Four Pillars writes a great series of posts on entrepreneurship. His “wacky” business ideas (his words) are not so wacky to me. But for those who sit in colorless cubiles dreaming up business ideas, the question becomes is a business idea truly worth pursing and, if so, at what cost?

Seasoned entrepreneurs can tear a business idea six ways to sunset; we have collectively made thousands of mistakes. So, find an entrepreneur, present your idea and let them beat it up. If you are not discouraged after that, read on.

From a personal finance perspective, consider the following.

What is the sale cycle of your good or service? Sales cycle is fancy speak for how quickly (hours? days? weeks? months?) you can sell a product or service. The general rule of thumb is that the less novel and less premium priced a product, the quicker it will sell. Compare how many people churn through a greasy spoon to an upscale restaurant in any given evening.

Next, you have to know your cost of sales (COS) for the product or service you are selling. For example, thinking of becoming an importer? Your COS per product or service can consist of = (cost of goods + cost of import + storage costs + general administration costs + employee costs + cost of shipping to customers)/# of units sold. Assume in a worse case scenario, you have to dip into your own pocket to pay for everything.

Now you have your COS, what can you sell your product for? If you are competing on price then you clearly have to undercut your competitors (scary strategy unless you are Walmart since most studies show you have to undercut by an average of 30% to affect consumer buying patterns). If you compete on quality, what can you get away with in terms of premium pricing? Having set a price, sale price – COS = profit. Take your profit/revenue and you have a profit margin. Simple right?

Well…if you are a savvy entrepreneur, you tend not to worry about top line (revenue) or but the cash flow statement; if nothing else, cash flow should go up month after month; extremely simple but effective metric. What is the industry standard for accounts receivable aging? In professional services, it is generally short (given professionals obtain retainers beforehand, demand payment upon production of services). In other industries, it can be 30-45 days. The longer it takes for you to get paid, the longer you have to hold on with your personal finances.

Now, do this:

1. What do you think you realistically need to be paid in any year? Let’s say you say $50,000 per tax. Assume your profit margin is 50%, you have to sell $100,000 in any year to make that (this assumes you don’t invest a cent back into the business-big mistake)- by the way, 50% profit margin is rare; think lower (10-15% on quantity and 30-45% on services provision).
2. BUT… #1 only holds true if you collect 100% of your receivables on time. If your customers pay you late or not at all, this throws your assumptions off. Thus, research what the bad debt ratio is (the % of invoices written off as never to be paid) in the industry. If 10% of your invoices are not collectable, to make $50,000 a year on a profit margin of 50%, you have to actually sell $111,000 worth of goods since that extra $11,000 in sales you may never see paid.
3. BUT… its not as if all your customers will pay you by end of the month to pay you $50,000/12 on the 1st of every month. Some will pay late. So you will pay yourself different amounts of money a month to get to $50,000. Your personal fixed expenses will probably remain constant throughout so there may be months your bank account shrinks as your monthly draw is smaller than your personal expenses and months that it goes up.

…a couple of concluding thoughts:

• If the above shows you anything, it is do your research carefully. Starting a business sucks up a lot of time and money (even a modest home-based business). You have to prepare yourself for that beforehand by knowing what you are getting yourself into.
• yes, you have to become good at money to be a good entrepreneur. Entrepreneurship requires by necessity that you learn at least a bit of sales, marketing, book-keeping, finance and law.
• As the above shows, ideas get grounded down by reality. Make sure you are starting a business because your heart is into it not because you think it will make you rich quickly. There are days you will cry, laugh and, yes, hurl at being an entrepreneur because you never imagined doing book-keeping on Friday night so your heart really needs to be into it to over-come the crumpy days.

Best of luck with your business.