Estimating Income Needs
Part 3: Estimating Income Needs
If there is enough demand in the established target market, the next step is to determine if you can afford to start and sustain your business while generating enough income to make it worthwhile.
When you are measuring feasibility, take the time to estimate how much money you will need to start and operate your business, as well as how you will “pay” yourself and others. These next steps will help you estimate the costs of starting a business, the costs of operating the business, and your own personal income needs.
Prior to estimating the costs of starting your business, it is important to understand the nature of work you will be providing. Businesses that sell a service versus businesses that sell a product have very different start-up costs and should be analyzed differently from a cost perspective.
Having access to capital and income is a crucial part of starting and sustaining a business. Before you start operations, you need to have access to funds that can be used for initial start-up costs. Start-up cost calculator: link.
You can raise funds from various sources such as personal investments, traditional bank loans, loans guaranteed by the Small Business Administration (see more information here) or investments from friends, family, or other investors. Be sure to weigh the pros and cons of each from an equity/royalty/interest rate perspective. Although loans can help solve capital issues, it can be hard to qualify for them if you do not have a solid business plan (see Part 4) or good creditworthiness. Interest payments can also build up quickly if you are unable to generate enough income to pay back the principal on the loan. Be aware of the negatives of loans as the entrepreneur Mark Cuban points out here.
- Estimate how much capital you have available personally, either in cash or investments
- Budget initial start-up costs and see if these costs will be covered by money that you already have available.
- The Small Business Administration has an easy-to-use document for budgeting start up costs. You can find a PDF here.
- Account for additional investments and fixed costs that may be necessary, such as purchasing equipment, additional marketing and PR costs, set-up costs, rental security deposits, etc.
- If you decide to take out a loan, determine if you will qualify for one. The best way to do so is by evaluating yourself using the 5-C's of Credit. If you can check off at least three of these criteria, you should feel comfortable with learning more about loans. If not, you might have to consider other options for funding. Here are some SBA resources for looking into loans: link / link.
- Character - Do you have a strong credit history that shows a trend of paying back debts on time and in full?
- Capacity - How many other liabilities do you have? Can you or your company handle additional loan payments?
- Capital - How much money do you have available? Is your company expected to generate enough money to pay back the debt?
- Conditions - This is hard to estimate but consider the “meat” of the loan, such as current interest rates, monthly payment amount, clauses in potential loans, etc.
- Collateral - What assets can you pledge as security in case you cannot repay the loan? Are you willing to pledge personal assets to take out a loan?
- Seek advice from a financial planner. They can help you plan for future events such as retirement or educational funding or give general financial advice. You can find a list of Financial & Investment Services professionals located in Hartwell on the Chamber website. This can be a good place to start your search for outside counsel but may not include all available options.
- You can find a list of Financial & Investment Services professionals located in Hartwell here on the Chamber website.
- According to one bank, below are some documents you will need to apply for a loan. Any bank should be able to outline specific details as to qualifications should you ask.
- Personal financial statement required for each guarantor/borrower.
- Personal and business tax returns for each guarantor/borrower.
- Interim business financial statements.
- Industry-specific questionnaires and financial statements -- Applies to religious organizations and nonprofit organizations, as well as agricultural and restaurant loans.
- Current bank account statements
- Other documents may be required based on your specific request
After you determine how much capital it will take to establish the business and how you will go about raising this capital, you should estimate how much income the business can potentially generate by creating a quick financial plan. Although you should already have immediate costs calculated, it is important that you estimate operational expenses alongside forecasted revenues for the next 2-3 years. Listed here are excel templates for income/cash-flow statements respectively that you can use: Income Statement Template and Cash Flow Statement Template. You can find different versions of this on the Microsoft Excel template library.
The level of detail that is incorporated into these plans can be flexible. However, the more in-depth these estimates are, the easier it will be to predict future profitability. If you realize that this will be an unsuccessful venture, it is not too late to return to the drawing board. You will also have a chance to revisit these financial plans when you create a business plan.
- Decide what products or services you will offer and how much you would like to charge for each offering while keeping in mind competitor’s margins.
- Brainstorm a list of every component you will need to provide each product/service and their approximate costs to you.
- Estimate how many products/services you can sell in a given period of time. Use any period that makes sense for your business.
- Calculate the expected gross profit (revenues - total cost of goods sold) for this period. Use any period that makes sense for the business - it can range from weekly, monthly, or even yearly.
- Generate a list of all costs not related to creating a product/providing a service. Include any costs that you will incur, regardless of how many products/services you sell
- Add up all these costs to get an estimate for total selling, general, and administrative expenses (SG&A).
- Find operating income by subtracting your SG&A expenses from gross profit.
Conduct a break-even analysis - Total variable and fixed costs are compared to sales revenue in order to determine the level of sales volume or production at which the business makes neither a profit nor a loss. At the very least, in the long run, consider both your living expenses and business expenses when deciding on a break-even point. This analysis should also include any debt payments (principal + interest).
Create formal projected profit and loss statements, using the estimates you calculated before for 2-3 years. Create a best, average, and worst case scenario for forecast revenues in order to gain an understanding of what benchmarks need to be met in sales to be profitable. Costs are much easier to forecast than revenues.
- Include all revenues. It may help to project by quarter so that you can account for seasonal demand shifts. When estimating revenue, look at data from competitors in similar growth stages as your business and estimate revenue from that. Here is a link to help you understand your competitive landscape.
- Separate expenses based on costs directly related to providing the product or service and other expenses. Other expenses per quarter can include recurring charges such as Internet, power, subscription-based point-of-sale systems, fuel, materials, and supplies, employee salaries, and less-frequent charges such as budgeting for equipment repairs, paying for PR or marketing help, hiring a CPA to file taxes, etc. Again, find comparable businesses to help estimate these costs. Variable costs, such as materials or taxes, can change with revenue so project accordingly.
Estimate projected cash flows
- If your business has any non-cash expenses (such as any payables or depreciation) or uses an accrual accounting method, you need to track changes in cash to see if you will have enough cash on hand at the end of the year/month
- There are three main sections in a cash flow statement: cash flow from operations, cash flow from financing, and cash flow from investments.
- Splitting your cash flows into these three sections will allow you to see how capital is being used and will help you draw meaningful conclusions.
The additional income left over after paying all expenses (including debt repayments) can be used in two main ways: it can be reinvested into the company or it be returned to the owners. When starting off your business, reinvestment into the company should be priority to establish yourself as a company in the market. Be aware however of sunk costs and investing money into a sinking ship. Every dollar you invest should be with a specific purpose that ties into added value for the business.
Although investing in the company is critical, you should consider treating a portion of profits as a salary to yourself as your business moves forward (See here and here). After all, it is important to consider how you will continue to fund your personal life as you embark on starting a business. There are different ways to generate this income but there are pros and cons to each.
- Itemize your personal living expenses for at least the next 2-3 years. Know that you may have to make personal sacrifices in order to grow the business but you should also be able to afford any necessities.
- Seriously consider how long it will take for your business to acquire paying customers. If you think that it will take an extended amount of time to generate customers and revenue, then you will need a source of income outside of the business to cover living expenses. You can generate this income through another job or by seeking additional funding.
- Consider the pros and cons (See here and here) of running your business part time vs full time. Some business owners choose to continue working a full-time job while running their own business, especially if they need additional income.