Forecasting can be a key to your survival.
Knowing when new business will come and how to prepare your operations to handle demand will all impact your net income.
Without this income you won’t be able to pay your expenses, let alone make a profit.
In fact you cannot realistically evaluate your business concept without examining its potential profitability in advance of starting.
Would you invest $10,000 in a stock without knowing something about the company’s profitability?
Many new business owners invest this amount or more without any clear idea of the possible financial return.
To determine what financial return you may achieve you will want to create a projection of the profit or loss of the business for its first year.
And you will want to estimate the amount of cash that will come into the business and what amount will go out. This is known as a cash flow projection.
Let’s look at each of these projections.
Making a Sales Projection
One of the hardest tasks you face before you open for business is to estimate what your sales will be by month for the first year in business.
This is particularly difficult because to gain the greatest use from this projection you should do it 3-6 months before you launch. There is no magic formula for making a sales projection, but we have some suggestions.
The first step in projecting sales is to do enough research into your business to determine if there is a seasonal pattern to the sales.
Articles about your type of business, interviews with other business owners and financial statistics collected by trade associations are helpful in determining what level of sales is produced during different times of the year.
Department stores, for example do more than 40% of the total years sales in November and December.
Use this information to determine what percentage of sales you are likely to do each month of your first year.
Second, go back to your business description and marketing strategy to describe which one or two of your products will produce the majority of your sales.
Determine what the “unit of transaction” will be for them. For example, if you are a consultant the unit of transaction is fees/hour or fees/day.
A retail store might have a unit of transaction of so many boxes of a product/transaction.
Using the promotional strategy you created earlier, estimate how many units you might sell in month one of your business; month two and so on.
Use MS Excel to make a spreadsheet showing thirteen vertical columns
Label the first column “Sales” and the other twelve columns “Month I”, “Month 2”, etc.
In the first rows (use one per major product or service) type in the unit of sales you estimate for each major product or service.
The third step is converting you unit sale estimate into dollars.
By now you should have developed your pricing–either a single fee per hour or a price list of various products or services and their prices.
Multiply each month’s unit sales estimate by your fee per unit or use an average of your different prices.
This produces your dollar sales projection per month. Write the dollar sales projection for each month at the top of its column (where you wrote the unit sales projection before).
You have now completed a reasonably accurate one-year projection of sales for your new business. You next need to look at your estimated expenses.
Estimating Your Expenses
If you have completed your research on start-up and monthly operating expenses, you should have a reasonably good idea of your expense categories. Expenses come in two varieties:
- Fixed expenses. These are cost that you have whether you have any sales or not.
- Variable expenses: Money you spend to get new customers and to make and deliver your product or service are your variable expenses.
For example, if you buy a van for your business, the monthly loan payment is a fixed expense, while the cost of gasoline is a variable expense. Common fixed expenses include rent, insurance premiums, furniture and equipment rental and wages to employees.
Common variable expenses include advertising, supplies, gas and oil, raw materials and sales commissions.
Some expenses must be paid each month; others are due just once per quarter or possibly twice per year.
In a vertical column next to Month I of your sales projections, write in “Operating Expenses” and fill in each fixed and variable expense you feel you will pay your first year.
Next to the title of the expense, estimate the monthly dollar amount and write it in horizontally across the vertical columns created when you made your monthly sales projections.
You now have a 12-mondi sales projection, by month, and a 12-month expense projection, by month. AR that is left now is to determine if you will be making a profit or loss each month.
There are three kinds of profit you deal with in business:
- Gross Profit. This is the dollars of sales left after paying for the materials or inventory used to produce the sale. In businesses selling their time, labor or knowledge their gross profit is usually equal to their sales, since there is no cost of product involved.
- Operating Profit. This is what is left of gross profit after you pay your monthly operating expenses (including your personal compensation). Interest on loans and taxes are not deducted.
- Net Profit. This is your sales income left after all expenses, interest costs and taxes to your state and Uncle Sam.
This is the profit left to put back into growing your business and to possibly pay yourself a bonus!
Returning to your projection worksheet, determine your profit (which is usually the operating profit) by subtracting from each month’s sales the monthly operating expenses, including your personal income, and interest expenses.
To cover the income tax deduction, add on 25% of the total expenses before taxes and then subtract all of the expenses from the sales projection to determine your profit or loss.
It is not uncommon to incur a loss for the first few months of your business. Sales often materialize more slowly than you estimated and your expenses often run higher than you estimated.
Your Cash Flow
Cash is the fuel that runs your business. Your marketing attracts prospects and sells them on buying your product or service. From these transactions come cash. But cash goes out in paying for the goods and services that your company must consume in order to be able to deliver to your customers.
The movement of cash in and out of your business is called cash flow. Your management challenge is to keep more cash coming in than going out. This result is known as having “positive cash flow.” To be able to control your cash you should understand a few concepts first.
Profit vs. Cash
Being profitable is not the same a having positive cash flow. How can this be?
The critical difference occurs because many businesses must give credit to their customers in order to the close the sale. Although the product or service being sold is highly profitable, if there is a delay in collecting the money a serious cash bind can develop.
This particularly can occur early in your new business because you will be able to get very little credit from your suppliers and so will usually have to pay for your supplies some time before you can convert them into sales.
You may say: “I don’t give credit.”
If you accept checks in payment, you are granting credit. Out of state checks require up to 10 working days to clear when deposited.
And it is very difficult to determine if the money will be there when the check is presented for payment.
A business with good cash flow may be barely profitable at the end of the year. And a highly profitable company (on paper) can go out of business because the cash does not flow when it is needed.
To look ahead to how much cash you will need and how much cash you will receive; you do what is known as a cash flow projection.
The Cash Flow Projection
The projection form used for cash flow looks very similar to that used for the profit and loss projection. There are twelve vertical columns, each headed by “Month…”
And there are horizontal rows containing expense categories. Several rows are added, however, on the Cash Flow Projection: “Starting Cash”, “Cash Sales”, “Credit Sales Collected”, “Monthly Cash Flow” and “Accumulated Cash Flow.”
- Starting Cash.Unlike the Profit and Loss Projection, where we are only interested in sales and expenses each month, the Cash Flow Projection also takes into consideration the amount of cash you initially invest in your business. This amount is filled in the “Starting Cash” block on the projection form.
- Cash Sales. Because you are only able to access sales for which you have collected the cash, you should separate your sales each month between those for which you receive payment and those where the customers promise to pay in the future.
- Credit Sales Collected. After your first month in business, you will hopefully receive payment for sales where you granted credit. When you receive the cash you record it in this row.
- Monthly Cash Flow. To arrive at the final outcome of the cash that came into your business in a month’s time and the money that was paid out, you take the total of the “Starting Cash” for the month, cash sales, credit sales collected, any other cash in, such as interest and subtract the total of cash paid out during the same month.The result is the “Monthly Cash Flow.” If more total cash was paid out than came in, this number is put inside of parentheses–($500)– and indicates that you had “negative cash flow” that month.
- Accumulated Cash Flow – After the first month, you add this months cash flow-positive or negative–to the previous months cash flow to see how you are progressing throughout the year.
It is not uncommon to show negative cash flow for several months after you start. But you cannot afford to go very long in this condition.
Every month that more cash goes out than comes in, you must inject more money into the business. This may mean borrowing more money, thereby increasing your business debt.
Realistically estimating your cash needs in advance of launching your business helps to prevent the unfortunate situation of running out of money just as your marketing starts to succeed.