One of the top reasons companies fail is that they run out of money. That seems easy to avoid, right? Oddly enough, many entrepreneurs do not have clarity around their revenue sources and even fewer have a strong grasp of their operational costs.
How can so many brilliant and tenacious entrepreneurs fail to get a clear picture of their business operations? Unfortunately, most entrepreneurs dread building financial models, as the process is rarely laid out in an easy-to-follow format. I want to change that. I believe that all entrepreneurs can quickly and easily get a handle on their financial operations.
Let’s take a look at the construction of an easy-to-follow financial model.
Traditional financial statements include the income statement, the balance sheet, and the statement of cash flow. We’re going to focus on the most critical aspect – the income statement.
The income statement is important, as it will allow you to develop and analyze your revenues and expenses. This is the thrust of what we want to understand as business owners. How much revenue flows through and how much does it cost?
Revenue – everything that comes in through sales
Cost of Revenue – all expenses associated with each revenue stream
Gross Revenue = Revenue – Cost of Revenue
Research and Development (R&D) – all expenses associated with developing your product or service.
Sales, General, and Administrative (SG&A) – all expenses associated with maintaining, promoting, and selling your product or service.
Operating Revenue = Gross Revenue – R&D and SG&A
Interest Expense – interest paid
Tax – generally 30% of taxable income
Net Income = (Operating Revenue – Interest Expense) x Tax
If you have $100 in revenue and $30 in cost of revenue, you would have $70 in gross revenue or 70% gross margins. If you spent $10 on R&D and $30 on SG&A, you would have $30 in operating revenue or 30% operating margins. If you paid $5 in interest, you would have $25 in taxable income. Uncle Sam would take $7.5 and you would have $17.5 in net income of 17.5% net margins
You keep $17.5 from every $100 you make. This is a healthy company.
If your net margins are negative for a long period of time, you want to reassess your operations. The average company should attempt to break even by year two and achieve net margins greater than 10%. Of course, there are certain companies that fall outside of this range. Typically, companies that derive their revenue from ads take three times longer to reach profitability.
The one item that you should always include from the balance sheet is cash. View the amount of cash that comes into the company each month, against the amount of cash it takes to run the company each month. This will give you a clear picture of your operations.
This post originally appeared on Atelier Advisors. Lili Balfour is the founder and CEO of the SoMa-based financial advisory firm, Atelier Advisors, creator of Lean Finance for Startups and Finance Boot Camp for Entrepreneurs. All AlleyWatch readers are automatically eligible for a 50% discount on either of the courses using the preceding links.
Image credit: CC by Chris Potter