Profitability Measurement for a New Business

  • AUTHOR: StartupNation Writer
  • DATE: 04/20/2006

Is fear of how you’re going to make ends meet until your new
business starts turning a profit holding you back from starting up? 
You’re not alone—but there is a way to conquer those fears.  If you take the time to make some profitability measurements and predictions
- you have to know where “there” is before you can get there – about
when you’ll break even and become profitable, you can let go of some of
that cash-strapped anxiety and focus on actually starting a business.

Crunch some numbers to measure profitability

Your
first step toward profitability measurement is to put together a cash
flow projection for the first two years of your new business. Start by
answering these four questions to get started on your path to
predicting profitability:

1. How much cash do you have to start your business?

If you’re saying to yourself “Good question!” then perhaps you better stop and read up on finding funding for your business
But, seriously, before you can put together your cash flow projection,
you’ll need to know how much money you have to start and operate your
business.

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2. How will your business make money?

You’re a savvy entrepreneur, so you already know that you must do some market research and competitive analysis
to understand the growth potential of your business.  You should have
some market research on reasonable pricing for your product or service,
the piece of the market pie you can expect to grab for yourself, and
the growth potential in your industry. 

But have you
thought about the timing of your revenue opportunity?  Were you
planning to offer deep discounts or coupons for your product or service
in the early days of your business, just so you can attract as many new
customers as possible?  At some point down the road, you would have to
adjust those prices to what you think is a reasonable level for the
long haul.  You’d better take that into account as you map out your
expected revenue month-by-month.  Not to mention that you need to
account for people not always paying you on time (what fancy
accountants like to call a “collection lag”).

3. How will your business spend money?

Running
your business is going to cost you some money, too, so your next step
is to take a look at your expenses.  The good news: if you’ve followed our formula for estimating your startup costs, you’re already ahead of the game. But understanding when you’ll
incur those startup costs, so that you can divvy them up by month, is
just as important in this process.  Think about exactly when payment is
due for each expense – you’re not doing yourself any favors by paying
bills before they’re due, since that money could be sitting in your
bank account working for you by accruing interest.

4. How will your business make up cash shortages during months with negative cash flow?

You
have to build yourself a safety net or backup plan for those months
when you know you’re going to come up short (and, yes, even the
smartest entrepreneur comes up short sometimes).  Measuring
profitability is all about planning, and you may have already lined up
a wealthy friend or family member to provide a short-term loan, or have credit cards or home equity for financing on an as-needed basis. Or maybe you still have savings
that you’ve set aside as operating capital.  No matter what the source,
make sure you can spell out where you’ll be getting that extra cash
from, and how much is available to you.

Put it all together for profitability measurement and use it wisely!

You’ve got all of this data collected, now what?!?  Take advantage of a handy tool like our Cash Management Report, and plug in the numbers you’ve gathered.  

Our
Cash Management Report might look scary to you non-financial types, but
it’s built around a relatively simple process – you enter the numbers
you collected through your research, the formulas and linkages in the
Excel workbook work their magic, and “Voila!”  You see a final report
that has incorporated all of your hard work into a two–year cash flow
forecast for your new business.

But don’t stop there -
actually putting the Cash Management Report to use is the critical
part.  Also, just a word of caution – this report does not replace the
need for an accountant and accounting software
(or some other means of tracking accounts receivable and payable on a
daily basis).  You should put an accounting system in place in addition
to this document.

You’re going to use the Cash Management Report as a strategic planning document that goes hand-in-hand with your business plan
It should be a star by which you steer your financial ship, but it’s
highly likely that you’ll see some differences between it and your
actual revenues and expenses.  To make sure you get the most value out
of it, compare your actual expenses and revenues to it on a monthly
basis.  Look for differences between the two reports and figure out how
to correct or “balance” them, just as you would with your checkbook. 
That’s how you’ll figure out how to apply your cash reserves to cover
any shortages.

Knowing what makes a business profitable

Okay,
so when is this profitability thing going to happen for you?  The
answer is different for everyone, but profitability measurement is as
clear as knowing when your business has more cash coming in than going
out in a given month.

There’s no magic formula for the
“when” of profitability, but you can arm yourself with a pretty good
profit prediction by going through the process we’ve laid out.  You
might start seeing a profit at a very different point than the
entrepreneur next door.  If you’re in a particularly hot industry or
you have little overhead cost, maybe you’ll get there in six months. 
If you’ve had to invest a boatload upfront in a storefront and
inventory, you may be in the red for a year or more. Some businesses
are more seasonal, and might therefore experience profitability at
certain times of year (such as a landscaping or pool-cleaning business
in the summer), and experience a negative or break-even cash flow at
other times of the year.

But if you know what to expect
before you even get started, you can plan to balance out those tough
months by spreading the wealth from the good months around.  The last
thing you want to do is not be able to make payroll because you didn’t
plan ahead for that mid-winter lull in business.

And, finally, if you’re still not sure what to expect in your particular industry, do some networking with business leaders
and others in your field to ask them how long it took them to reach
profitability, and if they experienced any seasonal dips.  It’s very
dangerous to guess about these things, so don’t be shy when it comes to
profitability measurement – do your homework and your hobnobbing!

Amanda Webber is a freelance writer for StartupNation.

  ABOUT THE AUTHOR:
StartupNation Writer
StartupNation Writer

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