Become a Small Business #8

Finance Essentials for Small Business
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I. Insufficient capital
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Tendencies of small business owners:
- overestimate cash inflows
- underestimate cash outflows

Carefully and realistically map out your expected cash inflows and outflows for at least the first six months of your new business. Many new businesses with great business ideas don't make it through the critical first few months. A great idea is not sufficient. You need to insure that you have access to enough capital to get you through those first few months.

II. Poor cash management
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1. Cash flows
Prepare a cash forecast (=budget)
- fixed costs: costs that do not change
- variable costs: costs that are very relative to activities (eg. for a restaurant costs may vary based on the number of customers)

identify ALL of your fixed and variable costs

Fixed costs for a restaurant:
$5000: building rent
$6000: equipment rent
$2500: utilities
$1000: insurance
$1500: advertising
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$16000: total

How many customers do you expect? It's the hard part, the success of failure of your business depend on it. How many customers can you realistically expect?

Estimated customers for the restaurant: 5000/month, 167 customers/day
they spend $8/visit -> 5000 * $8 = $40000

Variable costs for the restaurant:
$12000: food
$2500:  packaging
$6500:  labor
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$21000: total -> $21000 / 5000 = $4.20/customer (-> sensitivity analysis for our cash forecast)

(expected) forecasted cash inflow:
$40000: revenue
$21000: variable costs
$16000: fixed costs
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$3000: net cash inflow

2. Cash flow example:

Restaurant forecast:
1st month: 4000 customers
2nd month: 4500 customers
3rd month: 5000 customers
+$10000 in the bank

Average selling price per customer:
1st month: $7
2nd month: $7.50
3rd month: $8

Variable costs per customer:
1st month: $4.30
2nd month: $4.30
3rd month: $4.40

Forecast cash flows:
Cash on hand + expected cash inflow - expected cash outflow
1st month: $10000 + $28000 - $17200 - $16000 = $4800
2nd month:  $4800 + $33750 - $19500 - $16000 = $3200
3rd month:  $3200 + $40000 - $22000 - $16000 = $5200

Over time I will get better at forecasting customer demand and at forecasting my costs.
Managing my cash using this cash forecast is it allows me to see well ahead of time when I might be short of cash.

III. Poor record keeping and controls
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1. Record keeping
- inflows
- outflows
- obligations to others
- obligations to you

Why important?
- accurate information helps you run the business better
- bankers or investors need accurate information before financing
- accurate information helps make sure you pay the right amount of taxes

2. Controls
= procedures in place to ensure that one, the information that is being collected in your accounting system is accurate and reliable, thereby helping you to run your business better. And two, to safeguard your assets and your records.

How will you document that your cash outflows are legitimate business expenses?

IV: Improper product pricing
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1. Pricing a consulting job
Sometimes they set their prices too high driving away business, but more often they set their prices too low and end up not covering all of their costs.

Q: what's the price for a 1 day training course in Kuala Lumpur?
A: 1 day work for $1000 might be fine.
However, it needs 5 day preparation, 2 days travel there, 2 days travel back =~ 12 days of work
So the final price would be $15,000 considering ALL the costs.

2. Product pricing
If your price is too high, regardless of your cost, someone in the market will underprice you, assuming that the quality of product or service is similar.

The biggest mistake new business owners make in product pricing is not considering and covering all of their costs when entering a market.

Our friend must consider her opportunity costs, what else could she do with her time? Assume that our friend could shut down her wedding announcement business, and get a job making after tax $36,000 per year.

That would mean the opportunity cost of running her business is $3,000 per month. Now she can ask the question, I need my wedding announcement business to generate at least $3,000 in profit after taxes each month, what must happen for that to happen? Can I reduce any of my fixed costs and by how much? Can I reduce any of my variable costs and by how much? Can I increase the number of orders per month? How high can I raise my price before it is worth it for customers to travel elsewhere? Now she can do some sensitivity analysis with her cash flow projections to determine what's it going to take to make this business venture worth her time?


V. Uncontrolled growth
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They tried to grow their way into profitability. The rationale was if we grow faster, we'll become more profitable. Classic mistake. A better approach is to first fix the profitability of your existing operations, and then think about growing.
If you've got profitability problems or cash flow problems, faster growth is almost always not the solution.

Growth requires cash, and cash is what new businesses don't have much

How does growth cause cash flow problems? In a typical business that is selling a product to a customer on credit, that is the customer will pay in say 30 days, you as the business owner need to pay your rent, pay your insurance, pay your employees, pay for the inventory, then sell that inventory, and wait for 30 days to collect the cash. To grow faster means you need to buy and pay for more inventory and then sell that inventory, and wait for 30 days to collect the cash.
The more inventory you have to buy the more inventory you have to pay for, and then still wait 30 days to collect the cash.

First, be careful with inventory. Home Depot had 107 days' worth of inventory. What that means is that on average when inventory came into their stores it sat on average on the shelves for 107 days before it was sold, and they had to pay for it in 48 days.

With the focus on growth there was less focus on keeping expenses down and under control. Expenses just got away from the company. Their sales grew at 40 percent, but it turns out that their expenses grew even faster.