Advertiser Disclosure

Your Guide to Small Business Financing

Oct. 28, 2014
Small Business
Many or all of the products featured here are from our partners who compensate us. This may influence which products we write about and where and how the product appears on a page. However, this does not influence our evaluations. Our opinions are our own.

Planning to start a small business? You’re not alone. There are 23 million registered small businesses in the United States, according to the Small Business Administration.

A key step in launching your dream is acquiring the money to do it. But small business financing can be tricky for the novice entrepreneur. You must estimate startup costs, prep financial statements, create cash flow and more.

All small businesses, from startups to the more established, will differ in terms of cash flow, maturity, size and other characteristics. There is no single financing option that works for everyone, so make sure you adjust your expectations with your company’s unique situation in mind.

To help you navigate, here are some general guidelines to follow for financing your small business.

Estimating startup costs

Whether you’re planning on a brick-and-mortar store or are going to work from a home office, you’ll need to calculate how much money it will take to get off the ground. This will require a detailed list with three distinct categories:

  • Business assets: Include anything you’ll need over the long term, including office space, inventory and equipment. These are typically one-time costs and are also known as capital expenses or expenditures.
  • Business expenses: Include anything you have to spend money on before starting up and in your initial phase. This may include creating a website, obtaining permits, setting up an LLC and retaining advisors, as well as paying for rent, marketing materials and employee salaries.
  • Money in the bank: In the first six to 12 months of running your business you’ll likely need to cover costs and expenses with a reserve account before sales break even. Add up all your startup and monthly costs for this time period and determine how much you’ll need in the bank to stay afloat.

When you create your list of expenses and assets, research and assign an estimated amount for each item. When in doubt, overestimate.

The IRS does allow startups to write off up to $5,000 in business startup costs before the business opens shop. All deductibles are listed on IRS Publication 535.

Preparing financial statements

Financial statements mainly refer to the balance sheet and the income statement. They are essential in preparing tax returns and, most typically, when applying for loans. This step is less important if your company is bootstrapped or if you’re planning to rely on crowdfunding or funding from family and friends.

  • A balance sheet lists assets as well as liabilities and net worth. Liabilities are obligations to creditors and investors who have provided money for your business. Net worth represents the amount they have invested. Assets indicate how those funds are used and represent anything of value owned or due to the business, including current assets (such as cash and inventory), fixed assets (land and equipment) and intangibles (market research and patents). Your assets should equal your liabilities plus your net worth.
  • An income statement shows how much profit the business brings in as well as all expenses over a period of time. This is used to determine how much the business actually makes when expenses are paid for.

Using personal finances vs. loans

To finance your business without outside investors you’ll need to use your own money, take loans from family and friends or obtain a small business loan.

You can bootstrap your business by using personal assets to fund the endeavor. Personal financing gives you freedom of ownership and potentially debt-free operations. In this way, businesses can start small and scale operations with the help of outside financing from banks or alternative lenders.

Many businesses also get rolling with loans from friends and family members. If you plan to borrow money from people close to you and it’s not a gift, consider signing and notarizing a promissory note to create a legally binding payment plan.

Or, you can try crowdfunding, which allows you to keep money from donors without repayment.

If you choose to obtain a small business loan from a bank, you’ll generally have a loan origination fee and interest to pay. If you qualify, a Small Business Administration loan, which is guaranteed by the government, can allow you to make smaller payments over a longer period of time. While loans enable you to put far more money into your business, it also means you’ll have more money to pay back.

The median small business loan banks give is about $130,000 to $140,000, but can go as high as $250,000, according to the SBA. Small business loans from the SBA average about $371,000, but can range anywhere from $5,000 microloans up to the maximum $5 million.

If you decide to obtain a loan and you don’t have any business credit history, then lenders will need to look to your personal credit to determine all terms. Startups and businesses that haven’t been around for more than a year will have far more difficulty obtaining a loan.

Small community banks or credit unions may grant small business loans to your startup if you have good credit, a strong business plan and plenty of collateral. Otherwise, you’re better off seeking other finance options.

Developing cash flow analysis

Cash flow is how money moves in and out of your businesses. You need to determine the amount of cash that will flow out from your business and measure it against the cash that will flow in. Ideally, you want the inflow of cash to be greater than your outflow in order to cover expenses and turn a profit.

Three main aspects of your business go into the analysis:

  • Operations: Measures net income and losses by assessing all sales and business expenditures within the company against inflows and outflows of cash transactions
  • Investments: Includes capital expenditures for property and equipment, investment securities, and purchase and sales of long-term business assets.
  • Financing: All money you receive to finance your business, including loan payments

So, for example, say ACME Restaurant has cash inflow of $25,000 in its first quarter from a combination of restaurant sales and a business loan. Its cash expenditures in that first quarter are about $20,000 including the cost of food, salaries, rent, a new stove, marketing, insurance and loan interest. So, for this quarter, the cash flow at ACME Restaurant is able to cover all expenditures with an additional $5,000 in profit.

Using breakeven analysis

Breakeven analysis helps you determine when your business will “break even” on all expenses and begin to draw a profit. Establishing a breakeven point is important to determining business financing because you need to figure out how much money you’ll need to cover expenses—and for how long—before sales revenue reaches the point of profit.

The expenses you outlined in your startup estimates will be your benchmark for determining how much revenue you’ll need. You should be able to cover all fixed expenses that aren’t affected by sales, such as rent, insurance and salaries. However, you’ll also have to cover variable expenses that fluctuate depending on sales, such as inventory and shipping.

Bear in mind that you don’t automatically break even when your sales equal your overhead expenses. For instance, say ABC Toys sells its toys at $10 per item. Variable costs to sell that toy are $4 per item and the toy store has $10,000 in overhead each month. If 1,000 toys were sold in one month at $10 each, the revenue would be $10,000. However, in order to break even the revenue needs to cover $4,000 in variable costs ($4 x 1,000 toys sold) as well as the total overhead. Though the $10,000 in revenue meets the $10,000 in overhead, it does not cover the additional $4,000 in variable costs and, therefore, does not meet the breakeven point.

For more information on small business financing and getting your business started, consult NerdWallet’s Small Business Guide.

Image of boat launching via Shutterstock.