Estimating Startup Costs
Determining your budgetary needs is a critical stage in starting your business.
Every business is unique and carries a specific cash needs at different stages of development. Thus, there is no universal method for estimating your start-up costs. The budget varies depending on the type of your business. Some can start on small budget while others need large investments such as for long-term equipment and acquisition or renovation of a building.
In computing for your startup costs, calculate an estimate of the cost you will acquire for the first months of operation. These expenses are either one-time costs, such as the fee of incorporating your business, or ongoing costs, such as cost of utilities, inventory, insurance, etc. After recognizing these costs, identify whether they are important or optional. A realistic startup budget should only include items that are important to start your business.
Important expenses are categorized as fixed and variable. Fixed expenses are rent, utilities, administrative costs and insurance costs. Variable expenses are inventory, shipping and packaging costs, sales commissions, and other costs associated with the direct sale of a product or service.
The most effective method to estimate your start-up costs is to use a worksheet that identifies your business’ one-time and ongoing costs.
Using Personal Finances
One common source of start-up budget is your personal finance. This approach, however, can result to tremendous strain on your personal fund since it takes time before your new business earns profit. It is hence important to organize your personal finance.
Start by writing a monthly household budget that includes your income and your household expenses. Be conservative in handling your household expenses because it will also determine the success of your business. Any problem on your personal budget directly risks your business.
It is important to build a strong personal credit history because it will serve as the basis of your lenders and suppliers in determining your terms of credit.
Preparing Financial Statements
Financial statements serve as roadmap in directing businesses towards the right direction. Their value extends beyond preparing tax returns or applying for loans. The following paragraphs discuss the basic components of primary financial statements: the balance sheet and the income statement.
The balance sheet is the summary of your business financials. It mainly includes assets, and liabilities and net worth (assets = liabilities + net worth). Balance sheet items change daily and reflect the activities of your business. It can help you understand and develop your business by providing relevant financial information such as your ability to collect revenues, manage your inventory, and asses your ability to satisfy creditors.
Liabilities and net worth are sources of funds that are collected from creditors and investors. Liabilities are obligations to creditors while net worth are the owner’s investment in the business. Creditors and owners are both considered as “investors” in the business, although, they are repaid in a different timeframe. They are also important in sustaining and expanding your business operation.
Consequently, assets represent the use of funds. The cash or other funds provided by creditors of investors are used to acquire assets. These include things of value that are acquired and owned or due to a business.
Current Assets mature in less than one year. They are the sum of:
Cash is used to pay for bills and obligations. It includes all checking, money market and short-term savings account.
- Accounts Receivable (A/R)
Accounts receivables are money due from customers. When the inventory is sold, an invoice is sent to the customer, and cash is collected at later time. The receivable exists for the time period between the sale of inventory and the receipt of cash.
Inventory represents products purchased by a business to resell at a profit. Businesses buy raw material inventory to be processed. It is eventually sold as finished goods inventory. When inventory is sold, it doesn’t bring cash immediately to a business but it creates receivable. Once the receivables are collected, cash returns to the business. Thus, inventory must be well managed to avoid keeping too much cash tied up in inventory. A business must also maintain sufficient inventory to prevent stockouts (having nothing to sell) which may result in loss of profits and customers.
- Notes Receivable (N/R)
N/R is a claim due to the business as a result of making a loan. It is often a loan made by three stakeholders: customers who are unable to pay their invoice on time, employees or officers of business who are in need of financial support, such as down payment on home. However, officer borrowing is considered as the worst form of N/R since it reduces the business net worth.
- Other current assets
Other current assets represent prepaid expenses, other miscellaneous and current assets.
Fixed assets are acquired physical assets whose life exceeds one year. These include the following:
- Machinery and equipment
- Furniture and fixtures
- Leasehold improvements
Total Assets is the sum of all the assets acquired and owned by or claims due to a business.
Liabilities and Net Worth
Current liabilities are obligations that will mature and must be paid within 12 months. These liabilities are important especially when cash is inadequate. These will keep a business away from experiencing insolvency (incapacity to pay debt). Current creditors must always be satisfied to maintain a steady and important source of credit for short-term obligations.
These include the following accounts:
- Accounts Payable (A/P) are obligations due to suppliers who have provided inventory, goods or services used in operating the business.
- Accrued Expenses are obligations owed, but not billed, which include wages and payroll taxes, interest on a loan, or obligations accruing.
- Notes Payables are obligations in the form of promissory notes which must be paid in less than 12 months.
Non-current liabilities are obligations that are due the following year. These include non-current portion of long-term debt, a portion of a term loan that is not due in a year; and notes payable to officers, shareholders or owners’ cash that they invest in the business.
Total liabilities represent the sum of all the obligations of business and claims of creditors on its assets.
Equity is the difference between total assets and total liabilities. It is the owners’ contribution in financing the assets of the business.
The income statement is another type of financial statement that includes all income and expense accounts over a period of time. It is also referred as the profit and loss statement since it shows how much money the business will make after expenses are deducted.
Developing a Cash Flow Analysis
Cash is fundamental in every phase of a business, especially for the small ones. Hence, it is necessary to create a system that avoids the danger of unavailable cash that can affect your business operations and your eligibility to receive a loan.
Cash flow represents the movement of money in and out of your business. It includes inflow which is derived from operations such as sale of goods and services, loans, line of credit, and asset sales and outflow which occurs during operations such as business expenditures, loan payments, and business purchases. It is important to maintain a balance between these two figures at all times because it will help you manage funds to cover operational costs and bills and aid you in predicting possible problems in the future.
Income statements are important in projecting future cash flows. Consequently, cash flow statement can serve another, unique purpose. They can include non-cash items and expenses to adjust profit. Thus, cash flow analysis statements show the changes over time as well as available net cash.
A cash flow statement is divided into three parts.
- Operating activities represent the section that assesses cash flow trends from sales and business transactions. All income from non-cash items are adjusted to include inflows and outflows of cash transaction in computing for net income or net loss of a business.
- Investment activities represent the section that evaluates inflows and outflows from purchases and sales of long-term business investments which include property, assets, equipment, and securities.
- Financing activities represent the section that accounts for cash flow trends from financing your business such as loans.
Breakeven analysis is a method that identifies when your business begins to make profit and at the same time pay for all its expenses. It will help you identify your startup cost which is an important input to determine the sales revenue that can cover all ongoing business expenses.
The breakeven analysis will help you compute for the breakeven point, which is the level when revenue equals all business costs. To calculate this level, fixed and variable costs must be determined. Fixed costs are expenses that do not change when sales volume varies, such as rent and administrative salaries. These expenses must be paid whether you’re making sales or not. On the other hand, variable cost directly changes with sales volume, such as purchasing inventory, shipping, and manufacturing a product.
The breakeven point is computed using the formula: Breakeven point = fixed costs/ (unit selling price – variable costs)
Borrowing Money for Your Business
Through developing cash flow analysis and breakeven analysis, you’ve gained a better understanding on the potential of your business to make profit. These financial methods may also help you decide whether your business is in need of additional funding. Borrowing money is the most common source of funding for small business. However, before getting a loan, you need to understand how the bank will evaluate your application. The following are some of the key factors that lender assesses before granting loan to a borrower.
Types of Financing
There are two types of financing: equity and debt. Equity financing is the money raised by the company from investors who, in exchange, get a share of ownership in the business. Debt financing is the money borrowed from a lender, such as banks, savings and loans, credit unions, and commercial finance companies, which must be repaid over a period of time, usually with interest.
In choosing between the two options, you must consider your company’s debt-to-equity ratio, which shows the relation between money you have borrowed and money you have invested in your business. The more money invested by the owners, the easier to obtain loan financing.
Ability to Repay
The capacity to repay the money you borrowed must be justified in your loan package. Banks look for two sources of repayment: cash flows from your business and secondary source such as collateral. Also, the lender assesses the past financial statements of a business to evaluate its financial health, specifically, its cash flow.
Businesses that have been established for a number of years with good financial record, generally, are the target recipient of loans from banks. If however, your business is a start-up, it is necessary to prepare a comprehensive loan report to explain how the business will be able to repay the loan.
Banks often require collateral as a secondary source of repayment. Collateral is a personal and business assets that can be sold if the profit of your business is not sufficient to repay the loan. If the potential borrower has no collateral, a co-signer with collateral to pledge must be in place.
The value of the collateral is not based on market value. It is discounted to incorporate the value that would be lost if the assets had to be sold.
The success of your business heavily relies on your managerial expertise. As evidence, poor management is often the reason behind a business failure. Thus, lenders also closely look into your education and experience including that of your key managers.
Questions Your Lender Will Ask
Be prepared to answer a variety of questions when you apply for a loan. The following may serve as your reference in preparing for this process.
- Can the business repay the loan? (Is cash flow greater than debt service?)
- Can you repay the loan if the business fails? (Is collateral sufficient to repay the loan?)
- Does the business collect its bills?
- Does the business pay its bills?
- Does the business control its inventory?
- Does the business control expenses?
- Are the officers committed to the business?
- Does the business have a profitable operating history?
- Does the business match its sources and uses of funds?
- Are sales growing?
- Are profits increasing as a percentage of sales?
- Is there any discretionary cash flow?
- What is the future of the industry?
- Who is your competition and what are their strengths and weaknesses?