In my previous two columns on financial planning, I discussed three tools that should be part of any business plan — the break-even analysis, the profit/loss forecast and the cash-flow projection. Now it’s time to consider a fourth essential tool: the capital spending plan.
To start a new business or expand an existing one, you will probably need to invest in some big-ticket items such as cameras, computers and related hardware, software, office furniture, and such. These are generally called “capital items” to distinguish them from other things your business needs to operate on a day-to-day basis, such as office supplies, insurance, utilities, and the professional services of lawyers and accountants.
Such day-to-day expenses are considered fixed costs if they are recurring and are not dependent on specific projects. Expenses related to specific projects — such as travel, meals, and assistants — are considered costs of the sale, or variable costs. Capital items, on the other hand, are things your business buys infrequently, generally either at the time of start-up, when you need to expand your line of products and/or services, or when items wear out and need to be replaced.
Capital items are generally expected to be in use for more than one year. For tax purposes, expenses for capital items, called “capital expenses,” are usually treated differently from regular expenses, as we will learn.
Capital Spending Plan
The first step in creating your capital spending plan is to write down all the costs you think you will incur to start or expand your business.
Treat this as a brainstorming exercise — write everything down, and then go back over your list to see which items are essential and directly related to your start-up goals. Which items do you absolutely need to get your business up and running? Which can wait until you begin to make a profit? Which can you do without? Which can you obtain on an as-needed basis, either by renting or borrowing?
Once you have whittled down your list to the essential items, it’s time to start checking sources and prices. Are any of these items something you already own, which can be converted to a business asset? Do you need to buy new equipment, or can you make do with used? Are you better off finding local vendors with whom you can establish an ongoing relationship, or are you willing to forgo that in exchange for low, low Internet pricing?
Once you have determined a price for each capital item, compute the grand total of all essential items, and then add an extra 10 to 20 percent as a line item called “Contingency.” This ensures that you will have enough money in your capital spending plan to cover price hikes, errors in estimating, and unanticipated needs.
Be sure also to keep track of start-up and organizational costs you have already incurred in preparation for launching your business — such as advertising, consulting fees, travel, and so forth — because these may be deductible expenses.
Initial Working Capital
Many small businesses take a year or more after starting up to become profitable — that’s just the nature of small business. In addition to having money to invest in capital items, you’ll also need money, or initial working capital, to tide you over until your balance sheet shows green instead of red ink.
Where will all this money come from? Although you may hope to secure a juicy bank loan or find an “angel investor,” the fact is that most small businesses rely on money from the business owners themselves to provide the required start-up capital, usually in the form of savings or personal debt (credit cards, second mortgage, line of credit).
You may also need to work for someone else, either full or part time, while you save enough to begin gradually working for yourself. Family members and friends may also be sources of funding, but be sure to draw up a written agreement specifying the terms of any such loan or investment.
Having a solid business plan is certainly one requirement of obtaining any sort of outside funding for your business. You should be aware that banks and other traditional lenders are often reluctant to fund small business start-ups, especially in this tight economy.
A key factor in getting a loan is being able to demonstrate the ability to repay it — and this is hard without a proven track record of profitability and positive cash flow. The U.S. Small Business Administration has useful information about various loan programs for start-up and existing small businesses on its Web site.
Because capital items are those that remain useful for your business for more than one year, the IRS wants you to deduct a pro-rated portion of each item’s value in a given tax year, a process called “depreciation.”
The IRS assigns an expected lifespan to various classes of business assets. In other words, if a capital item is considered by the IRS to last five years, then you are allowed to deduct one-fifth of its cost, starting in the year the item was placed in service.
For example, in January 2006 my business spent $3,686 for new computer equipment, which is considered to have a useful life of five years. My accountant decided to use the straight-line method of depreciation, which simply divides the cost of the equipment by its useful life. Thus I was entitled to deduct $737 from my business income for tax year 2006, and I can continue to deduct the same amount through tax year 2010.
In certain cases, you can deduct the entire cost of a capital item in a single tax year — this is called “expensing” a business asset, rather than depreciating it. You should confer with your accountant, tax preparer, or CPA to determine which method is best for your individual circumstances.
Remember that business assets are ones generally considered to be owned 100 percent by your business. If you use an asset, such as a computer, for both business and personal use, you are not entitled to a full deduction. The IRS maintains a Web site for small businesses that is both helpful and easy to use.
I hope the three columns I’ve written on financial planning have been useful. I have been using this material in a course I am teaching at the University of South Carolina’s School of Journalism and Mass Communications.
Called “Freelancing for Creative Professionals,” the course covers all important aspects of starting and operating a successful small business. A link to the course syllabus is on my faculty Web page.
As I continue to teach this course, I may find more useful information, which I am happy to share with you. I also look forward to hearing from you on any business-related topics — let’s keep the conversation going!