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Start It Up

How do you determine if your idea is financially feasible?

Nikki Roser

By Nikki Roser

Nikki Roser is the President & CEO of First Bank, a community bank serving Southeastern Illinois and Southwestern Indiana. She is a CPA, holds an MBA, is passionate about building relationships with entrepreneurs and business owners, and leverages her experience to share financial and strategic advice. Partnering with clients and watching their business thrive and prosper is her greatest joy.

Determining whether your new idea for a startup business is financially feasible is very difficult. As we discussed in the previous article, you do not have historical data to build your sales forecast. The financial section of your business plan should be the last section that you complete because it is built upon the work done in the other sections: determining your market, startup costs, and sales forecasts.

If you need financial assistance in starting your business, this section of your business plan is critical. It tells investors and creditors whether you will have the ability to repay their investment in your company. On the other hand, it may tell you that you should not go into business because the business idea is not going to be financially viable. Just remember that a financial projection is based upon an educated guess on future sales.

Even if you do not need financial assistance starting your business, this section of your business plan will help you set goals and establish mileposts to measure the success of your new venture.

Prepare a cash-flow forecast to make sure you don’t run out of cash

For a start-up company, most investors and lenders want to see three to five years of cash flow projections. The first year should be on a monthly basis, the second year on a quarterly basis, and the third through the fifth year can be annual numbers. Essentially, a cash flow projection is an attempt to predict what your future bank statements will look like. Will you have spare cash at the end of each month or will you need financial support to pay the expenses until you become profitable? When preparing your cash flow projections, we recommend that you prepare two versions – a conservative projection and an optimistic projection. The most important part of preparing your cash-flow projection is to be realistic.

Since most start-up businesses experience a "cash flow crunch" at some point, this is an important exercise. If you spot a future shortfall, it gives you time to approach investors or lenders about a bridge loan. A cash-flow forecast will:

  • Help you manage the cash coming into and going out of your business. You can compare your actual cash income and expenses to your projections to see how well your new business is doing.
  • This cash-flow projection will give you time to address future cash-flow issues. For example, if you know you are likely to run out of cash in a few months, it’s easier to come up with a plan to reduce the chances of this happening. Investors and lenders are more likely to provide assistance with a cash shortfall if it is a part of your business plan.
  • If you decide to proceed with your business idea, you can update the estimated information in your cash flow projection with actual figures after you have started to prepare more accurate projections on an ongoing basis.

Download our complimentary Cash Flow Template to make it easier to complete your cash-flow projection.

Components of a cash flow forecast for your business plan

There are four distinct parts to a cash-flow statement for the financial section of your business plan.

For the first year of the financial forecast, income and expenses should be projected on a monthly basis; the second year, the projection should be completed on a quarterly basis; and the third through fifth years, the projection should be completed on an annual basis.

The first row on the cash-flow projection will be your beginning, and the last row will be your cash balance at the end of the month.

Start with your sales forecast

In the previous article in this series, you prepared a sales forecast for a three to five-year period. This forecast will become the first section of your financial plan. In this section, you have forecast the number of units you expect to sell for the month, your projected sales price, and your projected cost of sales or production. This will give you the amount of money available to cover overhead expenses.

The second section includes an expense budget

Most financial advisors recommend that you divide your expenses into two groups – fixed costs and variable costs. Your fixed costs include things like rent, utilities, insurance, and administrative payroll. Variable costs include items such as advertising and promotional expenses. The lower the fixed costs are, the less risk there is in the projection.

  • When projecting expenses, don’t forget to include payroll and income taxes. You don’t have to be exact in projecting these items; just multiply payroll and income by your best-guess tax percentages.
  • When projecting labor costs, remember the importance of scaling your business at the right pace. If you hire too many employees, there may not be enough work coming in to keep them productive. On the other hand, if you don’t hire enough people you may end up spending more money on overtime pay.

The third section includes your investing activities

In the third section of your cash flow statement, you will include the projected purchase of any additional equipment you may need as your sales volume increases.

The fourth section includes your financing activities

In the third section of the financial plan you should include your financing activities. This includes payments on term debt for equipment and real estate, interest payments on outstanding operating lines, loan advances to cover shortfalls, and operating loan pay-downs when excess cash is available. This section would also include purchases of equipment.

Identify your cash cycle

When you are preparing your cash-flow statement, you will need to take into account your business’s unique cash cycle. In reviewing your cash cycle, there are two factors that will impact your cash flow:

  • The time it takes to convert inventory into cash. If you hold an item in inventory for an average of 60 days, it could take 60 days for you to be paid after a sale is completed. If you are required to pay your vendors within 30 days, that would mean you have 90 days between the time you have to pay for your product and when you will get paid. This can have a major impact upon your cash forecast and should be built into it.
  • Seasonal sales. For example, retail sales tend to be centered around Christmas and lawn and garden sales in the spring and fall. Construction income cash-flow tends to be lower in January through April.

Creating credible financial projections for a start-up business

Investors and lenders know that your financial projections are not set in stone, but they do expect a realistic target. Anyone you go to for funding will test your income and cash-flow projections for reasonableness. Over the years, they have seen many overly optimistic projections, so they will be skeptical of any projection they review.

Five tips for creating acceptable financial projections

  1. They must demonstrate a reasonable business strategy.
  2. 5-year projections are the standard for investors. They expect to see consistent growth that will allow you to generate enough profits to return their money within five years.
  3. Venture capital and Angel Investors expect to see aggressive revenue growth that will provide a high return on their investment.
  4. Gross margins and other financial ratios should be in line with industry averages. While it is reasonable to expect your ratio to be different the first year, by the third year your ratios should be similar to industry averages.
  5. Base your funding requests on projected cash shortfalls. While it is reasonable to pad your funding request by up to 20%, a request significantly larger than the projected shortfall will cast doubt upon your projections.

The quality of your management team or your own prior experience in successfully starting a new business can impact the investor’s or lender’s decisions.

Your cash-flow projection may require several re-iterations before you finalize it. This is very common. In addition, if you decide to go ahead and start your new business, you will need to update your plan frequently, especially during that first year.

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