A friend of mine has recently set up a new business.
She has determination, resilience, passion and self-discipline and, like many entrepreneurs I know, she is not formally trained in finance. Focusing on 4 finance priorities from the start can help toward achieving long term business prosperity.
Appreciate that both profit and cash matter
Have you come across the phrase “profit is sanity and cash is reality”? Cash is the lifeblood of every business. Without sufficient, readily accessible cash, you cannot pay your creditors, staff and overheads when they are due. Profit is the difference between income (sales) and costs (goods sold, wages, overheads). When income doesn’t cover costs, the business cannot generate cash from activities. Any cash reserves in the business get depleted and the business runs out of cash. It is critical to understand the full cost of selling your product not just the cost of goods sold. If you are not making a profit considering all costs, you need to take immediate action.
Think strategically about how you want to finance your business
Every business needs cash to survive and prosper (see priority 1 above). On start up, you may have invested your own capital. At some point your business may run out of money so you need to weigh up your financing options. External finance essentially comes in two flavours: Debt and equity.
Debt is borrowing that must be repaid e.g. a bank loan. Equity by contrast is money from shareholders (investors) that has no repayment date. Both carry drawbacks and benefits for your business, and for you. Debt carries interest which has to be paid at (regular) intervals. Servicing costs will increase if rates rise (as many of us are now experiencing). Your profits will suffer. On the plus side, lenders cannot share in any upside returns. You only have to repay the capital originally borrowed plus interest. Any leftover profit is yours.
Shareholders, by contrast, are part owners in your business. They receive shares (in exchange for monies invested) which gives them the right to a “share” in the profits plus growth of the business. You are under no obligation to pay a dividend so you can reinvest any surplus cash generated in the business. Make sure your financing strategy aligns with the cash needs of the business as well as your personal ambitions when deciding between debt and equity.
Continuously (relentlessly) focus on managing your working capital
Working capital is the term used to explain the operational cash needs of a business. Most businesses have a product as their core proposition. Money “comes in” from customers and money “goes out” to suppliers. Businesses typically agree credit terms with suppliers for stock (typically 30 days). Your customers (particularly corporate customers) equally expect credit terms. If you buy stock from a supplier (on 30 days), you will have a month to settle that debt. Selling stock however cannot be guaranteed. It may “sit on the shelf” for, say, 15 days before sale and your customer may not pay even after the (say 30 days) credit terms have elapsed. In working capital parlance, you must wait 45 days to get cash, yet you must pay your supplier at 30 days. Unless you can renegotiate terms with your supplier, you will have a cash shortfall. It is critical in any business to forecast carefully how much cash you will need and for how long to avoid liquidity problems.
There are a number of ways in which you can lower working capital needs.
- Estimating the “right” quantity of stock to purchases prevents you tying up cash, whilst minimising missed sales opportunities.
- Always credit check new customers (and repeat periodically for existing customers)
- Chase debts as they become payable
- Never advance more credit than you can afford to lose!
Even with the best planning, a business may face cash flow problems periodically. This is where having an overdraft facility can be critical. You should nevertheless minimise how much you need to draw on the facility by managing your working capital as effectively as possible.
Invest time and effort to understand financial statements
Financial statements are rarely, if ever, accurate and therefore need careful interpretation. Did you know for example that a balance sheet is not intended to provide a valuation of a business? Profit is a “best guess”, based on assumptions and conventions including guessing how much you might get from your credit customers and how long assets will last.
Understanding what your balance sheet and profit and loss is telling you and, equally, what it cannot tell you, is a critically valuable skill. It is a skill well worth investing in.
About the author
Si Hussain is an expert in financial training and consulting, and is the co-author of The Finance Book: Understand the numbers even if you’re not a finance professional with Stuart Warner.