7 Financial Questions Every Entrepreneur Should Be Able to Answer
Aug 5, 2022 - 7 min read
“Everyone can tell you the risk. An entrepreneur can see the reward.”- Robert Kiyosaki
Many of you must have heard about such quotes if you don't already live by them. The word “entrepreneurship” has become a new sensation around the world, especially among the youths who believe in independence and are driven by their passion to create an impact on society. Nepal has not been immune to this sensation either. In FY 2020-21, despite the hard-hitting Covid Pandemic, registrations of new firms reached a record-breaking figure of 83,386, compared to the earlier year's data of 48,854.
However, the success rate in the startup world is meager. The global data suggests that 9 out of 10 startups fail around the world. While there is no such data about Nepalese startups, it is not unreasonable to assume that the statistics would be similar, if not worse, in Nepal.
According to a survey by CB Insights, the top reason for the failed startups was reported to be their financial predicament (38%). While there are many questions that entrepreneurs should be mindful of to make their business a success, the following are some of the financial questions that every entrepreneur should know the answer to.
- What are your Business Drivers?
Drivers are the measurable, comparable, and significant inputs and activities in a business that drive its operational and financial results.
Revenue, cost, and expense drivers provide a snapshot of the company's operation, which can vary by industry. Revenue drivers for a food delivery company, for instance, may include the number of daily orders, number of working days, average order value, commission rate, etc. whereas the cost drivers may include daily orders, average distance covered per order, average mileage per delivery vehicle, average fuel cost, delivery wage per employee, number of employees, etc.
Information about these drivers can help the owners to compare their stance with the industry, measure the company's performance, formulate appropriate decisions, and evaluate strategies. For instance, a food delivery company could witness a decrease in average order value driver, in response to which it may introduce a mandatory minimum order value.
Drivers are the cold, hard, but dependable truths of the company which can indicate the trend of its performance. They are the basis for the future projections, scalability, as well as valuation of any company. Every entrepreneur should identify, quantify, and keep track of their revenue, cost, and expense drivers to accurately understand where their company stands, what efforts have been made to improve these indicators, and what decisions and strategies should be formulated for the future.
- Raise Capital: Should you? When? How much? How?
Other than the initial investment to get started with your business, you might need funding to finance different strategies at different stages of your company's lifetime. To bring ambitious visions to life, businesses might have to raise capital to scale up.
The answer to the questions- whether the company should raise the capital at all, how it should be raised, what the appropriate amount is, and when the right time to do so is- is different for different businesses depending on the nature of their business models.
Trading businesses, for instance, can raise capital through bank loans, whereas innovative tech startups may not be bankable, given the associated risks such as first-mover challenges and lack of collateral. Other than personal wealth, the other funding sources for such startups could be venture capitals, private equities, angel investors, individual investors, companies, etc.
Considering the current and expected SWOT analysis, entrepreneurs need to create financial models, project cash flows, and other financial figures and metrics, to figure out whether the additional capital would add value to the company. If it does, the model should be used to determine the appropriate time to raise capital, the amount it might need, the preferable investment deal structure, the ways the funding is exhausted, and the consequences realized in its financial metrics.
- How is your cash position?
Very few businesses have models that can generate a cash flow right away. Even though the businesses are profitable, cash flow is not guaranteed. Cash and profit being at odds with each other is not an uncommon phenomenon, especially in small businesses that need to invest in their assets to grow further. To grow and build a customer base, startups spend heavily on marketing and advertising by adopting a penetration pricing strategy, offering sales schemes and discounts, and so on, all of which require heavy cash outflow.
Hence, a cash crunch can be a big challenge for entrepreneurs across different industries in the early stages when the business has not yet established itself in the market to generate enough cash inflows from different revenue sources.
Entrepreneurs need to assess where the money is going, and where it is coming from periodically to accurately predict the availability of cash to back the company's decisions. Some of the metrics to analyze cash flow are:
a. Burn Rate: What money is lost per month?
A negative net burn rate, which happens when monthly revenue is higher than monthly expenses, is an ideal scenario for startups.
Burn rate depends upon the business model, funding, and growth strategy. A commercial building, for instance, is going to have negative FCF, with a high burn rate for a significant amount of time. The company needs to invest in land, buildings, and other assets, requiring cash outflow for a long time, until the building is fully set up to start earning rental revenue. The case may not be similar for a trading company, where the cash conversion cycle is much lower.
While cash burn is not a bad thing for startups, as we need to spend money to make money, unnoticed quick cash burn can be detrimental to them. A high burn rate shortens the cash runway, with a lingering threat of cash burnout. If the burn rate is high, with negative Free Cash Flow (FCF), the takeaway for an entrepreneur is that the company will have to rely on investors' money to fund the next few periods of its life.
b. Cash Runway: How many months till your startup runs out of cash?
If the cash burn rate is high, the business will run out of cash eventually. The longer the cash runway, the more time you have to build and grow your startup. A shorter runway can indicate that either your revenue is not growing at a sustainable rate, or you are spending too much money too soon.
Cash Runway = current cash balance/burn rate
To elongate the cash runway, either the expenses should be reduced, the revenues should be increased, or additional funding should be raised. To be sure of which path to take, creating a financial model with multiple scenarios can clarify the way forward.
No entrepreneur can afford to ignore these cash metrics if they are here to build successful businesses. These metrics also determine when the business can self-sustain. Only after having answers to these questions, entrepreneurs can appropriately make decisions regarding cost-cutting, revenue diversification/ constriction, investments, additional funding, etc.
- What are your Customer Lifetime Value (CLV) and Customer Acquisition Cost (CAC)?
CAC gives the average amount of money that's spent to acquire one new customer, whereas CLV gives the average revenue that can be expected to be collected from a customer before he/she churns.
CAC includes any marketing and sales cost to acquire customers including advertising and marketing expenses, sales employees' salary, etc. There's no hard and fast rule regarding how much the CAC should be. Spending too much on the acquisition can invite a cash crunch whereas spending too little can result in the opportunity cost.
Entrepreneurs need to find a balance somewhere in between and try to spend just enough to attract high-value customers, which can be done by considering CLV. CLV: CAC ratio compares the lifetime worth of a customer with the average amount required to acquire the customer. For instance, if the ratio is 1:4, you are spending 4 times as much to acquire customers relative to what value they bring into the company. The ideal CLV: CAC ratio is greater than 3 for companies expecting growth.
Entrepreneurs should be mindful of this ratio, especially those with recurring revenue modeled businesses, to determine their marketing spending.
- What is your Break Even Point?
It determines when your business will be able to cover all its expenses and begin to make a profit. When the income coming from sales exactly matches all the expenses incurred, the business breaks even. Beyond this point, the company makes a profit.
Break Even point (in units) = fixed costs / (Sales price per unit – Variable costs per unit)
The break even analysis gives insights to entrepreneurs regarding how profitable the current product line is, the minimum sales volume required to start making a profit, how changing price or sales volume will impact the profit, and how the price and sales volume should be changed to make up for change in fixed costs.
Entrepreneurs should know their break even point to set performance targets, reevaluate their cost and revenue drivers, determine resources needed to reach the set targets, identify additional capital requirements, and determine whether their business model is realistic and sustainable or not.
- Where do you want your business to be in five or ten years?
Profit is the essence of any business. Whether your business idea is generating or will generate profit is a key question to consider.
Many entrepreneurs tend to be more concerned about revenue than profit. While revenue is a very important figure that indicates the growth and expansion of the market share of the company, gross margin paints a more realistic picture of how much revenue you are actually generating, and net margin indicates how feasible and scalable your business is.
Gross Profit Margin (GPM) = (Revenue – Cost of Goods Sold) / Revenue x 100
Net Profit Margin (NPM)= Net Profit ⁄ Total revenue x 100
A startup might be skyrocketing in terms of expansion and revenue. However, if the cost of generating such revenues is accelerating at a pace faster than that of revenue, the company might have to make changes in its strategies. Hence, entrepreneurs should take notes of profit margins to keep both cost and income in check.
Similarly, Return on Investment (ROI) and payback period are the other important profitability metrics that are especially of interest to investors. ROI measures how much gain or loss is generated from the investment made in the company, whereas the payback period is the time it takes to recover the cost of an investment.
ROI = Net income / Cost of investment x 100
Payback Period = Initial investment / Cash flow per year
The more the ROI is and the less the payback period is, the more attractive the company becomes to investors. Entrepreneurs need to know the past, current and expected ROI and payback period of the business to evaluate the effectiveness of the investment made in the company.
- Where do you want your business to be in five or ten years?
As cliché as it may sound, this question is very important for all entrepreneurs. Setting a long-term vision for the business not only provides inspiration but also gives direction to the company in its day-to-day operations.
It’s never too early to set budgets and goals for the future. For instance, if the food delivery company envisions expanding enough to capture 50% of the market share and start earning profit enough to self-finance further expansion plans in the next 10 years, then entrepreneurs can set budgets, create financial projections, identify the appropriate strategies and resources to bring the dream to life, and then set smaller targets and plans about its day-to-day operations that are in line with the vision to achieve the end goal.
Entrepreneurs need to be clear about their long-term measurable objectives to effectively formulate strategies and make decisions.
There is more than one mantra for being a successful entrepreneur. You might be offering the best product the market has ever seen, and still fail to survive. A startup cannot sustain value creation if its most basic and key metrics don’t add up. Hence, every entrepreneur should be mindful of at least the above financial questions to keep the company’s financial health in check and move forward with their ideas.