Products and Services

Cashflow Forecasts

... AND Break Even Point

THE BASICS

•  Among the most important figures for your business is cash flow; use it to predict if you'll have enough money to pay future bills.
 
•  Don't confuse making a profit with cash flow. You might be making a profit, but if you run out of cash to pay your bills, your business can't operate
  
•  You can be making what seems a healthy turnover but in fact making a loss: work out the break-even point so you know how much you have to sell to cover your costs

MAIN TOPICS

•  OVERVIEW
  
•  THE CASH FLOW FORECASE : Cash is Oxygen
  
•  THE BREAK-EVEN POINT : is where Profit Starts

OVERVIEW

This information sheet describes two basic financial tools every business should use, the cash-flow forecast and the break-even point. You don't have to be an accountant to understand these terms, as once you read this information sheet you'll see why they are 'must haves' for success.

THE CASH FLOW FORECASE : Cash is Oxygen

Cash is the oxygen of business, because unless cash is available to pay bills when needed the business might be unable to operate or close its doors - even if profits are being made.

A cash flow forecast helps you estimate how much you can spend today without unexpectedly running out of cash. It uses estimated or real figures you collect and add to a simple worksheet (Table 1 on page 4) from the day you start the business. After 12 months you'll have a good idea as to what your cash balance will be, month by month for your second year of operation. You can also use the worksheet to write a business plan using cash flow projections (estimates). For more details about writing business plans, visit the Business Victoria website (www.business.vic.gov.au).

There are a few ways to use a cash flow forecast as a planning tool:

• short term planning to see where more cash than usual is needed in a month, for example, when several large annual bills are due, and the cash in the bank is likely to be low.

• business planning (long term planning) to find where cash flow could break the business, especially when the business wants to expand. For example, a seasonal swimwear retailer, after months of quiet winter trading with a low cash flow, has to buy new season's stock, employ extra staff and advertise. But it may also be planning to extend into the shop next door. After several lean months, the cash supply may be at its lowest - even without the added expense of the new premises. Cash will be very tight for several months, even with good takings, so the cash flow will need careful planning.

Having a cash flow spreadsheet is just the first step. You need to know how to analyse the figures to see where the strengths and weaknesses of your business are:

You should be doing all of the following:

• Estimate your cash flow if you're writing a business plan
• Track your actual cash flow if you already have a business
• Stress test what will happen to your cash flow if there's a increase or fall in profits and expenses (depending on what you're expecting)

Did you know?

Odd as it may seem, most small businesses are making a profit when they go out of business. Why? Because they ran out of cash to pay their bills and had to close their doors.

Use cash flow planning as a tool to make sure you know the best times to spend, especially if you need extra cash to expand the business.

Tips

• In some cases you'll need to rely on loans or savings for more than a year until the business turns over enough to be profitable.
• Avoid taking money out of the business unless it's in your financial plan, as it will take the business longer to reach the break-even point.
• Consider using a small business mentor along the way or another professional: they can offer objectivity and advice and constructive criticism!

THE BREAK EVEN POINT : is where Profit Starts

Every business needs to know how many sales have to be made before all the expenses are covered and actual profit begins. A business could well be turning over a lot of money - but running at a loss. This is where a simple calculation, the break-even point, is used to find where profit really starts.

Break-even analysis: To find the break-even point we use a calculation called the break-even analysis. Keep in mind it's just an estimate, because in reality calculating an exact break-even point is complicated.

Using the break-even analysis to calculate the break-even point

To do the calculation, we'll use three figures from an average month's sales, extracted from the twelve-month statements of profit and loss, and cash flow. If you don't have these figures (perhaps you're writing a business plan for a business you want to start) use your best estimates. The following information defines the terms using an ice-cream retail outlet as an example.

Description of terms used to calculate break-even

Example: ice-cream shop

• Average total revenue per unit: This is the price you charge the customer for each sale (or hour of service for a service provider) before you deduct any of your costs to produce it. Our shop sells natural ice-creams at $5.00 each
   
• Average per unit cost: what it costs to make each unit (a unit can also be an hour of service) once the business is set up and ready to produce and sell it. The per unit cost includes the materials and direct labour costs. The cost doesn't consider complicating factors such as savings made from buying materials in bulk. The cost of materials and basic labour for each ice-cream is $2.00 each. 
• An average month's fixed running costs: the costs for an average month for lighting, insurance, wages, office stationery, rent, interest payments. These are basic running costs you have to pay in an average month to be able to start producing and selling the very first item of anything. We spend $5,000 a month to run a shop and lease the equipment. 

The formula is:

Average month's fixed running costs = break-even point (number of units to sell) multiplied by (Unit selling price - cost to produce)

Example using the figures from the ice cream shop:

$5,000 average month's fixed running costs

$5 average revenue per unit

$2 average per unit cost

To calculate breakeven point (X) becomes

 $5,000 = X ($5-$2)

= we need to sell 1,667 ice-creams a month before we make a profit

1,667 ice-creams x $5 = $8,333).

Remember this simple version of the break-even calculation uses just one product - an ice-cream sold at one price. Realities are businesses sell different products with different profit margins. The point of this exercise is to help you build an understanding of the value of calculating the break-even point and its value to the business.