Join Jim Stice for an in-depth discussion in this video Cash flows, part of Finance Essentials for Small Business.
- We know you'll need sufficient capital to get your new business through the critical first few months. Let's assume you've made it through those first few months. You will still need to track your cash inflows and outflows to ensure that you have sufficient cash to pay the bills that are surely coming. Whether you are at the start of your business or well into the lifecycle of your business, managing cash is critical for the wellbeing of your business. Cash management does not happen by chance. It is up to you to ensure that your cash is managed.
We will do this by preparing a cash forecast or budget. Let's start our discussion of cash management by distinguishing between two types of costs, fixed costs and variable costs. Fixed costs are exactly that, they're fixed. Budgeting for fixed costs is relatively straightforward. The amount is fixed, at least over the short term. Variable costs are costs that vary relative to some activity or cost driver. For a restaurant, for example, costs might vary based on the number of customers.
For a shop at the mall, costs may vary based on the number of hours that the shop is open, labor costs, utility costs, and so forth. Now there can be a number of cost drivers, or in other words, costs can vary for a number of reasons. It just depends on how complicated you want to get. For our example, we will assume one driver that results in variable costs just to keep things simple. Adding more drivers makes the arithmetic a little more complex, but the concept is still the same. Now step one in cash management is to identify all of your fixed and all of your variable costs.
All of those costs. It's easy to forget an expense here or an expense there, and before you know it, your cash forecasts are useless. The cash forecast is only as good as the inputs. Now let's go into the fast food restaurant business. What costs associated with this business will be fixed and which will be variable? Before I can nail down the variable costs, I need to ask this question, variable relative to what? I'm going to assume that certain costs vary based on the number of customers.
For a given month my fixed costs will involve rent on the building, rent on my equipment or loan payments if I'm purchasing the equipment, utilities, insurance, and advertising. You will get the idea so let's stop there. It's critical that I identify all of my fixed costs. So to this point we have the following fixed costs: rent on the building of $5,000, rent on our equipment of $6,000, utilities of $2,500, and insurance of $1,000, and advertising of $1,500, for a forecasted total fixed costs for the month of $16,000.
These costs will be incurred regardless of whether 10 customers or 1,000 customers walk through the door. Next we'll talk about variable costs.
- Describe the most common reason small businesses fail.
- Identify two reasons why your business plan needs to budget cash inflows and outflows for the first six months of your business’s operation.
- Write the formula to forecast cash flow for the first four months of your small business.
- Explain the first step you should take if your new small business is not making the profit you anticipated.
- Identify the most important thing to keep in mind if you are considering faster growth for your small business.