THE PROBLEM: Investment is Needed but the Exact Amount is Unknown
Entrepreneurs know that investment is needed to grow their business, but often the founder doesn't know how much cash is needed. This is a key PROBLEM for the entrepreneur.
An investor will want to hear a precise investment amount from the entrepreneur not only so she can estimate the return on her investment, but -- and this is IMPORTANT -- to show if the entrepreneur has thought enough about his new business to have planned it out! An investor is less likely to invest in a new business which has not been planned out.
Profits = Cash is Generated
Losses = Cash is Consumed
PROFITS are an important source of cash for a business. If cash is coming in from profits, then funds from an external investor may not be needed.
LOSSES mean the business is not GENERATING cash...it's actually CONSUMING cash. That is, cash is NEEDED for the business to pay it's expenses and continue operations into the next month (or year).
If the Entrepreneur seeks an Investor for cash to pay business losses, the investor will ask:
HOW MUCH INVESTMENT IS NEEDED?
To Answer the Investor, the Entrepreneur must know 2 things:
1. HOW BIG ARE THE LOSSES
2. HOW LONG WILL THE LOSSES OCCUR
Example #1: If losses will be $2,000 for two months before reaching profitability, then the Entrepreneur would need an investment of $4,000.
Example #2: If over the next 5 months, losses of $4,000 and $3,000, a profit of $1,000, then losses of $2,000 and $1,000, are expected, then the Entrepreneur would need a minimum investment of $9,000. (the sum of -$4,000 -$3,000 +$1,000 -$2,000 -$1,000). All of the months must be considered.
However, more cash may still be needed. Examining only profits & losses doesn't include any additional capital which may be needed to operate the business. Such capital is called Working Capital.
In Example #2, if customers pay for products in 30 days, but vendors require payment in 15 days, cash is needed to pay the vendors before cash arrives from the customers. If $500 of materials were purchased, then the total investment required in Example #2 would be $9,500, not $9,000.
Working capital is often overlooked when considering the total investment needed.
These are simple examples, but they can get complex quickly.
A Financial Forecast Model is critical for the Entrepreneur to effectively respond to the Investor!
FAQs ==> here