To further touch upon last week’s article written about GPM (gross profit margins) and the two fundamental statements: balance sheet & profit (loss) statement, I wanted to further discuss the preparation of a businesses finances. There are two things to consider when starting a business or even managing a new business for that matter. Understanding how you are going to fund your business and when you can expect profits.
In order to understand how you are going to fund your business you better understand what your financing needs are in addition to the types of options that will be available to you. Money, or capital, not only helps your business get off the ground but keeps the business sustainable. Some options that exist for your business entail borrowing money, using business versus personal finances, and other eligible business assistance.
In my experience most young companies entertain the idea of either equity financing or debt financing. Equity financing is money that is raised by a company in exchange for a share of ownership. This is not limited to publically traded corporations but is a viable option for all facets of business. Obtaining equity allows a business to obtain funds without incurring debt, or simply put, without having to repay a specific amount of money at a particular time. Equity financing can come from a plethora of sources including friends, relatives, employees, customers, industry colleagues, or non-professional investors. The most common equity finance contributors are venture capitalists.
In contrast to equity financing, debt financing is borrowing money that must be repaid over a period of time, usually with interest. This debt can be short-term, which is fully repaid in under one year, or long-term, repayment is due in excess of one year. The difference between equity and debt is ownership. With debt financing the lender does not gain ownership interest in the business, and the return on investment is tied to interest payments. In general debt financing requires some collateral to guarantee the repayment of the loan and interest. If you are an LLC or private corporation the lender can ask for a personal guarantee in case of default in addition to the collateral placed against the loan. This tactic is used to mitigate lending risks as well as ensure the borrower has sufficient personal interest at stake towards making the business succeed.
After funding and sustaining your business operations the next question is always tied to making money. One key question I am often asked by startups is, “When will I start seeing profits?” The answer to this question lies in the breakeven analysis. This tool is used to determine when a business’s revenue will outpace its expenses, which is also known as, making a profit. In order to determine this extensive research should have been conducted on start up costs. Generally speaking this can be obtained from the business plan (if you do not have a business plan it would be beneficial to begin there). Knowing what your expenses are going to be will inform you of the sales revenue you need to cover those expenses. In addition to market demand this should help set a guideline for pricing of your products as well. For established businesses or business units, to calculate the breakeven point, identify all of your fixed and variable costs.
Fixed costs are typically referred to as overhead because they are needed to run the business but not attributed to sales volume. For example, rent, administrative salaries, telephone lines, and other non-sales volume related expenses are considered fixed costs. Variable costs are just the opposite and are tied directly with sales volume such as additional servers, increased bandwidth, and disk drives. Knowing your fixed and variable costs will help determine how many unit sales are needed and how much to sell them for to breakeven.
For example, if it costs $25 to create one virtual private server, and there are fixed costs of $1,000, the break-even point for selling the Virtual Private Servers would be 40.
(If the price of each server sold was $50), 1,000 (fixed cost) / (50 – 25) = 40 Virtual Private Servers.
Revenue = $50 x 40 units sold = $2,000 | Fixed Cost = $1,000 | Variable Cost = $25 per unit sold = 25 x 40 = $1,000 | Net Income = Revenue – Expenses or $2,000 - $1,000 - $1,000 = 0 [Break-even].
In the same analysis, selling 41 virtual private servers would be the point of profitability. 41 VPS x $50 = $2,050 - $1,000 – (25*41) = $2,050 - $2,025 = $25. Undercutting or underestimating your variable and fixed costs is only going to undermine the integrity of your analysis. Be sure to include realistic figures and be able to support how you derived these numbers. Many investors will pick this analysis and ask you how you plan to get to the number of units needed to break-even. If you have any questions please feel free to contact Doug@YIPFolio.com.
Doug C. is a Financial Analyst for a top 20 Fortune 500 Financial Services company and owner of YIPFolio Financial & Management Consulting Services. He specializes in Financial & Accounting services including balance sheet, P&L, fixed assets, and capital funding. He has spent several years in the Hosting and Technology industry while consulting management and senior management on all aspects from raising capital to managing daily cash flow. Doug received his BS in Finance from Fairfield University and resides in the Greater New York City area.