Categorized | Financial Management

FINANCE, TAXES, AND BANKING 2.4. Financial Management

Shoestring Venture: The Startup Bible (1st Edition)Financial management is a broad topic covering how you manage, account for, and use your business’s financial resources. The most critical financial decisions you make are in the areas of cash flow and bookkeeping.

Cash flow is the flow of cash in and out of your organization—it is the life-blood of your business. To stay in business, you need to structure your finances so that more cash is flowing into the business than flowing out. It is entirely possible to have an unprofitable business with positive cash flow and even more possible to have a profitable business with negative cash flow, all thanks to the magic of accrual accounting! So while profit is your aim, cash flow is what pays the bills. Cash flow affects everything you do: how you pay bills, how customers pay you, accounts receivable, and how you structure your business’s loans.

Bookkeeping and accounting is basically how you record, structure, and control financial transactions. Since you have a number of legal alternatives for accounting for these transactions, at the very least you need to participate in and understand the financial controls your business puts on the bookkeeping and accounting process to ensure integrity in recording these transactions. (Chapter 4.12 deals with specific outsourcing resources for accounting, bookkeeping, and taxes).

A financial or accounting control is a pre-made decision for how financial transactions are recorded and structured and how money is spent. For instance, you will probably have a petty cash fund. You will also have rules, or controls, as to the types of transactions that can use petty cash and the amount that can be withdrawn at any particular time. Your control may limit petty cash to transactions of $10 or less. In a more sophisticated vein, if you’re running an inventory dependent business, you will need to match inventory costs to inventory sales. If you can’t do it directly, then you will need to set up accounting controls that set a value to the inventory being sold, for instance, valuing the cost of the last inventory being sold at the price of the first inventory that you’ve bought (First-In, Last-Out).

The financial and accounting controls determine how much tax you will pay, how profitable your business will be, and whether or not your business will bleed money. It is not an exaggeration to say that many small businesses and start-ups fail because of inadequate controls. I recently consulted in closing a retail business failure and found that the store was paying bills to vendors for inventory stock it never received. There were no controls in the business to match vendor bills to received shipments and base all payments on that match, leading to losses in the tens of thousands. It’s a simple control: you match an invoice to an inventory shipment and you don’t pay if you don’t have the shipment. That was just one financial control among dozens that contributed significantly to the business’s failure.

Skipping the financial controls is the number one oversight I’ve encountered in all my years of start-up consulting.

Finally, you should know how to generate, read, understand, analyze, and act on financial statements. These statements, such as a balance sheet, income statement, or cash flow statement, tell you the financial condition of your business. Your ability to read and analyze these statements is your only access to the “reality” of your business. So while it may be tempting at first to skip many financial management tasks, when you only have yourself as an investor or employee, it’s important to realize that your business is about money. Financial statements tell you whether the business is making or losing money.

  • An income statement shows your business’s revenues, costs, and profits for a given financial period. Since it’s also called a profit and loss statement, its obvious that its primary function is to show how profitable your business is, that is, the income coming into the business. Income comes in several different forms on an income statement: income after direct expenses ( gross income), income after direct expenses and general operating expenses ( operating income),income after direct expenses, general operating expenses, and interest payments ( income before taxes), and income after every single expense, including taxes, has been deducted ( net income). While net income is the ultimate measure of profitability, all of these are important measures of the success of your business and tell you where profitability is coming from . . . or where it’s threatened.
  • An balance sheet is a snapshot of the book value of the business. While an income statement covers a period of time (usually three months or one year), the balance sheet tells you the value of the business on a single day. As the name might suggest, the balance sheet has two sides both of which must be in absolutely equal balance. On the one side are all the assets of the business: cash, inventory, loans to other people (including accounts receivable), property, and even intangible assets, such as the monetary value of your brand (see 8.1 for a discussion of brand equity). The other side of the business lists all short- and long-term debts of the business and the owner’s equity. While debt can be precisely determined, owner’s equity is found by subtracting the debt from the book value of the assets. That, in the end, is the book value of the business and is one measure (the lowest, in fact) of the business’s value. If you remember our discussion of financial structure (2.1), you’ll then see that the right side of a balance sheet, the debts and owner’s equity, is, in fact, the financial structure of the business!
  • An cash flow statement shows the money coming in and the money going out of the business. over a period of time, usually three months, six months, or one year. While an income statement shows the profitability of a business and a balance sheet shows its book value, the cash flow statement shows the short-term viability of a company. If the cash flow is positive, the business will keep its doors open for a while. If cash flow is negative, the business is heading towards bankruptcy, even if the income statement shows it’s profitable.

The most important use of financial statements is financial analysis, which sifts through the financial statement numbers to tell you how well your business is doing: how profitable it is, how capable you are of paying your debts, and so on. Financial analysis accomplishes these tasks by generating financial or business ratios from the financial statements. Okay, you didn’t go into business to be a number cruncher, but don’t let words like “ financial analysis” or “ financial ratios” scare you off. These numbers are the health measures of your business. They are the heart rate, pulse rate, blood pressure, weight, and cholesterol level of your business. If you don’t know the most current numbers for your physical body, you risk hitting the pavement with a heart attack, stroke, or worse. If you don’t know the financial ratios of your business, you risk going out of business . . . or worse.

  • Some ratios tell you how profitable your business is, like gross margin, operating margin, or net margin, all of which tell you what percentage of money coming in is actually profit. Equity investors take a keen interest in these numbers and they are the first ratios that an investor looks at when evaluating your real or prospective financial statements.
  • Some ratios tell you how well you can pay your bills, the so-called liquidity ratios, such as the current ratio or quick ratio. These two ratios, for instance, basically tell you that if all the people you owed money to wanted their money right now, how much you could pay them. If you’re applying for a loan, the lender is very highly interested in these ratios along with your cash flow numbers. You should be, too, because they tell you whether you’re going to stay in business or be out on the street.
  • Some ratios tell you how much debt you’re carrying relative to the health of the business, such as your debt- equity ratio. Lenders are very interested in these ratios, too, and will sometimes require limits on these ratios and demand regular reporting on them. They will frequently attach call provisions on your loan related to these ratios; drop below a certain amount, and they have the right to call in the full amount of the loan.
  • Some ratios tell you how efficient your business is ( efficiency ratios). These ratios, like return on assets, return on equity, inventory turnover, and cash flow return on investment, tell you how well you’re using the financial and physical assets of your company to generate profits. Equity investors are fanatically interested in these numbers, so if you’re equity funded, you want to stay on top of these numbers from the moment you draw up prospective financials to the day you sell your stake in the business.

Since we’re not writing a financial bible here, we’re not going to spend the several pages teaching you how to calculate these ratios, even though it’s a sore temptation. There are plenty of online resources, including those below, that will teach you the basics of financial statements and calculating financial ratios. You must learn the basics of financial ratios if you wish to succeed.

FINANCIAL RATIOS ARE NOT AN OPTION

Not if you’re seeking investors. You have to structure your prospective financials to produce the most credibly successful prospective ratios. At least half of the business plan prospective financials I’ve worked on, including many prepared by CPAs or finance pros, yield pretty dismal financial ratios or investment outcomes when you actually crunch the numbers. Nobody did the ratios until the financials landed on my desk, and I’m the marketing guy! For one prospective restaurant, the five year discounted return on equity was 3%! (Don’t worry what “discounted return on equity”means; suffice it to say that 3% really blows!) When you consider that a treasury bond will yield slightly less than that with zero risk, you only stand a chance if your investor can’t spell or dress themselves in the morning. Since it’s guaranteed that a prospective investor will do the ratios, there’s nothing to be done in these cases except redo the numbers. That doesn’t mean that your prospective financials should have ratios (most don’t), it just means you should calculate all the relevant ratios, particularly those that an investor would be interested in, on your prospective financials to find out if you’re outlining a good investment.

Remember: business is about making money. So you should not only be generating regular financial statements, you should have your basic financial ratios in your hands pretty regularly. At the very least, this will help you deal with potential investors and lenders, because you can be guaranteed they will be calculating these ratios before handing you their hard-earned cash.

2.4.1. ManagementHelp.orghttp://www.managementhelp.org – ManagementHelp.org is a rich library of online books that covers a range of small- and medium-sized business topics. Their Basic Guide to Financial Management (http://www.managementhelp.org/finance/fp_fnce/fp_fnce.htm) is one of the best online introductions to the entire topic of business financial management. While directed at larger small businesses—at least ones large enough to have a board and a treasurer—everything will apply in some way to your shoestring venture.

The same author (Carter McNamara) has also written The Basics of Financial Management for U.S. Small For-Profit Businesses (http://www.managementhelp.org/finance/fp_fnce/fp_basic.htm), a short but thorough introduction to the entire topic. This is one of your best online introductions to basic accounting and what you should know about your books and how they work. Other articles and small books include:

  • Balanced Scorecard
  • Buying a Business
  • Fundraising
  • Loans to Start a Business
  • Taxes

2.4.2. BusinessTown: Basic Accountinghttp://www.businesstown.com/accounting/basic.asp BusinessTown.com is a virtual encyclopedia on running a small business. If ever there was an “MBA for small business” site on the Internet, this one comes the closest. BusinessTown.com offers basic articles in the following topics:

  • Accounting
  • Advertising
  • Fundraising
  • Getting Started
  • Hiring & Firing
  • Home Business
  • Internet
  • Office
  • Sales
  • Taxes
  • Selling a Business
  • And just about every topic you can think of in running a business

I have found their article on basic accounting the most thorough, easiest-to-follow introduction to the topic. You particularly want to focus on their discussions of the meat and potatoes of financial statements and how to analyze them. Accounting topics include:

  • General Ledger
  • The Language of Accounting
  • Components of the Accounting System
  • Basic Terms and Concepts
  • Income Statements
  • Balance Sheets
  • Depreciation
  • Amortization
  • Inventory Accounting

Like it or not, to manage your business properly you need to understand all these topics at the level presented in these articles. Go for it!

2.4.3. AmericanExpress Open For Business: Financial Ratio Calculatorshttp://www133.americanexpress.com/osbn/tool/ratios/financialratio.asp – The American Express Open For Business site is simply a sales site for their charge and credit cards. But they have put up wonderfully useful calculators for determining your financial ratios along with easy explanations of what these ratios mean. You just plug in numbers from your financial statements and, there you go!

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