In a previous column, I wrote about financial planning and described one of four common financial-planning tools, the break-even analysis. The break-even analysis is part of any good business plan, and it is especially useful for new, or start-up, businesses.
The break-even analysis usually covers a specific time period, such as your first year in business. This simple tool gives you a quick snapshot of your proposed business — will you take in enough revenue during your first year to cover your fixed costs? If the answer is yes, your business stands a good chance of breaking even that first year. If not, it’s back to the drawing board: either increase sales, raise prices, improve profitability, or cut costs.
Two other financial-planning tools that should be part of your business plan are the profit/loss forecast and the cash-flow projection. Let’s see what these tools help you accomplish and how they differ.
The profit/loss forecast is very similar to the break-even analysis, and it makes use of the same financial data — your estimated sales revenue, your estimated fixed costs, and your estimated gross profit percentage.
Just to review, estimated sales revenue is the total amount you expect to receive for providing the goods and/or services your business offers. In other words, at the end of your first year in business, how much can you expect to have billed your clients?
Fixed costs, also called overhead, are the day-to-day costs of being in business, whether you are busy with projects or sitting around waiting for the phone to ring.
Gross profit percentage is the amount you have left over from every dollar you bill to a client — after you deduct your variable costs, or costs of the sale. In other words, you almost always spend something to earn every dollar, and you need to factor that into your bottom line.
The break-even analysis takes these three estimates — sales revenue, fixed costs, gross profit percentage — and tells you whether your sales revenue, after being discounted by your variable costs, will be enough to cover your fixed costs.
The profit/loss forecast uses the same estimates as the break-even analysis but introduces the factor of time — usually by dividing your yearly estimates into month-by-month segments. In other words, how will your business fare month to month?
Unlike the break-even analysis, which is usually a snapshot of your first year in business, the profit/loss forecast takes into account the fact that your sales and expenses will probably vary month to month. There are various versions of preformatted profit/loss forecasts available on the Internet, but it is easy enough to construct your own using Microsoft Excel.
Even better, if you buy a copy of The Small Business Start-Up Kit, by Peri H.Pakroo (Nolo Press, 2008), you get a CD with many helpful documents, including the financial-planning tools I have been discussing.
The first column of your profit/loss forecast should contain the following entries:
- Sales Revenue
- Gross Profit Percentage
- Fixed Expenses (itemized, such as rent, utilities, supplies, etc.)
- Total Fixed Expenses
- Net Profit or Loss
The next 12 columns should be for each month of the year — I’ve included three months in the sample below:
In some versions of the profit/loss forecast, the variable costs are also listed as line items instead of being factored into the gross profit percentage. The advantage of doing it this way is that you get to see exactly what these costs are and whether or not they vary month to month.
No matter which method you choose, here’s the great thing about setting up this spreadsheet: once you’ve been in business for a year, you can begin to plug in real numbers instead of just using estimates. This will make your profit/loss forecast much more useful.
I tell my students that if I were stuck on a desert island with just one financial-planning tool, I’d pick the cash-flow projection. Why? The cash-flow projection shows you how much money you have in the bank at any given time — and that’s literally the bottom line to running your business.
It doesn’t matter how busy you are or how many jobs you have lined up. If you can’t pay your bills — especially basic things like rent, utilities, salaries, and taxes — you will be on your way to going out of business. The cash-flow projection shows you how money flows into and out of your business — helping you to, in the words of Watergate’s Deep Throat, “follow the money.” It also tells you how much cash you can expect to have on hand month to month. And cash on hand can help your business weather the economy’s ups and downs and the fickle nature of freelancing.
The cash-flow projection is simply a balance sheet. On it, you list all your income and all your expenses. Whereas the profit/loss forecast omits items such as owner’s deposit, loans, and capital expenditures (big-ticket items like cameras, computers, etc.), the cash-flow projection includes everything. Here’s a three-month sample:
As you can see, the cash-flow projection helps you see exactly where your money is going and how much cash you will have on hand at the end of each month. This is especially useful in planning for recurring big expenses, such as quarterly estimated tax payments, payroll taxes, etc. Many businesses fail or get into legal trouble because they do not have enough cash on hand to cover these types of expenses.
By using these and other financial-planning tools, you can put your business on the road to profitability and success. Happy holidays and a wonderful New Year to all!