So you’ve got a good idea for a business. Congratulations!
But turning ideas into reality can be an expensive process. You’ll have to
spend money before you even start, and then keep spending money as you try to
build up your customer base. So how do you figure out how much money you’ll
need, and whether you can afford it?
In this tutorial, you’ll learn how to create a financial model for your new business. You’ll see how to make realistic assumptions about where the revenue will come from and what your expenses will be. You’ll discover a handy calculator to help you estimate startup expenses, and a method for working out your break-even point. And we’ll use a free template to create a basic model in Microsoft Excel.
You won’t need to know any complex math or business concepts for this tutorial. We’ll keep things simple, and illustrate the process using the example of a fictional juice bar we plan to establish. The principles will work just as well for other types of business as well, of course, including web-based companies.
1. Define Your Business Model
In this tutorial, I’m assuming you already have an idea for your business (if not, try our tutorial How to Come Up with Startup Ideas Worth Pursuing).
Before you can build a realistic financial model for your business, however, you’ll need to flesh out your idea. This is particularly important if you’re trying something new and unproven, because you’ll need to see if there really is a demand for your product or service. But even with traditional business ideas, it’s important to do some research so that you can come up with some solid estimates.
Our juice bar idea is pretty simple, for example, but we’ll still need to do some research. What location are we aiming for? How much does rent cost there? How much competition is there, both direct (another juice bar) and indirect (other cafes and stores that also sell juice)? Is there enough customer demand? What factors affect that demand (weather, price, etc.)? How much disposable income do people have around here?
The questions and answers will vary depending on your business idea, of course, but the idea is to gather some more detailed knowledge. In the future steps, we’ll be constructing a financial model based on some assumptions and estimates about how much you’ll have to pay and how much you can expect to earn. The strength of your model depends on the strength of your estimates, so it pays to do your research early on.
You can do a certain amount of research online and using books and other reference materials, but it really pays to get out there and speak to people as well. Do surveys of your potential customers, asking them what they want, how they want it, and how much they’d pay for it. You can also speak to people who are already in business about their experiences, although of course it might be best to avoid quizzing people you’ll be in direct competition with. And you could try trade associations and other local business groups, as well as non-profit and governmental organisations aimed at providing advice to small business owners and entrepreneurs.
2. Make Some Assumptions
How much money can you expect to make? Until you open your doors, of course, you never know. But you can certainly make educated guesses, rather than relying on guesswork.
Broadly speaking, there are a couple of different methods of estimating expected revenue: top-down and bottom-up.
A top-down revenue estimate is based on looking at the overall market size, and estimating how much market share your business can garner.
Our market research might show, for example, that people in our town spent $10 million last year on buying healthy drinks and snacks. So if we can snag a 5% market share, we can expect to make about $500,000 a year.
The advantages of the top-down method are that it’s quick and simple if you have the right data available, and it can provide a good view of the overall size of the opportunity.
The disadvantages are that it’s not very accurate, and can lead to over-optimistic estimates. The “market size” number can often be difficult to find, and may itself be based on assumptions and guesstimates by a market research company. And then you’re layering your own assumptions and guesstimates on top of that by coming up with a “market share” number, which is very difficult to estimate accurately.
If you’re launching a new app, for example, you might see the overall market size reported as $35 billion, and figure that even you can grab just 0.1% of the market, you’ll make a cool $35 million. It sounds pretty reasonable—how hard can it be, after all, to get just a tiny 0.1% market share? A lot harder than it sounds, actually, otherwise we’d all be millionaires.
In the bottom-up approach, on the other hand, you build up your estimates from the smallest units. For our juice bar, we’ll add up all the different costs in our business, and estimate them month by month into the future. Then we’ll think about how many glasses of juice we can realistically sell and at what price, and use that to come up with our revenue estimate.
The advantage of this approach is that it forces you to think in detail about how your business will make money and what your expenses will be. It’s still not exact, because you’re still making estimates about the future based on limited information, but there’s a better chance of your estimates being based on solid ground.
The disadvantage is that it can be quite laborious to build up a detailed financial model in this way. You’re not just doing a single calculation now—you’re adding up many different lines of revenue and expense.
Fortunately there are templates out there to help us. In this tutorial, we’re going to focus on the bottom-up approach, so I’ve downloaded a free Excel template from StartupModels.com. There’s a wide variety of templates available online, each with differing levels of complexity, so feel free to search for your own. This article on financial models includes links to numerous templates.
All you have to do is fill in the numbers based on your assumptions, and the spreadsheet will then calculate your expected profits month by month, as well as filling in your company’s projected financial statements (for more on how to read the statements, see our series on the fundaments of financial statements).
For example, I enter expected revenue and expenses in a variety of different categories:
And the spreadsheet produces an income statement:
You can download the whole spreadsheet showing the model for our fictional juice bar by clicking the link in the sidebar.
3. Calculate Startup Costs
In order to get off the ground, you’ll probably need to spend some money before you start. But how much? To put together a realistic financial model, it’s important to calculate your startup expenses as accurately as possible.
We’ll need a location for our juice bar, for example, so we’ll have to include the security deposit, first month’s rent, and any other fees. We’ll need to buy or rent equipment and furniture for our store, and pay someone to install it. Image is important, so we’ll need a talented designer to make our store look fresh and enticing. Unless it’s a very small juice bar and we plan to work long hours, we’ll need to hire some staff as well. And then there’s pre-launch advertising, and insurance, and fees for registering our business and setting it up with the right legal structure.
We’ll also need some cash in hand to cover us for a few months until we break even (we’ll look at the break-even point in the next section). So take your basic, unavoidable expenses like rent, utilities and salaries, and multiply them by the number of months you need to cover. Our juice bar will be quite quick to set up, so we’ll just set aside three months of costs. If it will be a long time before you start making money, you’ll need a much bigger stash.
If you need help calculating your startup costs, you can use this handy calculator from The Wall Street Journal. There’s nothing tricky about the math here—you’re just adding up numbers—but the online calculator can help by prompting you to think of all the different categories of expense you’re likely to encounter.
What if the startup costs are too high? It doesn’t necessarily mean the end of your idea. You’ll just need a source of external funding—an investor, perhaps, or a generous relative, or a bank loan. For more information and ideas on raising money, check out our comprehensive eight-part series on funding a business.
4. Calculate the Break-Even Point
A good way of testing your progress so far is to calculate your break-even point. This is the number of items you’ll need to sell each day (or week, or month) to cover your costs.
There’s a formula to work this out, but don’t worry—it’s quite simple. Here it is:
Break-Even Revenue = Fixed Costs / Gross Margin Percentage
Let’s look at what each of those terms mean and how we can calculate them, using our juice bar example.
Gross Margin Percentage
For every glass of juice that we sell, how much of that is profit? Let’s say our juice sells for $5 a glass (it’s good, premium, organic juice!). The fruit and other ingredients cost $2, leaving us a healthy $3 in gross margin. The gross margin percentage, therefore, is $3 divided by $5, which equals 60%.
The fixed costs are simply the regular expenses we incur each month to keep the juice bar open: rent, utilities, staff salaries, and so on. We won’t include startup costs, because right now we’re interested in ongoing expenses when the business is up and running. And we won’t include things like the cost of the ingredients, because those were included already in the gross margin percentage calculation. Let’s keep things simple, and say that our rent is $1,000 a month, our utilities are $500, and we pay out $4,000 in salaries. So that’s a total of $5,500 in fixed costs every month.
So now that we have our two other variables, we can plug them into the formula and get:
Break-Even Revenue = $5,500 / 60% = $9,167
That means that each month, our juice bar needs to make $9,167 just to break even. If we make more than that, we’re profitable; if we fall short, we’re in trouble.
We can break that down further if we want to—it works out to about $305 a day, assuming we’re open seven days a week. And since each glass of juice costs $5, we’ll need to sell 61 glasses every day to break even (305 divided by 5).
Is that realistic? How are we going to attract those 61 customers every day, and keep them coming back? Are we in a good enough location to attract plenty of passers-by, or will we need to advertise far and wide? How long will it take before we can reach our daily or monthly break-even point, and do we have enough funds to survive until that happens? All of these questions and more can help you refine your model at this point, and deal with any potential problems.
And if you didn’t follow those calculations, or just want a simpler method, you can also try this online calculator.
5. Put It All Together
Now that you’ve defined your business model, made some basic assumptions about your business, calculated your startup costs accurately, and refined your model based on a break-even analysis, it’s time to finalize your financial model.
Go back to the spreadsheet and feed in all the information you’ve gathered so far, making any adjustments necessary to ensure you end up with the most realistic model possible.
No matter how carefully you’ve planned, however, one thing’s for sure: some of the assumptions in your model will be wrong. As you start your business and come into contact with more and more customers, you’ll discover that they want things you hadn’t thought of.
On top of that, real life is unpredictable, and you may incur a whole range of unexpected expenses. In short, it’s highly unlikely that your profits will precisely follow the neat upward trajectory you’ve set out in your model.
So as you move forward, it’s important to return to your model at regular intervals and refine it based on the new information you discover. Whether you use this Excel template or move on to use accounting software, keep assessing your progress against the plan, and tweaking the model to provide the most accurate possible picture of what lies ahead for your business.