There is one crucial principle that underlies everything about starting and running a business. On Wall Street, smart traders look at one thing above all else when deciding whether to purchase a security, or not: risk! Those traders look for any number of ways to reduce the risk of owning a particular stock, bond or derivative. This allows them to limit potential losses and maximize hoped-for gains. In a new business, the initial risk is the money (investment capital) spent before one even engages their first client. A subsequent risk is the money (revenue) received from clients that’s converted to income via the accounting of all expenses. Reprising my previous post, the reduction of risk is attained through expense control. It is always important to keep in mind that revenue is not income. Income equals revenue minus expenses (we are speaking here of gross income, which is furthered distilled into net income after paying a business’s tax liability).

Just as with a stock purchase, starting and managing a business is an investment. And like any investment, you have to pony up x-amount of dollars before you ever see a dime come your way. Such items as business licenses, telephone service, office space (if not working from home), bookkeeping, taxes and myriad other start-up expenses are examples of the capital outlay necessary for getting started.

Determining Our Income

We don’t always know how much revenue we can look forward to in a given month. And yet, to be successful in business we need to control as many factors as possible. So if we can’t control revenue, what can we control? Expenses. Yes, they too can deliver surprises (e.g., your computer just flatlined), but in large part, we generally know the repetitive costs we will incur each month (utilities, office rent, taxes, etc. ). Knowing the amount of a particular month’s expenses serves more than one function. First, we know our risk for that month. And that’s the first step in calculating our return on investment (ROI). Our ROI will of course be the difference (delta) between the eventual revenue generated and the amount of money spent in support of our business. ROI can be positive or negative. But, in short, the amount of the return on investment determines whether it was worth the risk we took to earn an income.

The flip side of that equation is we know how much revenue we need to produce a particular amount of income by creating a break-even point (BEP). By knowing the total projected costs for one month, we can determine the amount of revenue we need to break even for the month. Anything over and above that BEP is considered profit, or income. That’s income we can use to support ourselves, or reduce the amount of our original investment, thus mitigating our overall risk.

At the beginning of this post, I gave the example of traders determining whether to buy or not to buy a security based on the amount of risk. How much risk determines whether to start or continue a business?

Up Next: The Role of Risk — Part 2