flow of $2,500 ($7,500 in sales and $5,000 in expenses).

The month prior to that, Month 7 year 1 is significant as well as that is the point where your cumulative losses cease to increase. This figure is thus your "cash need". In the simplified example this company expects to lose a total of $17,500 before it becomes cash-flow positive and therefore this company needs to come up with $17,500 in order to make it to Month 7 of Year 1 at which point it should be okay on its own.

The other significant point is Month 11 Year 1, this is the cash flow breakeven point, the point where the company has made back the money from its cash needs. Next week we will take a more detailed look at our completed financial projections including cash needs, and sensitivity to our assumptions.

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