Introduction
Business is the foundation of the world economy. Unfortunately, many businesses fail due to financial reasons. In business ventures, the failure rate is extremely high, especially in the early years. This article highlights some of the key factors that need to be addressed to minimize the likelihood of financial failure in business. The discussion is carried out under the following headings:
- Financial planning;
- Financial management.
Financial planning
Financial planning must be done continuously in any business. It should start with the conception of a new business and continue until the business is closed or merged with another business. However, planning is pointless if the management of a business does not have the necessary business and financial acumen. Management needs to understand the basics, even if the actual financial planning is outsourced. This includes an understanding of financial statements, cash flows, and financial ratios. They need to know whether the company is making enough profit, whether there is sufficient liquidity and solvency, where potential problems lie, and how they can be resolved.
Financial planning should include the following activities:
- Sales planning. Without sufficient turnover, no business can survive in the long term. Breakeven sales must be known. Sales targets must be realistic and support the required growth and profits.
- CREDIT Policy. Credit is generally provided to achieve required sales. However, this is done at risk (of the defaulting debtors) and costs money. Therefore, it is extremely important to have a proper credit policy that is strictly adhered to. The policy should include what type of people or institutions will obtain credit, under what circumstances, how much they will qualify for, the guarantees that must be in place, the terms of the credit, and how payment (and lack thereof) will be managed.
- Prices. Pricing is a science in its own right. Prices that are too high deter customers, and prices that are too low reduce the profitability of the business. Therefore, prices must be competitive. The gross margins of a business are the direct result of pricing. Gross profits are necessary to cover a company’s financial obligations and allow for growth. Different products and services need to be analyzed for profitability and should only be kept as part of the offering if they provide sufficient margins or are strategically important.
- Cash flow projections. Various aspects of a business impact on your cash flow. Many seemingly healthy businesses go bankrupt due to cash flow problems. It is very important for a company to plan sales and expenses and, especially, their calendar. The money that must be received in 90 days cannot pay the current expenses.
Financial management
Business finances must be continuously monitored and managed. Problems must be identified and corrected as soon as possible. Being proactive now can make a big difference later.
The financial aspects of a business, which need to be managed, include the following:
- Money. It is necessary to finance capital expenditures and working capital. Planning a business and its cash flows should highlight the need and timing of financing. Financing can be done through current shareholders, through the sale of new shares or through external financing. External financing is expensive and risky for the business. It can cause the financial downfall of a company when commitments are not met. On the other hand, it can allow for much faster growth. Financing must be part of a company’s broader strategy and be in line with the risk profile of the business.
- Stock ownership. Inventory must be at optimal levels. Being very low in stock (with regular out-of-stocks) can have negative effects on customer relationships and slow churn. Too much stock ownership is expensive and risky (due to obsolescence and theft). Inventory levels must be professionally determined and managed (using inventory optimization models that take into account the importance of a product, stock response time, and lead times when ordering a product).
- Accounts receivable. In general, it is important to provide credit in today’s economy. The difference in debtors paying on average after 30 or 60 days can, however, make the difference between success and failure (this is clearly reflected in cash flow projections). Debtors must be analyzed according to their seniority and debtors who do not comply with their credit terms must be diligently followed up and, where appropriate, their credit provisions revoked.
- The growth of the business. A business can only grow as fast as it can generate enough money (through profits, investments, or financing) to finance its working capital. Growth above this is not sustainable and, in the long run, will cause a company to fail financially. A company’s sustainable growth rate is determined by a combination of its profitability, efficient utilization of its assets, financial leverage (debt-to-equity ratio), and retained earnings that remain in the business. This rate needs to be closely monitored and its various determinants managed effectively.
- bills Expense items must be budgeted. Substantial deviations from the real vs. Budgeted numbers must be explained, and their effects filtered into new budgets, cash flows, and other financial projections. In practice, times of rapid growth and good economic conditions are dangerous in the sense that there is a tendency to over-increase spending during this time. So it can be difficult to control expenses (especially those related to wages and salaries) in times of economic downturn.
- Financial coefficients. Proper use of ratios can help management identify problems and take corrective action. It is important to know the profitability, liquidity and solvency of the company, to know where the possible problems are and then how to correct them. Ratio analysis should be performed on a monthly basis (if applicable) and should be compared to other companies in the industry and especially to specific and past figures (previous period and same period last year).
- Cash flow. Everything in the success or failure of a business has a tendency to impact cash flow. Cash flows should be examined for potential problems and adjusted monthly. By ignoring cash flows for a few months, a small problem can easily turn into something out of control.
Summary
This article highlights just a few, but very important, issues that need to be planned for and managed within a business to decrease the risk of financial failure. In general, the most important issue to manage is the cash flow of a company. All income and expenses and their actual times are reflected in a cash flow statement. There is a causal relationship in both directions between all aspects (mentioned in this article) and the cash flow of a company.
Copyright © 2008 – Wim Venter
