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So, by this point, you’ve done some market research on your business idea. You know where you want to put your business and who your ideal customer will be, and you are sure there is a demand for your product or service.
Here’s the part nobody likes to talk about because business is supposed to be about chasing your passions, ignoring the naysayers and pursuing your dreams because, deep down, it will work. The problem is that 20% of small businesses that don’t make it past the first year have founders who feel exactly like you do about their concepts. They fail not because they don’t have passion. They have that in spades. No, what they are missing isn’t a deep seeded belief that they can make their business work; it’s knowledge of basic financial principles and how to build out realistic models based on financial analysis. They don’t understand how much money their business needs to earn to survive, or (even more likely) they don’t know how much they can earn from their business realistically!
The truth is most small business owners have passion. They don’t, however, have a passion for building spreadsheets and combing analytical data to determine if their business, the way they have it envisioned or even currently operating, is genuinely financially viable!
One of the biggest reasons I advocate for aspiring small business owners to apply for commercial lending products, even if they think they have the money to make it work independently, is that it will force them through these processes. We all know that commercial lenders are looking at our business as an investment and that they will turn us down if they are not confident that they will be able to make the return promised on their money. So why don’t we consider putting our money into our businesses similarly? If you don’t think a financial institution would be willing to invest in your business, you have not yet done the work required to prove your business's financial viability, period.
I know financial analysis sounds boring. You might not know or care how to build an income statement or the difference between net sales, gross revenue, gross profit, EBITDA, or net profit (and yes, those are all different but related numbers). Still, I promise that learning the ins and outs of your business's financials and projections will make you much more likely to succeed.
Where should you start?
Start with the basics. You will need an accountant eventually to file taxes, build official financial statements and get general advice about the financial health of your business. My advice is, don’t wait until you NEED one to FIND one. Chat with other business owners you know, get some referrals, and start shopping around. This is likely the only time you’ll be able to chat with multiple accounts for free, so make the most of it. Quiz them all on financial statements, terms you’ve heard but aren’t sure of, how to structure your accounts, tax laws in your area, when you have to file, depreciation periods of assets you intend to buy, and so on. Get as much information as possible from them, take notes, and ask for samples of the financial statements they will build you. Take the time needed to LEARN about business financials.
One thing that I did, probably two years before I ever actually started a business, was read a book called “Financial Basics” published by Harvard Business Review. I’d be lying if I said it wasn’t some of the driest material I’ve ever read, But it’ll teach you the difference between a P&L, a cash flow statement and a balance sheet. Don’t, however, get caught on the mental hamster wheel of “analysis paralysis.” Do the research you need to, learn what you need to understand the core financial principles of business and start planning.
So what are the subsequent steps to ensure you have a bulletproof financial analysis to present to your investors, including yourself, and have them feel confident your business will make them money?
Here are the five steps I would recommend any entrepreneur work through and include in their business plan:
- Determine precisely what providing your services or products to clients will cost you. (cost of goods sold)
- Figure out what your competitors charge for similar products (even if you think your offering is superior)
- Ballpark, how many units will you be able to sell and deliver each month for the first five years
- Determine overhead and operational costs for each year, including start-up costs in your first fiscal year but factoring in depreciation rates accordingly (ask your accountant about allowable depreciation.)
- Using this information, create mock annual statements for your first five years in business, including income statements(P&L), cash flow statements and balance sheets.
Let’s break these down into actionable items and things you will need to consider at each step along the way:
Determining precisely what providing your services or products to clients will cost you.
This step will include all of the items you can consider the cost of goods sold on your income statement or P&L, depending on where your business is located. This is much easier to determine for the “products” you plan to sell than “services.” COGS (cost of goods sold) are things like raw materials that need to be purchased to create products, labour (but only the labour required to make the good, not the labour required to sell it), disposable or single-use items that have to be replaced at predictable intervals based on use (rubber gloves, bags, or door access codes that cost per user). Most things you can draw a direct correlation between cost and sales can be counted as an expense in this category. For specific items, ensure to discuss them with your accountant. Once you finish this step, you should know exactly what it will cost the business to produce and distribute every unit sold. On your income statement, COGS is subtracted from net income (revenue minus returns and discounts) to give you gross profits.
Figuring out what your competitors are charging for similar products.
This one is self-explanatory, but a few points are worth mentioning. First of all, in the market analysis section of your business plan, you should have identified some critical competitors for your business. Remember that who your competitors are will vary greatly depending on what type of business you are planning out. Brick-and-mortar businesses can identify geographically close competitors with a simple Google search. Online businesses will likely need to do more digging to determine who they compete with. Depending on their location, they are much more likely to have competitors with entirely different operating costs and COGS. These are all things to consider when examining competitor pricing. That being said, the market doesn’t care if your costs are higher or lower than your competitors. I’m not saying you need to price your products or services according to your competitors, but you need to make sure you have a clear value proposition if they are going to be higher! Once you’ve researched, you should have a reasonable starting point for your pricing strategy. So now you know what your COGS are and what you will sell your product or services for. The next step is the most ambiguous number of this equation, but that doesn’t mean it isn’t important.
Ballpark, how many units will you be able to sell and deliver each month for the first five years?
I’d be lying if I told you determining this was an exact science. Without knowing the type of product or service you are selling, it’s hard to give concrete advice on figuring out a reasonable estimate for how many units you can sell each month. Still, there are some things you should consider in every business to determine this number. For products, the first thing to consider is fulfilment. If a million people buy your product tomorrow, can you fulfill all the orders in the time promised? This factor gets even more complicated, considering that money isn’t the only barrier to fulfillment. For example, if your business is producing handmade leather wallets for a premium cost, and you are the person who produces them, you either need to cap your product sales or recruit more people to make wallets. That can be through training employees, outsourcing or other means. Either way, the quality of your product is likely to change, which can make for many unhappy customers if that’s what your brand is built on. On the service provider side of things, you can be limited to the capacity of the space you operate out of or how many clients you can provide quality service to before needing to hire additional employees. There are many things to consider when trying to make accurate predictions. I would advise finding others running similar businesses and asking as many questions as possible about how much they can sell and how many resources are required to maintain those numbers. If there’s one thing I can convince you to keep in mind while determining this figure, it’s to assume the worst about your perspective sales. Your business will not sell to capacity in the first month and probably not in the first year, keep your predictions realistic and gradual; even if you have unshakable faith in your salesmanship and product, investors will not buy into predictions showing a straight line to the top, and as an investor, you shouldn’t either.
Determine overhead and operational costs for each year.
Now is the point where you are going to change directions a little bit away from figuring out how much money you can make and keep in terms of sales and focus on how much of that you are going to have to spend to start your business and keep it alive over the first five years. It’s important to note that while roughly 20% of small businesses fail within the first year, that figure jumps to 50% within the first five years. That’s one of the reasons we want to map these figures over the 5-year horizon.
Let’s define Op Ex (operational expenses) and OH (overhead expenses). Op Ex typically refers to costs outside of COGS that are required to generate revenue but would cease should the business stop trying to generate revenue. Some easy examples include leased vehicles/equipment, temporary offices/structures, and employees involved directly in the fulfillment of a purchased service. OH refers to expenses the business would have to continue to pay whether or not it generated revenue. Some examples include long-term building leases or mortgages, utilities for these spaces, and janitorial expenses. Of course, as with everything in accounting and life, there are some grey areas between these categories, and it can depend on where you operate your business. For financial projections in a small business, these can be lumped together under “expenses” on your income and cash flow statements. On the other hand, Cap Ex (capital expenditures) must be captured separately as they will not count as a “write-off” against your income all in the year they are incurred. Instead, they will show up under their own heading on your balance sheet, and the expense you will see on your income statement will be “depreciation expense” or “amortization expense,” depending on whether these are physical assets like a piece of equipment or intangible assets such as patents or copyrights. Cap-Ex will appear on your cash flow statements within the year they are purchased.
Using this information, create mock annual statements for your first five years in business, including income statements(P&L), cash flow statements and balance sheets.
Time to put all the information together and create some beautiful financial statements to show what you expect your business’s financial position to look like at all times between now and the end of your 5th year in business. Be sure to include how you reached these projections, any assumptions you made and why you believe them to be accurate. Personally, I like to show exactly how much money is projected to be earned every month on a simple but attention-grabbing spreadsheet right in the center of the financial section of your business plan, along with a table showing a summary of revenue, expenses and profits on an annual basis without potential investors having to read through all your statement. Then you can include copies of all your detailed projection statements in the appendix for anyone wanting to look closer. Just be sure to mark all statements “Projection Only” in bold letters so investors don’t get confused and think they are factual statements.
I know this one was a long to take in, and I thought about shortening it up. However, if you really want to get a good grasp on your business's finances and have the best chance of convincing potential investors and yourself that this is the best opportunity they can put their money into, you need to have the data to back that up clearly displayed within your business plan.
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If you want to know more about how to build a head-turning financial analysis into your business plan, make sure to reach out to us to set up a free chat about how we can help!
