If you're thinking about launching a new business, you may not know where to start with your finances. Of course, you'll need a decent amount of cash flow to maintain your company. However, if you are organized and thorough, you can plan out your financing and keep your startup budget on track.
Here's how to figure out approximately how much you'll need to launch your business.
You most likely have high expectations for your company. However, blind optimism may cause you to invest too much money too quickly. At the very beginning, it's smart to keep an open mind and prepare for issues that may arise, experts say.
Cynthia McCahon, founder and CEO of business-plan software company Enloop, said business owners should start with a bit of healthy skepticism.
"A prospective business owner should start planning a small business by simply understanding the potential of the business idea," McCahon told Business News Daily. "What this means is not assuming your idea will be successful."
The best approach is to test your idea in a small, inexpensive way that gives you a good indication of whether customers actually need your product and how much they're willing to pay for it, McCahon said. If the test seems successful, then you can start planning your business based on what you learned. [See Related Story: Creative Financing Methods for Startups]
Estimate your costs
While every type of business has its own financing needs, there are some tips that can help you figure out how much cash you'll require. Entrepreneur Drew Gerber, who started a technology company, a publicity firm and a financial planning company, estimates that an entrepreneur will need six months' worth of fixed costs on hand at startup.
"Have a plan to cover your expenses in the first month," Gerber said. "Identify your customers before you open the door so you can have a way to start covering those expenses."
When planning your costs, don't underestimate the expenses, and remember that they can rise as the business grows, Gerber said. It's easy to overlook costs when you're thinking about the big picture, but you should be more precise when planning for your fixed expenses, he added.
Indeed, underestimating costs can decimate your company, McCahon said.
"One of the main reasons most small businesses fail is that they simply run out of cash," she said. "Writing a business plan without basing your forecasts on reality often leads to an unfortunate, and often unnecessary, business failure. Without the benefit of experience or actual historical financials, it's easy to overestimate a new company's revenue and underestimate costs."
Understand what types of costs you'll have
According to the U.S. Small Business Administration, there are various types of expenses to consider when starting your business. It's important to differentiate these types of costs, in order to properly manage your business's cash flow for the short and long term, said Eyal Shinar, CEO of Fundbox, a cash flow management company. Here are a few types of costs for new business owners to consider:
1. One-time versus ongoing costs. One-time expenses will be relevant mostly in the startup process, such as the expenses for incorporating a company. If there's a month when you have to make a one-time equipment purchase, your money going out will likely be greater than the money coming in, Shinar said. This means your cash flow will be disrupted that month, and you will need to make up for it the following month. Ongoing costs, by contrast, are paid on a regular basis, and include expenses such as utilities. These generally do not fluctuate as much from month to month.
2. Essential versus optional costs. Essential costs are expenses that are absolutely necessary for the company's growth and development. Optional purchases should be made only if the budget allows. "If you have an optional and nonurgent cost, it may be best to wait until you have enough cash reserves for that purchase," Shinar said.
3. Fixed versus variable costs. Fixed expenses, such as rent, are consistent from month to month, whereas variable expenses depend on the direct sale of products or services. Shinar noted that fixed costs may eat up a high percentage of revenue in the early days, but as you scale up, their relative burden becomes negligible.
Project your cash flow
Another important aspect of a startup's financial planning is to project the business's cash flow. Bill Brigham, director at the New York State Small Business Development Center in Albany, New York, advised new business owners to project their cash flows for at least the first three months of the business's life. Brigham said to add up not only fixed costs but also the estimated costs of goods and best- and worst-case revenues.
If you borrow money, make sure you know not only how much you borrowed but also the interest you owe, Brigham said. Calculating these costs puts a floor on the revenues needed to keep the business viable and provides a good picture of the cash necessary to start it up.
Gerber recommended starting a business without borrowing at all, if possible. Borrowing puts a lot of pressure on any business and its owners, as it leaves less room for error, he said.
Once you get your business going, use QuickBooks or FreshBooks, which can connect directly to a bank account, to track expenses throughout each month and during tax season, Shinar advised.
Figure out your financing methods
Once you've determined your costs and cash-flow projections, you'll need to consider how to pursue financing. How you obtain funds will affect the future of your business for years to come. Personal savings, loans from family and friends, bank loans, and government loans and grants are just a few of the many types of potential funding sources. Many companies are financed using a combination of sources.
One place to go for help is SCORE, which advises small business owners. Formerly known as the Service Corps of Retired Executives, this volunteer organization partners with the Small Business Administration and offers training and workshops for people who want to be entrepreneurs. Most important, SCORE offers counseling from people who have been in the business you might want to be in, and who know the specific issues that you're likely to encounter.
You can find tools for calculating and managing your startup costs on the following websites:
Additional reporting by Katherine Arline and Jesse Emspak.