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1.3 - Putting a Business Idea Into Practice

Topicoverview

Inthistopicstudentsneedtocontinuetorelatetheconceptstothecontextsinwhichanenterpriseandanentrepreneurwillbeoperating.Theymustbeawarehowbusinessimplementationcanbeaffectedbythelocalandnationalbusinessenvironmentandhowthismightimpactonasmallbusiness.Studentsmustbeawareofthissectionsrelationshipwiththeotherareasinthisthemeandhowagain,thismayimpactonbusinessdecision-making.Section Keythingstolearn

Businessaimsandobjectives

DefiningbusinessaimsandbusinessobjectivesFinancialaimsforastart-upbusinessNon-financialaimsforastart-upbusinessDifferencesinbusinessaimsandobjectivesbetweenfirms

Businessrevenues,costsandprofits

UnderstandingandcalculatingbusinessrevenueUnderstandingandcalculatingbusinesscostsUnderstandingandcalculatingbusinessprofitandlossInterestBreakevenconceptandthemarginofsafetyInterpretingbreakevendiagramsChangesinbreak-evenvariables

Cashandcash-flow TheimportanceofcashinabusinessCashversusprofitInterpretingcash-flowforecasts

Sourcesofbusinessfinance

Shorttermfinanceoptionsforsmallandstart-upbusinessesLong-termfinanceoptionsforsmallandstart-upbusinesses

Businessaimsandobjectives

Whatmotivatessomeonetobecomeanentrepreneur?

Formanypeoplethiswillbemoney.Thechancetoearnsignificantprofits,buyayacht,takenumerousholidays,buydesignergoodsandsendthekidstothebestprivateschools.

Moneyandpersonalwealthmaywellhowever,notbetherealmotivation.Evidencesuggeststhattherearemanymorereasonswhysomeonewantstostartabusiness.

Everybusinessstartssmall.However,iftheentrepreneurtakessomecalculatedrisks,showsalotofdeterminationandhassomeluck,astart-upbusinesscanbecomeverylarge,profitableandvaluable.However,noteveryentrepreneurwantstobuildabigbusinessandearnafortune.

Theobjectiveswhenstartingabusinesscanbebroadlysplitintotwocategories:financialobjectivesandnon-financialobjectives.

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ThepurposeofbusinessaimsandobjectivesAimsandobjectivesprovideadirectionforanybusiness.Withoutclearobjectives,abusinessmayprovidegoodsandservicesthatarenotappropriatetowhythebusinesswassetup.Thismayresultinthebusinessnotbeingsuccessful.Havingobjectivesjustwrittendownhowever,isnotenoughtoensurebusinesssuccess.Inorderforobjectivestobeeffective,theymustbeimplementedandmonitoredovertime.Someofthebenefitstoabusinessofhavingclearobjectivesareasfollows:

Reason Explanation

Direction

Clearobjectiveswillallowabusinesstodecideonthedirectionitshouldtake,forexample,whetheritshouldexpandornot,whetheritshouldchangeitstargetmarketorperhapsincreaseordecreaseitsrangeofgoodsorservices.

Focusforemployees Itisimportantthatallemployeesareawareofthebusiness’sobjectivesandthattheyareattemptingtofollowandmeetthem.Ifallemployeesareworkingtogetherinthesamedirection,thiswillincreaseefficiency.

Allowsplanning Theoverallfirm’sstrategy,whatitplanstodointhefuture,willbeinitsbusinessplan.Havingclearobjectiveswillallowconsistentplanningforthebusinessasawholeandanydepartmentswithinthebusiness.Theplanwillbedesignedsothatthebusinessobjectivescanbemet.

Measurementofsuccess

Havingbusinessobjectivesallowsabusinesstomeasureitssuccess.Inotherwords,throughabusinessreviewingitsobjectives,itwouldbeabletoseeifithadachievedthemornotorwhetheritwasonthewaytoachievingthem.Thismeansthatthebusinesscanthencorrectorchangeitsbusinessstrategyifitisnotworking.Abusinessmightalsoneedtochangeitsbusinessobjectivesiftheyareprovingimpossibletomeetoriftheyarebeingachievedtooeasily.Theabilitytomeasuresuccessismucheasiertocarryoutforfinancialobjectives,whichareeasilyquantifiable,ratherthannon-financialobjectives,suchas“beingmoreethical”or“increasingcustomersatisfaction”,whichareverydifficulttomeasure.

Financialobjectives

• Survival–overhalfofnewbusinessesfailwithinfiveyearsandmanynewbusinessesdonotsurvivemuchbeyondtheirlaunch.Oftenentrepreneursdiscoverthattheirbusinessideawasnotasgoodastheyoriginallythoughtandthereforethebusinesscannotrunprofitablyoritrunsoutofcash.Changesinthebusinessenvironmentalsomaymakeitharderforabusinesstobesuccessful.Thefirstpriorityofabusinessisthereforealwaystosurvive.

• Profit–makingprofitisthemainobjectiveformostbusinesses.Thisistherewardtotheentrepreneurfortheirhardworkandtherisksundertaken,oftenwiththeirownmoney.Ideally,theprofitearnedissufficienttoprovidetheentrepreneurwithenoughincometoliveon.Profitsmayalsobekeptinthebusinesstoallowittoexpandordevelopfurther.Otherobjectivesbusinessesmayhavewhicharelinkedtoprofitmaximisationareincreasingrevenue,theamountmadefromsales,ordecreasingcosts.

• Anotherfinancialobjectiveisfinancialsecurityorpersonalwealth.Workingforsomeoneelsemightmeanthelossofasecurelypaidjob,whichmeanstheentrepreneurwouldhaveno

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financialsecurity.Someentrepreneurshavealongertermobjective.Theyaimtobuildavaluablebusinessthatcansubstantiallyincreasetheirfuturewealth.Theycouldbeaimingtobuildupthebusinessandsellit,ormakeitsoitwillprovideasubstantialfutureincomeforthem,withnorisktothemofbeingmaderedundant!

• Salesmaximisation/marketshare–somebusinesseswillbemoreconcernedwithincreasingtheirsalesandthereforetheirmarketshare.Theymayacceptlowerprofitsintheshortterm,inordertoincreasesales.

Non-financialobjectives

Althoughmostbusinesseswillbefocussedonfinancialobjectives,therearemanyotherprioritiesthatwillexistfornewandsmallbusinesses.Providingahighqualityservicewillbeparticularlyimportantforanewbusiness.Lookingafteritscustomersanditsemployeeswouldalsobeanobjectiveformanysmallbusinesses.

Inmanycases,non-financialobjectiveswilllinktoorbeconsistentwithfinancialobjectives,butnotalwaysassometimesevenforasmallbusinessqualitymightconflictwithprofit.Thereforewhenbusinessessetanduseobjectives,theywillprioritisetheareaswhicharemostimportanttotheirorganisationandtheowners.

Herearesomeofthenon-financialmotivesthatareoftenquotedbyentrepreneurs:

• Socialobjectivessuchasbenefitingtheenvironment• Morecontroloverworkinglife–wanttochoosewhatkindofworkisdone;theneedforgreater

independenceisamajormotivator• Amoreflexibleandconvenientworkschedule,includingbeingabletoworkfromorcloseto

home;thismotiveisanimportantreasonbehindthemanyhome-basedbusinessstart-ups• Skillsarebeingwastedandtheirpotentialisnotbeingfulfilled• Escapinganuninterestingjoborcareer• Pursuinganinterestorhobbythattheyenjoy• Wanttobetheboss,astheyarefedupwithbeingtoldwhattodo• Wantthefeelingofpersonalsatisfactionfrombuildingupabusiness• Fedupwithworkinginabusinesshierarchyorabureaucraticorganisation,wheretherearelots

ofrules;peoplewithentrepreneurialcharacteristicsoftenfeelstifledworkingwithandforothers!

• Majorchangeinpersonalcircumstancesforexampleredundancy,divorce,illness,bereavement

Differentaimsandobjectives

Differentbusinesseswillhavedifferentaimsandobjectives.Thisisparticularlythecasewithsmallbusinesses,whereeveryentrepreneurislikelytohavedifferentmotivesforstartinguptheirownbusiness.Forexample:

Entrepreneur1:hasrecentlybeenmaderedundantfromalargebuildingfirm.Hewouldliketoturnhisskillsandexperienceintobuildingmaintenanceinhislocalarea.Hewantsvariedworkandenoughmoneytoliveoff,butdoesnotwanttobuildupthebusinessortravelfar.

Entrepreneur2:hasanewbusinessideaforawebapplicationforfindingplacesforagoodnightout.Theideaisprovingverypopularinthelocaltrials.Theentrepreneurwantstodevelopthisapplicationandsellitallovertheworldinordertomakealotofprofit.

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Businessobjectiveswillalsobeaffectedbytheexternalenvironmentwhichfirmsoperatewithin.Asmalllowcosthairdressermayhavedirectcompetitioninonearea,indirectcompetitionfromanexpensivehairdressingnationalbrandinanotherareaandnocompetitionatallinafurtherarea.Theobjectivesofsuchasmallbusinesswillbedifferentbecauseofthesituationitfindsitselfin.

Businessrevenues,costsandprofits

Inorderforabusinesstocalculateitsprofit(orloss)itneedstoworkoutitstotalcostsandtotalrevenue.

Costsarethespendingthatabusinesshastoundertakeinordertomakegoodsandprovideservices.Everybusinesshascosts,buttheyvaryintermsoftheirtypeandamount.Foranewbusiness,estimatingwhatthelikelycostsaregoingtobeisoftenverydifficult.

Successfulbusinessesplacegreatimportanceoncosts.Inmostcasestheywanttoensuretheyarekeptaslowaspossible.Therearemanyreasonsforthisincluding:

• Increasesincostsreducethepossibleprofitsthatthebusinesscanmake• Theyarethemaincauseofcash-flowproblemsinasmallbusiness• Theywillchangeastheoutputoractivityofabusinesschanges

Costscanbedividedintotwotypes:fixedandvariable

Fixedcosts

Fixedcostsdonotchangeasoutputvaries.Inotherwords,theyarefixedevenifoutputmovesupordownfromperiodtoperiod.

Examplesoffixedcostsinclude:

• Rentandcounciltax• Salaries• Marketing,forexampleadvertising,marketresearch• Insurance• Interestrepayments• Leasedequipmentcharges

Itisworthrememberingthatjustbecauseacostisclassifiedas“fixed”,itdoesnotmeanthatthecostwillstaythesameforever.Afixedcostcanchangeovertime.Forexample,therentofanofficeorshopmaystaythesamefor5years.However,therentmaychange(upordown)whentherentalagreementisrenegotiatedwhendue.Theimportantpointaboutacost,likerent,being“fixed”isthatithastobepaid,whateverthelevelofsalesachieved.Fixedcostsareparticularlyimportantwhenitcomestocalculatingthebreakevenoutputofabusiness.Thehighertheleveloffixedcostsinabusiness,thehighertheoutputneededtocoverthesecostsandbreakeven.

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Variablecosts

Variablecostschangewhenoutputchanges.Inotherwordsthehighertheoutput,thehigherthevariablecosts.

Variablecoststendtobethoserelatingdirectlytotheproductionorsaleofaproduct.Goodexamplesinclude:

• Rawmaterialsandbought-instocksandcomponents• Wagesbasedonhoursworkedoramountproduced• Marketingcostsbasedonsales• Agentandothercommissions

Totalvariablecostscanbecalculatedbyasimpleformula:

Variablecostperunitxoutput

Totalcosts

Thetotalcostsofabusinesscanbecalculatedbysimplyaddingtogetherthevariablecosts,atdifferentlevelsofoutput,tothefirm’sfixedcosts.Theformulathereforeis:

Totalcosts(TC)=totalfixedcosts(TFC)+totalvariablecosts(TVC)

Example:

Graham’svanrepairbusinessisasmallbusinessthathasthefollowingcostsandsalesoutputforMarch:

Variablecostsperjob £75

Garagerentandrates £500

Salaries £1,500

Advertising £100

Otherfixedcosts £400

Expectednumberofjobsformonth 100

Tocalculatethetotalcostsforthebusiness,startwiththevariablecosts.Theseequal£75perunitx100jobs=£7,500

Fixedcosts=£500(garagerentandrates)+£1,500(salaries)+£100(advertising)+£400(otherfixedcosts)=£2,500

ThereforethetotalcostsforGraham’sbusinessequal£7,500(totalvariablecosts)+£2,500(totalfixedcosts)=£10,000

Asoutputincreasesthetotalcostswillnotincreaseasfast.Thisisbecausethefixedcostswillstaythesame.Thismeansthatabusinessmayhaveloweraveragecostsofproductionasitgrows.

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RevenueandProfit

RevenueRevenueisthemoneythebusinessreceivesfromitssales.Thiscanberepresentedsimplyusingtheformula:

Revenue=sellingpriceperunitxquantitysold

Inpractice,mostbusinessessellmorethanonedifferentproductandhavemorethanonesellingprice,whichmakesthecalculationmorecomplicated.However,themethodremainsthesame.

Intheaboveexample,ifGrahamcharges£100foreachjobthathecompletes,hisrevenuewillequal:£100(sellingpriceperunit)x100(quantitysold)=£10,000.

IsGraham’sbusinessmakingaprofit?

Profit

Havingcalculatedthetotalcostsandthetotalrevenueforabusiness,itcannowworkoutitsprofit.Profitisthefinancialreturnorrewardthattheownersofabusinessaimtoachievetorewardthemfortheriskthattheytake.Itwillmeasurethesuccessofthatinvestment.

Profitisalsoanimportantsignaltootherprovidersoffinancetoabusiness.Banks,suppliersandotherlendersaremorelikelytoprovidefinancetoabusinessthatcandemonstratethatitmakesaprofit,orislikelytodosointhenearfuture,andthatitcanpaydebtsastheyfalldue.

Profitisalsoanimportantsourceoffinanceforabusiness.Profitsearned,whicharekeptinthebusinessandarenotdistributedtotheownersviadividendsorotherpayments,areknownasretainedprofits.Retainedprofitsareanimportantsourceoffinanceforanybusiness,butespeciallystart-uporsmallbusinesses.Themomentaproductissoldformorethanitcosttoproduce,thenaprofitisearnedwhichcanbereinvested

Profitcanbemeasuredandcalculatedbythefollowingformula:

PROFIT=TOTALREVENUE-TOTALCOSTS

Hereisanexamplewhichillustratestheformulainaction:

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Sales Costs Profitorloss?

£100,000 £75,000 £25,000profit

£100,000 £125,000 (£25,000)loss

Note:negativefiguresareshowninbrackets

þ Totalsalesgreaterthantotalcosts=PROFITý Totalsaleslessthantotalcosts=LOSSØ Totalsales=totalcosts=BREAKEVEN

Whatevertheresult,profit,lossorbreakingevenabusinesswillalwaysneedtoreviewitsperformanceandlookathowitmightbeimproved.Cancostsbedecreased?How?Andbywhen?Canrevenuebeincreased?Shouldthepricestaythesame?Canmorebesold?Isthereaneedforfurtherinvestmenttodecreasecostsorincreaserevenue?

Interest

Aswellasthecostsinvolvedinrunningabusiness,abusinessownermayalsohavetopayinterest,ifthebusinessneededtoborrowmoneyintheformofaloanormortgagewhenitwassetup.Thebusinessmayalsoarrangeanoverdraftwiththebank,whichwillalsoinvolvethepaymentofinterest.Interestwillthereforeformpartofthefirm’stotalcosts.Theamountneededtobepaidmayvaryifinterestrateschange.Thisishowever,dependentonthetermsoftheloan/mortgage/overdraft,whichwouldhavebeenagreedwiththebankandthebusinessowner,whenthespecificsourceoffinancewasfirsttakenout.

Thefollowingformulacanbeusedtocalculatetheinterestrateonaloanasapercentage:

Interestonloans(%)=totalrepayment–borrowedamountx100

borrowedamount

Example:

Ifanewbusinessstart-upborrowed£50,000butrepaid£60,000intotal,theinterestpercentagewouldbe:£60,000-£50,000x100=20% £50,000

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BreakevenAbusinesswillcalculateitsbreak-evenpointinorderforittohaveanideaofhowmuchitwillneedtoproducetosurvive.Break-evenisthepointwheretotalrevenueisequaltototalcosts,whichmeansthebusinessisnotmakingaprofitoraloss.Throughcalculatingbreakeven,abusinessknowshowmanyunitsitwillneedtoproduceandsellinordertostartmakingaprofit.

Thisinformationcanberepresentedonabreakevendiagramorgraphandwillshowthepotentialprofitorlossthatcouldbemadeatdifferentlevelsofoutput,asrevenueandcostschange.

BreakevendiagramforBusinessA:

Thisbreakevendiagramshowsthatfixedcostsaredrawnasastraightline,whichisthecasebecausetheydonotchangewithoutput.Thetotalcostlineisalsoshown,insteadofthevariablecostlineonitsown,asthetotalcostlinetakesintoaccountbothfixedandvariablecosts.Thetotalcostlinestartsatthesamepointasfixedcosts,asevenifthebusinessismakingnooutput,fixedcostsstillneedtobepaid.Atzerooutputhowever,variablecostsarezeroresultinginfixedcostsandtotalcostsbeingthesamevalue.Therevenuelineislastlydrawn,whichstartsatzeroandgoesupdiagonally.Thisisbecauseasthebusinessmakesandsellsmore,itwillgainmorerevenue.

Inthisexample,BusinessA’sbreak-evenpointis10,000units,thepointwheretotalcostsandtotalrevenuecross.Thismeansthatifthebusinessmanagestoproduceandsellthisamountofoutput,itwillnotbemakingaprofitoraloss.

Marginofsafety

BusinessAcanalsocalculatethemarginofsafetyfromthebreak-evendiagram.Thisisthedifferencebetweenitscurrentlevelofoutput/salesandthebreak-evenpoint.IfBusinessAwascurrentlysellingorproducing15,000units,itsmarginofsafetywouldbe15,000(currentlevelofoutput)–10,000(break-evenpoint)=5,000units.BusinessAwouldwantthemarginofsafetytobeashighaspossible,asthisshowshowmuchoutputorsalescouldfallbeforeithitsitsbreak-evenpointandthenafterthis,thebusinesswouldbemakingaloss.

Variablecosts

Marginofsafety

Breakevenpoint

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Areminderoftheformulaformarginofsafetyisshownhere:

Marginofsafety=actualorbudgetedsales–breakevensales

Calculatingprofitandlossfromthebreak-evenchartAbusinesscandeterminetheamountofpredictedprofitorlosslevelitexpectstomakeatdifferentlevelsofoutputfromthebreak-evendiagram.Asalreadydiscussed,profitiscalculatedbydeductingtotalcostsfromtotalrevenue.Fromreviewingthebreak-evendiagramforBusinessB(onthenextpage)itcanbeseen,atanoutputlevelof80units,thebusinessismaking£160revenueanditstotalcostsequateto£140.Ifwesubtractthetotalcostsfromthetotalrevenuetheprofitatthislevelofoutputequals:£160-£140=£20.

Itisclearthebusinessismakingaprofitatthislevelofoutput,asthefirm’sbreak-evenpointis60units(thepointwheretotalrevenue=totalcosts)andasthebusinessisoperatingat80units,ahigheroutputlevelthanthebreak-evenpoint,thenthebusinessmustbemakingaprofit.

However,ifthebusinessisoperatingbelowthebreak-evenpointof60units,thebusinesswillbemakingaloss.LookingagainatthebreakevenchartforBusinessBandassumingthebusinessisproducing20units,thevalueoftotalcostsatthislevelofoutputis£80andthetotalrevenuefigureis£40.Rememberthatprofit=totalrevenue–totalcosts,sointhiscase,thebusinessismakingalossas:£40-£80=(£40).

Thismethodofcalculatingprofit/lossforabusinesscanbeappliedtoanylevelofoutputforabusinessthathasproducedabreakevendiagram.However,thedifficultyisthatsometimesvaluesaredifficulttoreadfromthediagramandthereforeifabusinessreliedonthismethodonlyofcalculatingprofit,inaccuratefiguresmaybecalculatedandthereforeusedindecisionmaking.Forexample,lookingagainatthebreakevenchartforBusinessB,cantheprofitorlossbeaccuratelyworkedout,purelyfromreadingthegraph,ifthefirmwasoperatingatanoutputlevelof55units?

MonthlybreakevenchartforBusinessB:

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Theimpactofchangesinrevenueandcostsonthebreak-evenpoint

Aswellascalculatingprofitandlossandidentifyingthebreak-evenpoint,thebreak-evendiagramcanalsobeusedtohelpbusinessownerswithdecisionmakingand“whatif”scenarios.Bychangingoneormorevariablesinthebreak-evendiagram,businessowners,orbusinessdecision-makers,canthenassesstheimpactofthischangeonthebreak-evenpoint.Thiswillallowworstandbestcasesituationstobepreparedforbythebusiness.Someexamplesareincludedheretoillustratethisfurther.

Example1:Breakevendiagramtoshowtheimpactonthebreak-evenpointofanincreaseinsellingprice

Intheabovesituation,abusiness’ssellingpricehasincreasedfrom£2to£3.Thishasresultedintheamountneededtobesoldtobreakeven(thebreak-evenoutput)decreasingfrom60unitsto30units.Inthiscase,thebusinessmaythenconductsomeresearchtoseeifcustomerswouldbewillingtopaytheincreasedsellingpriceorwhetherdemandwoulddropsignificantly,aseventhoughthebreakpointhaslowered,inthiscaseitwouldtakethebusinessasignificantlylongertimetoreachthispointduetoadropindemand.

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Example2:Breakevendiagramtoshowtheimpactonthebreak-evenpointofanincreaseinfixedcosts

Inthiscase,thefixedcostsofthebusinesshaveincreasedfrom£60to£70.Thishasincreasedthetotalcostswhichhasresultedintheamountneededtobesoldtobreakeven(thebreak-evenoutput)increasingfrom60unitsto70units.Inthecase,ifthebusinessanticipatesthatitsfixedcostsaregoingtorise,whichwouldultimatelymakeithardertobreakevenandthereforebecomeprofitable,itmaylookfordifferentwaystobecomemoreefficienttolowercosts,toovercomethischange.

CalculatingbreakevenusingtheformulaRatherthandrawingabreakevendiagramtocalculatethebreak-evenpointeachtime,aquickerandmoreefficientmethodofcalculatingbreak-evenistousetheformulae.Thebreak-evenformulaeareshowninthebox:

Breakevenoutput= fixedcost

(salesprice–variablecost)Thiswillgiveyouthenumberofunitsthebusinessneedstoproduceandselltobreakeven

Break-evenpointincosts/revenue=break-evenpointinunitsxsalesprice

Thisformulacanbeusedtocalculatetherevenue(orcosts!)atthebreakevenlevelofoutput

Breakevenoutputusingtheformula

Inordertocalculatethebreak-evenoutputusingtheformula,threevariablesarerequired.Thesearefixedcosts,salespriceandvariablecostperunit.

Inexample2,theoriginalfixedcostsofthebusinesswere£60.

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Thecurrentvariablecostperunitis£1.Variablecostsarenotdrawndirectlyontothebreak-evenchart.However,thisvaluecanstillbecalculatediftotalcostsandfixedcostsareknownandtheformulahereisused:

Totalvariablecosts=totalcosts–totalfixedcosts

Fromreviewingthechart,ataneasytoreadpoint,i.e.10units,theoriginaltotalcostswere£70andtheoriginaltotalfixedcostswere£60.Totalvariablecostsatthislevelofoutputtherefore=£70-£60=£10.

Tocalculatethevariablecostperunit,thenumberofunitsjustneedstobedividedintothisamount=£10/10=£1.

Inordertocalculatethesalespriceorthesellingpriceperunit,asimilarmethodcanbeapplied.Ataneasytoreadpointi.e.10units,thetotalsalesrevenue=£20.Tocalculatethesalespriceorsellingpriceperunit,thenumberofunitsjustneedstobedividedintothisamount=£20/10=£2.

Wenowhaveallthevariablesrequiredtocalculatethebreak-evenoutputlevelusingtheformulaasshown:

Breakevenoutput= fixedcost = £60 = 60units(salesprice–variablecost) £2-£1

Thisbeingthesameanswerasobtainedfromthebreak-evenchart.

Break-evenpointincosts/revenueusingtheformulaWewilluseexample2againtoillustratehowtocalculatethebreak-evenpointincosts/revenue.Areminderoftheformulais:

Break-evenpointincosts/revenue=break-evenpointinunitsxsalesprice

Theoriginalbreak-evenpointinunits=60unitsx£2(salesprice)=£120.Thisagainshowsthesamevalueonthe“y”axisforcosts/revenuein£sasthebreak-evendiagram,atthebreak-evenpoint.

Thebenefitofusingbreakevenanalysistoabusiness

þ Break-evenisaveryusefulbusinesstool,asitcanquicklyillustratewhathappenstoafirm’sprofitsatdifferentoutputlevels.Thiscanhelpabusinesswithdecision-makingaboutcostlevelsandsellingprices.

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þ Abusinesscouldcreateaseriesofbreak-evendiagramstoillustratetheimpactonthebreak-evenpointifoneofthevariablesonthegraphchanged.Thisiscalled“whatif”analysis.

Breakevendoeshoweverhavelimitations:

ý Itassumesthattheaveragepricethatgoodssellatwillstaythesame.ý Itgivestheimpressionthatjustbecauseproductsareproducedthattheywillbesoldatthe

averageprice.ý Itcanbecomeverycomplicatedtoabusinesswhichsellsmanydifferentproducts.ý Itassumesthatvariablecostsareproportionaltooutput,whereastheymaygetcheaperas

outputrisesormoreexpensiveifworkershavetobepaidovertime.ý Itmaymeanthatthebusinessfocusesonbreakingevenratherthanmakingaprofit!

Cashandcash-flow

Cash-flowdescribesthemovementofcashintoandoutofabusiness.Itisnotthesameasprofit.Manyprofitablebusinessesfailbecausetheydonothaveenoughcashtopaytheirbills.Thisisbecauseprofitisrecordedstraightafterasale,whereascashisrecordedwhenitiseitherspentorreceivedbythebusiness.Ifabusinessofferstradecredittoacustomerforexample,of30days,thenthesaleandthereforeprofitisdocumentedwhenthegoodsaretakenbythecustomer,butthecashwillnotberecordeduntilpaymenti.e.thecashisreceived30dayslater!

Inbusiness,cashisalwaysonthemove…

• Cash-flowsintothebankaccountwhencustomerspayfortheirsales,whenaloanisreceivedfromthebank,interestisreceivedorwhenassetsaresold

• Cash-flowsoutofthebankaccountwhensuppliersarepaid,employeewagesandsalariesarepaid,interestispaidtothebankandsoon…

Youneedtobeabletodistinguishbetween:

• Cashinflows:movementsofcashintoabusiness• Cashoutflows:movementsofcashoutofthebusiness

Thedifferencebetweenthecashinflowsandcashoutflowsduringaspecificperiod,forexampleaweekoramonthisknownasthe“netcash-flow”.

Netcash-flow=cashinflows–cashoutflowsforagiventimeperiod

Thechallengeforanybusiness,particularlynewbusinesses,istomanageitsnetcash-flowsuccessfully,sothatthebusinessdoesnotrunoutofmoney.

MaintypesofcashinflowandoutflowThemaintypesofcash-flowcanbesummarisedasfollows:

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Cashinflows CashoutflowsCashsales Paymentofoverheads,wagesandsalaries

Receiptsfromtradecustomers Paymentofsuppliers,forexamplerawmaterials,inventories

Saleofspareassets Buyingequipment

Investmentofsharecapital Interestonbankloanoroverdraft

Personalfundsinvested Paymentofdividends

Receiptofbankloan Repaymentofloans

Governmentgrants Incometax,VATandcorporationtax

Whybusinessessuffercash-flowproblems

Start-upandsmallbusinessesareespeciallyvulnerabletocash-flowproblems.Thereasonsforthiscanbedividedintotwotypes:

• notenoughmoneycomingintothebusinessfastenough• toomuchmoneygoingoutofthebusinesstooquickly

Inaddition,ifabusinessdoeshavecash-flowproblemsthennewbusinessesorbusinessesfacingfinancialdifficultieswilloftennothavereservesofretainedprofitstoseethemthroughuntilthingsimprove.Ifabusinessrunsoutofcashandisnotabletoobtainnewfinance,itwillbecomeinsolvent.

Ifabusinesshasapositivecash-flowitwillbuildupcashreserves.Thiscanbesavedincaseoffutureproblemsorusedforfutureinvestment.

Thecash-flowforecast

Thecash-flowforecastpredictsthenetcash-flowsofthebusinessoverafutureperiod.Itcanbeusedtoidentifylikelycash-flowproblemsandhelpavoidorsolvethem.

Theforecastestimateswhatthecashinflowsintothebankaccountandoutflowsoutofthebankaccountwillbe.Theresultofthecash-flowforecastisalsoanestimateofthebankbalanceattheendofeachperiodcovered(normallythisisforeachmonth).Anexampleofasimplecash-flowforecastisshownbelow:

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£'000 January February March April May June

Cashinflows 200 250 200 150 100 250

Cashoutflows 250 300 300 100 250 150

Netcash-flow(cashinflows–cashoutflows)

(50) (50) (100) 50 (150) 100

Openingbalance(samefigureastheclosingbalanceforthepreviousmonth)

250 200 150 50 100 (50)

Closingbalance(netcash-flow+openingbalance)

200 150 50 100 (50) 50

Ascanbeseenfromthetable,theclosingbalancebecomestheopeningbalanceforthenextmonth.Thisisthenaddedtothenetcash-flowforthatmonth,whichmaybeapositive(April)ornegative(May),inordertocalculatetheclosingbalanceforthatmonth.Theclosingbalanceeachmonthmightbeasurplus,whichmeansthebusinesshasapositivecashbalanceattheendofthemonth,oradeficit,whichmeansthatthebusinesshasanegativecashbalanceattheendofthemonth(oftenindicatedbybrackets,asinMay).

Lookingatthiscash-flowforecastalittlemorecarefully,itshowsthatthebusinesswillstarttheperiod,i.e.January,withacashsurplusoropeningbalanceof£250,000.Duringthefirstthreemonths,thenetcash-flowisnegative,asitispredictedthattherewillbemorecashoutflowsthaninflows,whichwillreducetheclosingbalancesurplusto£50,000inMarch.InAprilandJune,thecashoutflowsareestimatedtoreduceconsiderablymakingthemlessthanthecashinflows,resultinginasurplusintheclosingbalanceinthosetwomonths.InMayagain,theoutflowsarepredictedtobehigherthanthecashinflows.Theopeningbalance,of£100,isnotenoughtocoverthisincreaseandthereforethebusinessisforecastedtogointoadeficitof£50,000.

Businessesmustcarefullymonitorwhenthebusinessisforecasttoexperienceadeficit,asthishighlightsthebusinessmayrunoutofcash!

Torecapthekeyformulaeforcash-flowforecastsare:

Netcash-flow=cashinflows–cashoutflowsinagivenperiod

Openingbalance=closingbalanceofthepreviousperiod

Closingbalance=openingbalance+netcash-flow

Whythecash-flowforecastissoimportant

Abusinessusesacash-flowforecastto:

• Identifypotentialshortfallsincashbalancesinadvance–thinkofthecash-flowforecastasan“earlywarningsystem”.Thisisthemostimportantreasonforacash-flowforecastandenablesthebusinesstotakeaction,sothatitdoesnotexperienceanycash-flowissues,whichcanultimatelypreventthebusinessfromtradingandbecominginsolvent

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• Makessurethatthebusinesscanaffordtopaysuppliersandemployees-supplierswhichdonotgetpaidwillsoonstopsupplyingthebusiness;itisevenworseifemployeesarenotpaidontime,asinthiscasetherewouldbeno-onetoeitherproducethegoodsorprovidecustomerswiththelevelofservicethattheydemand

• Spotproblemswithcustomerpayments–preparingtheforecastencouragesthebusinesstolookathowquicklycustomersarepayingtheirdebts.Thisisonlyanissueinsomebusinessesandnotall.Forexample,mostretailerstakemostoftheirsalesincash/creditcardsatthepointofsalei.e.atthetimeofpurchase

• Compareactualfigurestoforecastfigures–thisallowsmanagementtospotifthereareanypotentialissuesandtakeappropriateaction,forexampleiftherearesignificantdifferencesbetweentheforecastedfiguresandtheactualfigures,abusinessownerwouldneedtoarrangeappropriatesourcesoffinancetocoveranyshortfallsincash

• Externalstakeholders,suchasbanks,mayrequirearegularforecast-certainlyifthebusinesshasabankloan,thebankwillwanttolookatthebusinesscash-flowcomparedtoitsforecastatregularintervals,toensurethatthebusinesswillcontinuetomakeitsrepayments

Maincausesofcash-flowproblemsAcash-flowproblemariseswhenabusinessstrugglestopayitsdebtsastheybecomedue.Whencash-flowisconsistentlynegativeandthebusinessusesupitscashbalances,thentheproblembecomesserious.Themaincausesofcash-flowproblemsare:

Factor Whyitcausesacash-flowproblem…

Lowprofitsor(worse)losses

Thereisadirectlinkbetweenlowprofitsorlossesandcash-flowproblems.Remember,mostloss-makingbusinesseseventuallyrunoutofcash

Over-investmentincapacity

Thishappenswhenabusinessspendstoomuchonmachinery,equipmentorpremises.Factoryequipment,whichisnotbeingused,doesnotgeneraterevenue,soisoftenawasteofcash

Toomuchstock Holdingtoomuchinventoryorstocktiesupcashandthereisanincreasedriskthattheseinventoriesbecomeobsoletei.e.cannotbesoldandthereforecannotgenerateanycashinflows

Allowingcustomerstoomuchcredit

Offeringcredittocustomers,i.e.buynowandpaylater,isagoodwaytobuildcustomerloyaltyandlong-termrevenue,butlatepaymentisacommonproblemandslow-payingcustomersputastrainoncash-flow

Overtrading Thisoccurswhereabusinessexpandstooquickly,puttingpressureonshort-termfinance.Forexample,aretailchainmighttrytoopentoomanystorestooquickly,beforeeachstartstogenerateprofits

Seasonaldemand Predictablechangesinseasonaldemandcreatecash-flowproblems,butbecausetheyareexpected,abusinessshouldbeabletohandletheseinanappropriateway

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SourcesofbusinessfinanceAstart-uporexistingsmallbusinesswillneedfinance.Theywillneeditforvariousreasons,shorttermandlongterm.Therearedifferentsourcesoffinanceavailableandtheactualsourcechosenbyabusinesswilldependontheamountandreasonthefinanceisrequired,aswellasthecircumstancesandthetypeoflegalstatusthebusinesshas.

Thechallengeofraisingmoney

Oftenthehardestpartofstartingabusinessisraisingthemoneytogetgoing.

Anentrepreneurmighthaveagreatbusinessideaandclearplanforhowtoexploitamarketopportunity.However,unlesssufficientfinancecanberaised,theentrepreneurwillstruggletomakethemostoftheopportunity.

Raisingfinanceforastart-uprequirescarefulplanning.Theentrepreneurneedstodecide:

• Howmuchfinanceisrequired?Raisingfinanceishardworkandexpensive–astart-upbusinessshouldavoidhavingtogothroughtheprocesstoooften!

• Whenandforhowlongthefinanceisneeded?Ausefuldistinctioncanbemadebetweenlong-termandshort-termfinance

• Whatsecurity(ifany)canbeprovided?Thiswillaffecttheabilityofthebusinesstoraiseabankorotherloanwherethelenderrequiressomesecurity(or“collateral”)

• Whethertheentrepreneurispreparedtogiveupsomecontrol(ownership)ofthestart-upinreturnforinvestment

• Whetherthecostofthefinance,forexampletheinterestcharged,isjustified

Thefinanceneedsofastart-upshouldalsotakeaccountofthesekeyareas:

• Set-upcosts:thecoststhatareincurredbeforethebusinessstartstotrade• Gettingreadytoproduce:thefixedorlongtermassetsthatthebusinessneedsbeforeitcan

begintotrade,suchasmachinery,equipment,vehiclesetc• Workingcapital:moneyrequiredforthedaytodayoperationofthebusiness.Moneywillbe

neededbythebusinesstobuythestocksrequiredbythebusiness,suchasrawmaterials,andallowanceshouldbemadeforamountsthatwillbeowedbycustomersoncesalesbegin,ifthebusinesschoosestoofferitscustomerstradecredit

• Growthanddevelopment:inthefuturethebusinessmaywishtogrowandexpandandthereforewillneedtoinvestinextracapacity,forexampleinextraspacetoproducemoreproducts

FinancetocoverdifferentperiodsAnimportantconsiderationwhenobtainingfinanceforabusinessiswhenandforhowlongthefinanceisneeded.Ausefuldistinctioncanbemadebetweenlong-termandshort-termsourcesoffinance.Thetablesummarisesthemainexamplesandusesofeachcategory:

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Long-term Short-term

Financesthewholebusinessovermanyyears Financesday-to-daytradingofthebusiness;repayableusuallywithinayear

Examples: Examples:

þ Personalsavingsþ Retainedprofitsþ Sharecapitalþ Venturecapitalþ Bankloansþ Crowdfunding

þ Bankoverdraftþ Tradecredit

Short-termsourcesofbusinessfinance:

Tradecredit

Thisisusedbymanybusinessesasashort-termsourceoffinance.Tradecreditessentiallymeansthatafirm’ssupplierswillallowittohavethegoodsandpayforthematalaterdate.

þ Thiscangivetimeforthebusinesstousethegoodsandsellitsproductsbeforeitpaysthesuppliers,whichwillimproveitscash-flowposition.

ý Ifthebillsarenotpaidontimehowever,thiscanleadtothebusinessgettingabadreputationandlosingfuturecreditarrangementswiththesupplier.

ý Itcanalsobeparticularlydifficultfornewstart-upbusinessestonegotiatetradecreditwithsuppliers,asthereisariskthatthebusinesswillfailandsuppliersmayendupnotgettingpaid!

Bankoverdraft

Businessesofallsizesusebankoverdraftsasameansoffinance.Asabusinessgetsbigger,itoftenfindsthatitsoverdraftfacilityalsoneedstogrow.Thatisbecauseanoverdraftisessentiallyashort-termsourceoffinancethatisavailabletohelpfundtheday-to-daypaymentsrequiredbyabusiness.Itallowsthebusinesstowithdrawfundsfromitsaccountthatarenotthere,uptoanagreedmaximumlimit,andisonlyusedwhenthebusinessrequiresadditional,temporaryamountsofmoney.

þ Thebigadvantageofabankoverdraftisitsflexibility.Ifabusinessexperiencesashort-termshortageofcashoranunexpectedcost,thenitcanbepaidbyusingsomeoftheoverdraftfacility.Interestisonlypaidontheamountused.

ý Themaindownsideofanoverdraftisthatitisrepayabletothebankatanytime.Abusinessmayhaveanoverdraftfacilityof£100,000i.e.itcanowethebankuptothatamount,butthebankmaylowerorevenwithdrawthatfacilityatanytime.Thishappenedtonumerousbusinesseswithbankoverdraftsduringthecreditcrunchof2007-8,manyofwhomwererelyingontheiroverdrafttostayinbusiness.

ý Theotherdrawbackofanoverdraftisthattheyusuallyhavehighlevelsofinterestattachedtothem,makingthemanexpensiveformoffinancewhentheyareused.

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Long-termsourcesofbusinessfinance:

Personalsavings

Anentrepreneurwillofteninvestpersonalcashbalancesintoastart-up.Thiscanbepersonalsavingsfromthebankorbuildingsociety.Thiscanalsobeintheformofprovidingassetsforthebusiness,forexampleusinganowncar,oritcanbeassimpleasworkingfornothing!Byusingthissourceoffinance,theentrepreneurisprovidingastrongsignal,tootherpotentialinvestorsandthebank,ofhis/hercommitmenttothebusinessventure.

þ Thisisacheapformoffinancethatisreadilyavailable.þ Investingpersonalsavingsmaximisesthecontroltheentrepreneurkeepsoverthebusiness.þ Theamountthatisavailablemaybelimited,resultinginthisbeingusedwithothersourcesof

financetofundthebusiness.

Loans

Thesemightbefromfriendsandfamilyorfromfinancialinstitutions,suchasabank.

Friendsandfamily:

Friendsandfamilywhoaresupportiveofthebusinessideamaybewillingtoprovidemoneyeitherdirectlytotheentrepreneurorintothebusiness.

þ Thiscanbequickandcheaptoarrange(certainlycomparedwithabankloan).þ Theinterestandrepaymenttermsmaybemoreflexiblethanabankloan.ý However,borrowinginthiswaycanaddtothestressfacedbyanentrepreneur,particularlyif

thebusinessgetsintodifficulties,asitcancausedisagreements.ý Theamountavailablemaybelimited,resultinginthisbeingcombinedwithothersourcesof

finance.

Bankloan:

Abankloanisanamountofmoneyborrowedforasetperiodwithanagreedrepaymentschedule.Therepaymentamountwilldependonthesizeanddurationoftheloanandtherateofinterest.Thisisacommonsourceoffinancethatasmallornewbusinesswouldchoose.However,bankloanstendtobemorereadilyavailableforwell-establishedandgrowingbusinesses,ratherthanstart-upbusinesses.Thereasonforthisisrisk–banksprefertoloantosuccessfulbusinesses,whichmakesthemmorelikelytobeabletorepaytheloanandinterest.

Ifabankloancanbeobtainedthenthereareseveraladvantagesforastart-uporanestablishedsmallbusiness:

þ Thebusinessisguaranteedthemoneyforacertainperiod-generallythreetotenyears(unlessitbreakstheloanconditions).

þ Loanscanbematchedtothelifetimeoftheequipmentorotherassetstheloanisbeingusedforþ Whileinterestmustbepaidontheloan,thereisnoneedtoprovidethebankwithashareinthe

business,sonocontrolislost.þ Interestratesmaybefixedfortheterm,makingiteasiertoforecastinterestpaymentsand

cash-flow.þ Repaymentsaremadeininstalments,resultinginthebusinesshavingaccesstosubstantial

amountsofcashthatdoesnotneedtobepaidbackallinone-go.

Therearealsosomedisadvantagesofabankloan:

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ý Timeconsuming-anewbusinesswouldneedtoproduceadetailedbusinessplantoshowtothebankinordertosecuretheloan,whichwouldtakeuptimeandresource;howeveritcouldbearguedinthelong-run,thatthiscarefulplanningwouldhelpthebusinesstohaveagreaterchanceofsuccessinthefuture.

ý Security-normallyhastobegiventothebankonsomeoftheassetsofthebusiness.Thebankwillhavecontrolovertheseassetsifthebusinessfails.

ý Lackofflexibility-asmallbusinessmighttakealoanoutfor£50,000butfindsitonlyneeded£30,000.Thatmeansthatinterestisbeingpaidon£20,000ofloanthatitdoesnotneed.

ý Interest–interestmustbepaidontheloanamount,whichincreasesthecostsofthebusiness.

Venturecapital

Venturecapitalistsofteninvestinsmallbusinesses.Venturecapitalcanbegainedfromprofessionalinvestorsorcompanieswhotypicallyinvestbetween£10,000to£750,000.

Venturecapitaliststendtohavemadetheirmoneybysettingupandsellingtheirownbusiness–inotherwordstheyhaveprovenentrepreneurialexpertise.Theadvantagesanddisadvantageofthissourceoffinanceare:

þ Venturecapitalistsoftenmaketheirownskills,experienceandcontactsavailabletothefirm.þ Theyhaveaccesstolargeamountsoffunds.ý Theventurecapitalcompanyorinvestorwillusuallywantashareofthebusinessandofthe

profits,whichcanresultinsomelossofcontroloverthefirmfortheentrepreneur,whichhe/shemaynotwanttogiveup.

Obtainingventurecapitalisquitedifferentfromraisingdebtoraloanfromalender,suchasabank.Lendershavealegalrighttointerestonaloanandrepaymentofthecapital,irrespectiveofthesuccessorfailureofthebusiness.Bycontrast,venturecapitalisofteninvestedinexchangeforastakeinthecompanywherethereturnwillbedependentonthegrowthandprofitabilityofthebusiness.

Noteverybusinessissuitableforinvestmentbyaventurecapitalist.Suchinvestorsprefertoinvestinsmallentrepreneurialbusinesseswhichareaiming(andhavethepotential)forsalesandprofitgrowth.Asaroughguideunlessabusinesscanoffertheprospectofsignificantturnovergrowthwithinfiveyears,itisunlikelytobeofinteresttoaventurecapitalfirm.

Sharecapital

Smallornewbusinessesthataresetupasaprivatelimitedcompanycanraisefinancebysellingsharesinthecompany.Therearemanyadvantagestoabusinessofraisingfinancethroughshareissues:

þ Largesumsofmoneycanberaised.þ Capitaldoesnothavetoberepaid.þ Thereisnointerest–dividendpaymentscanbemissedifprofitsarelow.

Therearehoweversomedisadvantagesincluding:

ý Possiblelossofcontroliftheoriginalownerssellmorethan50%ofthetotalshares.ý Needtosatisfyshareholdersexpectationsofdividendsandsharepricegrowth.

Retainedprofit

Thisisaveryimportantsourceoffinanceforanexistingsmallbusiness,butisclearlynotsuitableforanewbusiness,astheyareyettobuildupreservesofprofit!

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Theideaissimple.Whenabusinesshasworkedoutitsprofits,theownersorshareholderscandecidewhethertotaketheprofitsforthemselvesorreinvesttheprofitsbackintointhebusiness.

Retainedprofitshaveseveralmajoradvantages:

þ Theyarecheap,asnointeresthastobepaidonthem.þ Theyareveryflexible–thebusinessownershavecompletecontroloverhowtheyare

reinvestedandwhatproportioniskept,ratherthanpaidasdividends.þ Theydonotdiluteorreducetheownershipoftheorganisation,soforcompaniesthereisno

increasedriskofatakeover.

Thereare,however,alsosomedisadvantages:

ý Ifabusinessneedssometemporaryfinancebecauseitisfacingdifficulties,thenitisunlikelytohaveanyprofitsthatitcanuse.

ý Growthmaybeslowifitisdependentonretainedprofits,asprofitsmaynotbehighenoughtofinancethegrowthquickly.

Crowdfunding

Crowdfundingisarecentwayofsmallbusinessesorprojectsraisingmoneyfromoutsideinvestors,oftenthroughtheinternetoracrowdfundingplatformsuchaswww.kickstarter.comorwww.crowdfunder.co.uk

Aproposalispublicisedandtheaimisthatalargenumberofsmallinvestorswillbeattractedfromallovertheworld.Theinvestorswillgenerallybeinsympathywiththeaimsoftheprojectorthecauseforwhichthefundsarebeingraised.

Therearesomeadvantagestoabusinessofusingcrowdfundingtosecurefinance:

þ Itprovidescheapinvestmentwhenothersourcesofexternalfinancemaynotbeavailable.þ Iftheprojectisinterestingornewsworthyitmightattractgoodpublicity,whichwillhelpthe

businessinbecomingsuccessful.þ Thebusinessmaycreateawebblogorusesocialmediatokeepinvestorsinformed,whichmight

provideongoingfinance.þ Investorsmayhaveexperienceorskillsthattheycanofferthebusiness.

Therewillhoweverbedrawbacks:

ý Investorswillneedtobeofferedareturn;thismightbefreeuseofthegoodorserviceproduced,orashareintheprofits.Someschemeswillalsoprovideshares,whichthereforedilutesthecontroloftheoriginalownersofthebusiness.

ý Thereisariskthattherewillbealimittotheamountofmoneyinvestorsarewillingtouseinthisway.