Monetary Wisdom - July 2008

By Charlie Ragland

Increasing sales is not always the right strategy for improving financial performance. In some cases rapid sales growth can strain your cash resources and cause the business to fail. Small business owners need to understand the financial interrelationships in their business to successfully navigate the financial jungle.

Many entrepreneurs started their business to solve a problem or satisfy an unmet customer need. Their training is market focused and customer centric. Often these founders do not have formal training in accounting and finance. They tend to be directly involved with the core aspect of the business product or service and are focused on satisfying the market need. Many times these business owners are too busy to focus on the details necessary to maximize profitability—the mathematical equivalency of their daily business activity.

It is important to understand the pulse of the business. Many of the small business owners I meet generally feel that they know how their business is doing. They understand current sales levels, receivables, and payables. Many feel that if the business is doing poorly financially, they simply need to sell more.

Business owners need to understand the financial aspects of their business from securing financing, managing cash flow, and maximizing profitability. Additionally, they need to understand how to conduct a financial audit to identify potential problem areas and develop corrective solutions going forward. Is the inventory level too high? How about past due receivables? Are we taking advantage of cash discounts on payables?

Develop a monthly financial scorecard. A monthly financial scorecard, much like the dashboard on your car, provides feedback on how the business is doing. The primary financial tools are monthly income statements, balance sheets, and cash flow statements. Key individual statistics include cash, sales, inventory, payables and receivables.

The income statement measures a company’s sales and expense activity over a specified period of time. The income statement will give you a quick view of your profit or loss for the period. The balance sheet reflects the relationship between assets, liabilities, and equity. The balance sheet is a financial snapshot of a business at a particular point in time. It lists the assets (what the business owns) and the liabilities and equity (the suppliers of funds to purchase the assets). The cash flow statement shows when the money comes in and when it goes out. It’s an estimate of monthly cash expenses and cash income.

One way to understand the relationship between the income statement and balance sheet is in terms of a sporting event. The balance sheet is the scoreboard at the end of each period. The income statement provides the statistics—what happened during the period to impact the score. An income statement covers the time period between two balance sheets. Any changes in the value of the two balance sheets are explained by the income statement.

Understanding the working capital and cash flow cycle is critical to navigating the ebbs and flows of the sales cycle. Increasing sales will not always solve the profitability issues. In many businesses new sales are effectively financed through the purchase of inventory. The financing for the sale is not satisfied until the customer pays. Many times this gap can be 100 days or longer. Increasing sales can often worsen the firm’s financial condition instead of improving it. It’s not until sales slow that the cash flow cycle is reversed.

I find that those businesses that are diligent in reviewing their financial status on a monthly basis are more successful in responding to unanticipated situations.

Conduct a cause and effect analysis. Many companies begin assessing performance when they begin experiencing low pre-tax profits. There are five general causes of low pre-tax profits: high carrying costs, low gross profit margin, poor expense control, high interest and low sales. In turn each of these general causes is a result of operating decisions within the business.

A financial cause and effect analysis can be very helpful in benchmarking your financial performance versus similar companies in your industry. This process will help you understand the potential causes of problems in your business.

Begin your financial assessment with a general accounting ratio analysis and compare your results to industry averages specific to your line of business. Identify areas that are outside the general performance levels of similar businesses and take corrective action. If your inventory levels tend to be higher than those of your competitors, understand why and then take appropriate action. A good source for comparative financial statistics for most industries can be found in studies published by Risk Management Association (formerly Robert Morris Associates). These studies are available for purchase and download at www.rmahq.org.

A traditional financial ratio analysis can help you identify potential solvency, liquidity, and working capital issues. Low solvency, often identified by a low current ratio (current assets divided by current liabilities), can be caused by current liabilities being too high or using short-term funds (current liabilities) to fund long-term assets. Possible solutions include moving some short-term liabilities to long-term liabilities or sale/leaseback of some fixed assets.

Low liquidity, often identified by a low quick ratio (cash plus accounts receivable plus marketable securities divided by current liabilities), can be caused by the same issues for low solvency with the possible addition of high inventory levels. In addition to the solutions for low solvency, inventory can be reduced to a target level. Appropriate inventory can be derived by dividing cost of goods sold by the industry average inventory turnover rate.

Working capital requirements involve understanding the timing of cash inflows and outflo ws. When faced with low working capital, work inside out and focus on the things that can be controlled first. Convert excess inventory to cash, lower operating expenses, and convert fixed assets to cash to buy time. To speed money inflows, offer discounts for people who buy regularly, invoice immediately, and negotiate upfront incentives. Slow down money going out by negotiating extended terms with suppliers in advance based on the business situation. Consider requesting seasonal payments or flexible terms with a blanket purchase order.

Cash is critical to the success of any business. Cash is required to purchase inventory, pay wages, and maintain your equipment. Income, revenue, or profits can’t pay immediate bills. The goods that you manufacture or inventory that you purchase may not be sold for weeks or months. Additionally, it may take weeks or months to receive payment. Understand your internal financing requirements and focus on available cash to meet the daily needs of the business.

Avoid common mistakes. Being focused on solving a customer problem or developing new solutions to meeting emerging market needs is the essence of business. Similarly, understanding how to steer the financial engine is critical to business success. Common mistakes that many small business owners make include poor initial planning, improper monitoring of financial position, little understanding of costs and the pricing of products, failure to plan cash flow needs, failure to manage growth, improper debt structure, failure to monitor and control fixed costs, and poor banking relationships.

By tracking your financial performance on a monthly basis, benchmarking your results versus similar companies in your industry, and taking corrective action, you can effectively navigate the financial jungle.

Print the Article