I get asked a lot by our business clients "help me figure out what I need to make to support my lifestyle." The question is both a difficult and an easy question to answer. Difficult because the process will require that you understand both your current lifestyle (and you may need to make cuts) and your future, desired lifestyle. Easy because the math behind determining the right size for your business to sustain both your current lifestyle and your desired, future lifestyle is very simple.
This isn't about determining a sustainable household budget – but if you do want more information I'm a big fan of Richard Jenkins 60% Solution on MSN Money.
This is about determining how big (measured by revenue) your business needs to be to support your lifestyle without making you feel like you're in a cash flow crunch.
First, determine the basics of what your committed payments are, things like the mortgage, car payments, school tuition, credit card debt payments, alimony, child support, etc. Let's assume that you have the following:
- Mortgage - $2,500
- Cars - $1,000
- Private School Tuition - $1,000
- Credit Card Debt Service - $1,000 (assuming you are making progress on paying down)
Total monthly 'debt like' spend is $5,500. Now, take this number and divide by .35 (or 35%). This is a healthy debt to income ratio used by mortgage lenders to determine borrowing ability. I include things like Private Tuition because if you are not considering it debt for the purposes of this formula you will continue to feel cash poor. $5,500 / .35 = $15,700. This is the MONTHLY income your business needs to be generating. Annualized this is $189,000. This is assuming the business has no debt and you are not paying taxes on the profit.
Second, determine monthly debt requirements in the business. Assuming that you have $300,000 in debt that you want paid off in approximately five years, you're probably looking at around $75,000 in debt service. This is around $75,000 per year in debt service, so now you're looking at $264,000.
Third, determine the tax requirement. Take $264,000 and multiply by 1.35 (35% effective tax rate) and your business needs to generate $356,000 in profit in order to give you a lifestyle that does not make you feel cash strapped at home AND allows you to pay down debt in the business. As you can see, this is roughly double your monthly household requirement.
Fourth, determine the sales requirement. Most all of us know our profit margins in our businesses. I've found that generally services business without material costs run anywhere between 40% (few employees) to 25% (10 or more employees) not including owner salaries and fringes. Businesses that carry inventory and have product costs are generally around 10% - 15%. Take your business profit margin, not including your salary (add it back in) and fringes (like retirement) percentage and divide your profit requirement by this number. So, assuming you are a professional services company with a 25% profit margin, take $356,000 / .25% and you get $1,424,000 in annual sales required to meet this lifestyle.
Can you get by with less? Sure, but it means that you're going to feel cash crunched at some point.
So what if you want to play out your future lifestyle (e.g. add a vacation home, college tuition). Simply follow the same steps and create a plan to get the sales you need.
If you find that you aren't generating enough sales the read posts on increasing sales and increasing profitability.
