Saying “I don’t know” to this question bodes trouble for a business owner. Successful businesses (aka businesses that make money for their owners) are developed using a profit-making financial model.
Do you know your financial model? Do you know how your business makes money? The financial plan for making money and being profitable should be developed before the business plan is written. After all, you would not want to go to the trouble to write a plan for a business idea that cannot make money.
Four elements are crucial for developing a sound financial business model.
First, what is the cost structure (expenses of the business)? Total costs consist of fixed costs and variable costs.
Fixed costs are the expenses that remain the same over a period of time (such the rent of space during a year). These expenses—sometimes called overhead—are consistent regardless of how much or how little business is transacted.
Variable costs, on the other hand, increase or decrease based on the amount of business activity (such as manufacturing, production, sales).
Next, what is the break-even: how much revenue must the business generate to pay expenses—both fixed and variable? Only past break-even is the business profitable. A business not generating enough revenue to reach break-even is losing money and creating debt.
Third, how many sales transactions are needed to generate the revenue for break-even and beyond? If the business is not generating that much revenue, does the business owner have the capital to sustain the business until it reaches that revenue point?
Last, what is the cash flow projection for the business? Cash flow is the pattern of revenue coming into the business and expenditures going out of the business and the resulting availability of cash for business needs (such as paying bills).
Once you know these metrics of your financial model, you are ready to formulate a business plan. Or, as the owner of an existing business, knowing these metrics prepares you to make informed decisions about growing your business.
If you have been in business for years and you don’t yet know the answers to these four vital financial questions, don’t worry.
It’s never too late to start.