Joe Johnson, Ph.D.
Entrepreneur. Investor. Startup Expert.
You may have some great ideas and believe that you’re ready to make one of them a reality – but starting a business isn’t just about amazing ideas; there’s a great deal of practical knowledge that must be effectively applied in order to facilitate (not guarantee!) success. Before committing to a project, be certain that you fully understand your idea’s financial aspects and the likelihood of its being truly viable.
In this article, I’ll be covering a few financial basics that you’ll need to understand in order to help ensure that you have the requisite financial knowledge to start a business. Please take note that this list isn’t by any means meant to be comprehensive. For a better understanding of your particular business’ finances, make an appointment to consult with an accountant.
When vetting a specific business idea, creating a business model canvas can help you to determine the resources necessary to get up and running, how much it’s likely to cost, whether there’s a market for the concept, and whether it could potentially be profitable. Part of this process will include rendering your idea into financial terms.
The following terms are shown in alphabetical order:
Accounts payable is the total amount that your business owes to others. This figure can represent inventory, utilities, rent, services, and more.
Accounts receivable (AR) is the total amount that is owed to your business in exchange for your products or services. This figure represents the sum of your open invoices.
Assets are anything owned by your business having intrinsic cash value. This includes inventory, accounts receivable, any owned property or equipment, cash, and more. Assets constitute an important part of your business’ overall health.
A break-even analysis will help you to determine exactly when your revenues will exceed your expenses.
It’s essential to know how much money it costs to operate your business, especially if you aren’t yet profitable. Most businesses will experience a period of time early in their lifecycle when they aren’t making money. Knowing your burn rate – or how much money is necessary to operate your business each month – provides direct information on how much money is required to continue.
Knowledge of how money moves through your business – cash flow – matters. Evaluating how much cash you have on hand at both the beginning and end of a given month can help you to determine your cash flow and thereby provide insight into your business’ degree of solvency. Knowing that you can meet all of your financial obligations is of critical importance when attempting to run a successful endeavor. Cash inflows are your revenues, while cash outflows are your expenses.
Costs of Goods Sold (COGS)
If you’re selling a product, then you’re either paying to have it made or paying for a finished product that can be resold. The amount that you pay for those products is your costs of goods sold. Services can also have an associated COGS, as COGS includes labor costs in addition to raw materials. These costs are sometimes referred to as ‘direct costs.’
The equipment and property that your company owns lose value over time. This loss is called ‘depreciation.’ The act of depreciating your equipment and property enables you to claim a tax deduction for this loss of value.
Equity can mean one of two things. For small business owners, equity is generally the personal assets (usually cash) that they have invested into the business. For those companies which have accepted stock in trade for investment, equity is their ownership interest in the business.
Expenses are, essentially, your cost of doing business. Your business will likely have fixed expenses such as rent and loan payments. Regardless of how much your company is earning, you can generally count on these expenses to remain static over time. Variable expenses – those that change month-to-month depending on sales volume or other factors – include shipping costs, cost of goods sold, payroll, and more.
Gross margin is a percentage that denotes how much money you’re earning per dollar of revenue. If you have a 15% gross margin, you’re earning $0.15 on every dollar of sales. To determine this number, subtract your COGS from your revenue and then divide the result by the revenue. Having an understanding of your gross margin is important, as it can help you to decide whether you should reduce your COGS or increase your prices.
Gross income is all of the money earned prior to expenses.
Anything you owe is considered to be a liability, including business loans or other debts, accounts payable, and payroll.
Net income is your profit – it’s gross income minus expenses. When trying to determine viability, net income is a better indicator than gross income.
Profit margin informs you of how much you’re retaining from each dollar of sales after accounting for all expenses. To calculate it, divide net income (gross income minus expenses) by total sales. A 20% profit margin shows that your company is earning $0.20 for each dollar of sales. Increasing the profit margin will require either increasing the cost of your product/service or decreasing expenses.
Return on investment (ROI) is the percent of profit you’re earning on the money you’ve invested into business operations. To determine your ROI, divide net profits by your investment.
Understanding these terms can aid you in crafting financial statements that illustrate your company’s projections and current financial state. While having an accountant on retainer can make it simpler to generate these statements, many entrepreneurs beginning a business or testing a business idea tend to fill multiple roles, including those of bookkeeper and accountant, until their businesses grow sufficiently to justify either outsourcing those tasks or hiring someone to handle them in-house. Thankfully, accounting software is available to help you create financial statements (except projections).
When creating a business plan, it’s necessary to include financial projections. Projections are also helpful when seeking a bank loan, attempting to entice investors, charting a future course for an operating enterprise, or exploring potential new avenues of growth. They’re a good planning tool and should be revised whenever new information becomes available.
Projections are informed guesstimates based on your market research. You’ll need to determine your future expenses (including COGS), your likely sales based on current data, and how those figures may evolve over the next 3-5 years. For many, formulating this part of the business plan can be daunting. It is, however, a valuable exercise, as it can yield extremely useful information.
You should draft a sales forecast showing how many units that you believe you’ll sell (or services you’ll provide), the price you intend to charge, the resultant revenue, the COGS for that revenue, and the profits generated (revenue minus COGS).
An expense budget is useful for detailing exactly how money will be used. In addition to considerations such as rent and payroll, you should also consider marketing costs, shipping costs, manufacturing costs, equipment costs, etc. Because this is a projection, you won’t need to be as precise as you’d need to be on an expense report. Ensure that you cover both fixed and variable costs. The expenses themselves don’t need to be reviewed in-depth, but they should provide a reasonable picture of your plans. For example, while you don’t need to itemize the price of every furniture component that you intend to purchase, you should have a ballpark figure for all of it.
The following three reports should also be part of your projections, although their numbers may be estimated (if your business is already operational, you should be reviewing these reports regularly):
Your balance sheet is a snapshot of your business’ current financial status. It includes your assets, liabilities, and equity. Understanding exactly what your business owns, what it owes, and its current value can aid you in making better financial decisions and pinpointing problem areas. Unfortunately, a balance sheet can’t help to determine cash flow problems or assist in assessing whether expenses are too high, though the following two reports will (your accounting software should be able to generate these reports):
Profit and Loss Statement
Also called an ‘income sheet’ or a ‘statement of operations,’ the profit and loss statement details a business’ income and expenses by going into the minutiae of running a business. It should clearly show how much your company is spending on fixed and variable expenses, as well as the source(s) of your revenue. If revenue is lower than expenses, you must either reduce costs or increase sales.
Cash Flow Statement
Based on cash basis accounting, the cash flow statement details the amount of cash that your company had at the beginning of a specific period, how much has been generated, how much has been spent, and how much is currently on-hand. Because customers don’t always pay for products and services upfront, a cash flow statement is useful for ensuring that your company has sufficient cash on-hand to meet its obligations. Some companies may find that the way in which their payments are structured leaves them unable to meet certain obligations. This is often the case with seasonal companies which experience business fluctuations (such as landscapers, et al.).
Once you’ve learned to calculate your profit margin and to create an income statement and balance sheet, it’s important to utilize these newfound skills to assess the viability of your business. A close evaluation of your numbers can help you to determine whether to make changes to your business model or pivot completely. You may decide to negotiate with vendors in order to trim expenses or to increase sales goals. Making a regular practice of assessing your numbers (i.e. don’t wait until tax time!) can help you to spot trends, locate issues, and maximize growth.
About the Author
Dr. Joe Johnson is an entrepreneur, investor, and startup expert. He is the founder and principal of GoodField Investments and the GoodField Foundation (www.GoodField.com).
Joe has a Ph.D. in Entrepreneurial Leadership and an MBA. He is the author of the upcoming book on The Science of Why Most Entrepreneurs Fail and Some Succeed.
Most importantly, he is the incredibly blessed husband of one amazing wife and father of six wonderful children. He resides in Bradenton, Florida. For more information on Dr. Johnson and his work, go to www.JoeJohnson.com.