When you’re starting out in business, there may be tons of things you need to know. But here are four important tips to help you as an aspiring entrepreneur.
Know Your Real Goal
The initial goal of every business is to survive long enough to see if it’s viable or not. This is the point when your business generates the cash needed to pay its bills.
It’s true no matter what business you’re in.
Yet viability is just one step on the way to somewhere else. You must figure out where that somewhere else is.
- Earn a living from it, or
- Become financially independent
Understand Cash Flow, and Know Where It’s Coming From
Since most people are nervous going into their first business, it’s wise to have a business plan. It’s your best guess as to how you’ll get to viability.
To create a business plan, you must understand cash flow. Most people mistakenly confuse cash flow with sales. They think that all you need to be successful is to generate sales.
The truth is that you need the right kind of sales. The wrong kind can lead to business failure.
To avoid this, you must realize that your start-up capital is limited. So you need to make sure that you have enough capital to begin with, and that it’ll last long enough to determine if your business is viable or not.
The first step to creating a business plan is to come up with a reasonable forecast of sales by month for a year. Once you have these projections, calculate the cost of goods sold (COGS).
Subtracting COGS from sales, you get gross profit. Gross profit – when expressed as a percentage of sales – is your gross margins.
So if you sell an item for $1 that costs you 80 cents to buy, your gross profit is 20 cents. Or 20% gross margins.
Gross profit is the most important number in any new business. It determines everything else about your business – including the amount of capital and the volume of sales you need. You also pay your salary and all other bills from gross profit.
Say you need $6,000 in gross profit per month to cover your overhead. To get it – at 20% gross margins – you’d have to do $30,000 per month in sales.
And if your gross margin is 20%, you need $5 in sales for every $1 of expenses just to break even. But if you increased your margin to 40%, you’d only need $2.50 in sales for every $1 of expenses.
This is crucial to understand when you’re working with limited capital. With higher gross margins, you’ll need fewer sales to cover your expenses, and your capital will last longer.
Doing these calculations, you see that more sales don’t always lead to more profits.
The other reason to do a business plan is to understand how much start-up capital you need. This comes from the cash flow statement.
If your business is viable, the amount of capital you need is roughly equal to the largest deficit on the statement. If you put this amount into your business, you should be able to avoid running out of cash. To be safe, you may want to consider increasing that number by 50%.
So, if in your worst month it looks like you’ll have negative cash of $10,000, your business would need an investment of $15,000.
Why build this reserve? Because things usually cost more than you think, and profits are usually less.
Overcome the Sales Mentality
The sales mentality is the idea that you should focus all your attention on making sales. This is dangerous, because sales don’t equal cash.
You’re working with limited capital. So if you run out of cash, you’re out of business. If your gross profit can’t cover your expenses, you’ll need to dip into your capital. Do this too much, and soon you’ll run out.
This means you should maintain the highest monthly gross margin possible. Don’t go after low-margin sales.
It’s easy to lose focus on this point if you have the sales mentality. Let’s say that in your business plan you projected $40,000 in sales for the month at 40% gross margin. That’s your break-even point.
You’re having a bad month, and now you’re in your last week. Since you’ve only done $20,000 in sales, you’re desperate.
But you eventually find someone who’ll buy $20,000 worth of goods, if you’ll just lower your price. You negotiate and give a good deal, and now you’ve hit your $40,000 goal. You should be happy, right?
The reality is that you didn’t break even. Break-even was $40,000 at 40% gross margin, or $16,000 in gross profit. You sold $20,000 at 40%, and $20,000 at 10%. Your actual gross profit was $10,000. Actual gross margin was 25%, not 40%.
Now you can’t cover your expenses, and you’re short $6,000. This difference will have to come out of your capital.
What’s the lesson here?
Develop relationships with your high-margin customers. And don’t tie up so much receivables in one customer. What if they can’t pay? You put yourself at risk by hoping for much of your revenue to come from one customer.
Many entrepreneurs think about increasing revenue by charging less. But they’re focusing on the wrong thing. You should be asking yourself how much less revenue you’d get if you charged more.
Because gross profit is much more important than sales. It’s better to have $30,000 in gross profit on $80,000 in sales than to have the same gross profit on $100,000 in sales.
Because you’d have fewer shipments and headaches. So don’t reduce your margins. Increase them.
Anticipate Critical Mass
Your business won’t be a start-up forever. So you want to figure out when this phase ends, and when your business reaches critical mass. This is the point that every successful start-up eventually crosses, and it depends on some key factor reaching a certain level.
The factor could be the size of your customer base or your number of active accounts. Yet with all the different types of critical mass, they all translate into the same thing: self-renewing break-even cash flow. This is where the cash generated each month sustains the business, and you’re no longer surviving on external capital.
If you can establish a correlation between cash flow, sales, and customer base, you can determine critical mass easily.
Knowing the monthly cash flow you need to make your business self-sustaining, you can translate that number into average monthly sales. From there, you can calculate the size of the customer base needed to produce those sales. That’s your critical mass.
After critical mass, you have profit to put in the bank or invest back in the business. Now, you can take on some debt and explore other risks, because you’re playing with your own money.
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