Profitability Measurement for a New Business

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.

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.

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