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This story appears in the May 1996 issue of . Subscribe »

One of the major challenges of starting a business is finding the capital to get the doors open. What is equally important-and often overlooked-is the need for sufficient cash reserves with which to operate the business until it begins to generate revenue. Opening your doors with no money in the bank could mean you won't stay open for long. But how much money do you need?

To find out, you must formulate cash flow projections. These will help you determine how much money you need to operate until your business begins to turn a profit, and whether or not you can truly afford to start the business you've planned. Effective cash budgeting often makes the difference between staying in business and being forced into bankruptcy.

Your cash flow projections are more than internal worksheets. Bankers want to see evidence that you can cover your costs, pay yourself a livable wage (unless you have a separate income), and still meet your repayment obligations. Investors look for similar proof, depending on the details of their arrangement with you. However, don't confuse a cash flow projection with a profit and loss projection. The issue of cash needs has virtually nothing to do with profitability; it's simply a matter of tracking and managing the money coming in and going out. Bottom-line profitability and the ability to pay bills as they come due do not necessarily go hand-in-hand. Though cash flow statements are a critical management tool, they do not necessarily measure operating results. In fact, you may be on a strong growth track and still run into trouble because of insufficient cash.

Calculating Your Cash Flow Needs

To realistically project cash flow, consider anticipated seasonal fluctuations both in income and expenses. Also factor in the amounts and timing of cash receipts (money coming in) and disbursements (what you pay out). In other words, when will you be paid for your product or service, and when do you have to pay the expenses required to create or perform that product or service? Include every known expense in your cash flow projection, then allow 20 percent more for the unexpected. If you are buying a franchise, the franchisor will be able to help with this forecast. If you are purchasing an existing business, you'll have some history to consider. But if you're starting from scratch, you'll need to develop your own numbers. Your initial cash flow forecast will involve ongoing, monthly expenses and once-only starting costs. Use these general categories as a guide:

Monthly Expenses

Owner's salary. If you'll be working full time in your company, plan to pay yourself a reasonable wage. Of course, you may opt to not take a salary at first if you have a separate source of income, such as a second job or a working spouse.

Other salaries and wages. Calculate the number of people you expect to employ, the hours they will work and their pay rates.

Payroll taxes and related expenses. These are required employee expenses on top of the actual wages you pay. They include Social Security tax (also known as FICA); federal and state unemployment tax; Medicare tax; self-employment tax on your own income, if your business is a sole proprietorship; and workers' compensation. Your accountant can help you calculate these expenses.

Rent or mortgage. This figure is based on how much space you need to open your business, how much space you will need as your business grows, the type of facility (retail, office, manufacturing or warehouse), and its location. If you are setting up a homebased office, this figure can be zero; you can also have your company pay you rent. Many household expenses can be counted as business deductions (mortgage interest, security system, maintenance, etc.), but do not count them in your cash flow projection, since you would pay them even if you didn't have a home office.

If you expect to outgrow your facility within two years, you may want to consider starting with more space than you need to avoid having to move soon. Also consider the terms of your lease; you may be able to negotiate rent concessions to reduce your early cash needs.

Advertising. It is critical for a new business to create market awareness, so don't make the mistake of skimping on advertising. Of course, advertising is not an exact science, and there are no guaranteed results. Your business plan should include a detailed advertising and marketing strategy; carefully calculate the cost of each marketing activity.

Delivery expenses. Also known as freight, delivery includes the costs of having materials shipped to you and delivering products to your customers. These expenses tend to be proportional to sales, and you may be able to use industry averages to estimate them.

Supplies. Calculate all the consumable supplies you will need. These will vary, depending on the type of business, but may include office supplies (pens, stationery, tape, staples, etc.); computer supplies (disks, printer toner, etc.); paper and plastic goods (towels, cups, trash bags, etc.); and any other items consumed in the day-to-day operation of your business.

Telephone. Your basic local service should be a fixed amount, based on the number of lines you have. Estimate long-distance usage based on the geographic parameters of your market and the locations of your vendors.

Utilities. Gas and electricity costs should be fairly simple to calculate. If you lease an established facility, the leasing agent or prior tenant can provide you with historical data regarding utility costs. If the facility is new, the utility companies serving the area should be able to assist you in estimating expenses.

Health insurance. This includes the premiums for whatever coverage you purchase for yourself and your employees, and may be offset by employee contributions.

Business insurance. Your requirements will depend on your type of business, its location, the value of assets to be covered and the potential liability involved. Get proposals from at least three commercial insurers to determine how much coverage is appropriate and what it will cost.

Business taxes. This includes all ongoing business taxes, including property taxes; intangible taxes; various city, county and state operating license fees; professional license fees; and any other applicable taxes.

Maintenance. The cost of repairs and maintenance will vary, depending on the type and size of your facility and whether you own or lease. As an owner, you will bear the entire expense. If you rent, certain costs may be included in the rent, while others may be shared among a group of tenants, and still others may be your own responsibility.

Legal, accounting and consulting services. Estimate what you will spend for ongoing legal advice, accounting services and other professional services.

Miscellaneous. These are the costs that don't quite fit under any other category and are often unexpected. Your allocation for these expenses can be adjusted for accuracy once you are actually in operation.

Interest. This is the cost of the money you have borrowed to start and operate your business, and can only be calculated after you have determined what your other start-up cash needs are.

Once-Only Starting Costs

Fixtures and equipment. These items could include counters, shelving, displays, lighting, signage, cash registers, computers, desks and any equipment necessary to produce the products and services you will sell. If you lease or finance equipment, include the payments in your estimated monthly expenses.

Installation of fixtures and equipment. Calculate the cost of shipping, uncrating and installing the items listed under fixtures and equipment.

Decorating and remodeling. Just about every facility will require some work to make it suitable for your operation. Get two or three bids.

Starting inventory. If you are selling a product, this could be your largest single start-up expense. Use your business plan and general industry research to determine how much inventory you should have on hand when you open your doors.

Utility deposits. Contact each utility company to determine their deposit requirements.

Legal and consulting fees. These are the once-only fees involved in setting up your business, including establishing your legal structure, setting up a corporation, if appropriate, and setting up your books.

Licenses and permits. You may need to pay certain once-only fees for such items as construction permits and inspections, and other required occupational licenses.

Initial advertising and promotion. This is separate from your ongoing advertising program, because it is designed to kick-start your business with critical visibility. One rule of thumb is to allocate at least three times your regular monthly advertising budget for the grand opening campaign.

Cash on hand. This is the amount you need to operate your business from day to day, and can be calculated from your monthly expenditures or by surveying similar businesses.

Miscellaneous. Even the best of plans will involve some surprises. Use your own judgment as to the specific amount, but have some extra money to cover those unexpected expenses.

The Issue of Income

Part of any cash flow projection is income, but this is not the place for excessive optimism. Certainly you want to set high goals for yourself in terms of sales and marketing, but you must be prepared for revenue that is significantly lower than you projected, and have a contingency plan for cash management in place. For help in calculating best- and worst-case revenue figures, contact your industry trade associations or the local Small Business Administration (SBA) office.

Your initial cash flow projection should cover the period of time you expect to operate before you begin seeing enough income to cover your expenses. This could be a few months or longer, depending on the nature of your business. Though you need to know how much money you'll require for this period, it is not essential to have that amount of money in your checking account when you open. In fact, it's smarter not to.

Do not allow excess cash to remain idle in your cash account; transfer it to earning assets until you need to spend it. If you are using borrowed funds, set up a line of credit you can draw on as you need it, so that you are not paying interest on money you are not using. The rule to follow is this: You should keep enough cash on hand to meet your immediate needs, but not so much that you sacrifice profitability.

Though your first cash flow statement should be prepared before you start your business, this is not a once-only task; it's an exercise you'll be performing for the life of your business. In fact, your cash flow statement should be your most frequently prepared financial statement. Most businesses do their cash flow projections by the month, but you may want to do yours more often. Remember that, even if your business is built on a great product, its lifeblood is cash. Sound cash management will help you stay on course as you take your company from concept to profitability.

This article was excerpted from Entrepreneur Media Inc.'s Small Business Encyclopedia ($149). For more information, see page 87, or call (800) 421-2300 to order.

Jacquelyn Lynn has been a small-business management writer for 11 years.

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