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Introduction
Trade is the foundation of the world economy. Unfortunately many businesses fail for financial reasons. Entrepreneurial ventures have a very high failure rate – especially in the first few years. This article throws light upon some of the major factors that need to be addressed to reduce the chances of financial failure in business. The discussions are carried out under the following headings:
- Financial Planning;
- financial management.
Financial Planning
Financial planning should be done continuously in any business. It should start with the conception of a new venture and continue until the business is closed down or merged with another business. However, planning is meaningless if the management of a business does not have the necessary business and financial skills. 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 should know whether the company is making sufficient profits, whether there is sufficient liquidity and solvency, where are the potential problems and how they can solve them.
Financial planning should include the following activities:
- sales plan. No business can survive for long without sufficient turnover. Must have knowledge of break-even sales. Sales goals must be realistic and necessary to sustain growth and profits.
- Credit policy. Credit is generally granted to achieve the required sales. However, this is done at a risk (for debtors who fail to pay) and costs money. Therefore it is extremely important to have a proper credit policy which is followed strictly. The policy should include what types of people or institutions will get credit, under what conditions, how much they qualify for, guarantees that should be in place, credit terms and how payments (and lack thereof) will be managed.
- Price determination. Pricing is a science in itself. Too high prices deter customers and too low prices reduce the profitability of the business. So pricing has to be competitive. The gross margin of a business is a direct result of pricing. Gross profit is necessary to cover a company’s financial obligations and allow for growth. The profitability of various products and services needs to be analyzed and should be placed as part of the offering only if they provide adequate margin or if they are of strategic importance.
- Cashflow forecast. Many aspects of a business affect its cash flow. Many seemingly healthy businesses go bankrupt due to cash flow problems. Planning for sales and expenses, and especially its timing, is extremely important for a business. The money received in 90 days may not pay for current expenses.
financial management
Business finances must be continuously monitored and managed. Problems need to be identified and rectified as soon as possible. Being proactive now can make a big difference later.
Financial aspects of a business that need to be managed include the following:
- financing, Need to finance capital expenditure and working capital. A business plan and its cash flow should highlight the need and timing of financing. Financing can be done through existing shareholders, by selling new shares, or by external financing. External financing is costly and risky for the business. When commitments are not kept it can lead to the financial collapse of a business. On the other hand it can allow very fast development. The financing should be part of the company’s broader strategy and commensurate with the risk profile of the business.
- stock holding. Inventory should be at optimum levels. Too little stock holding (with regular stock outages) can have a negative impact on customer relationships and decrease turnover. Keeping a lot of stock is expensive and risky (out of date and prone to theft). Inventory levels should be professionally determined and managed (with the use of inventory optimization models that take into account product importance, stock turnaround times and product ordering lead times).
- accounts receivable. Providing credit in general is important in today’s economy. The difference in debtors paying on average after 30 days or 60 days, however, can make the difference between success and failure (this is clearly reflected in the cash flow projections). Debtors should be analyzed according to their aging and debtors who do not comply with their credit terms should be followed up and their credit allowance should be cancelled, if necessary.
- business growth. A business can only grow as fast as it can generate enough money (through profit, investment or financing) to finance its working capital. Growth above this is not sustainable and will lead to financial failure of a business in the long run. A company’s sustainable growth rate is determined by a combination of its profitability, efficient use of its assets, financial leverage (the ratio of debt to equity) and the retained earnings in the business. This rate should be closely monitored and its various determinants managed effectively.
- Expense. There should be a budget for expenditure items. Substantial deviations of actual versus budgeted figures need to be explained and its effects filtered through new budgets, cash flows and other financial projections. In practice, periods of rapid growth and good economic condition are dangerous in the sense that there exists a tendency for expenditures to increase substantially during this period. In such a situation, it can be difficult to control expenses (especially related to wages and salaries) in times of economic downturn.
- Financial Ratio. Proper use of ratios can assist management in identifying problems and taking corrective action. It is important to know the profitability, liquidity and solvency of the company in order to know where the potential problems are and then how to fix them. Ratio analysis should be done on a monthly basis (if applicable) and should be specifically targeted and compared with other companies in the industry (previous period and same period of previous year).
- cash flow. The success or failure of a business has a tendency to impact cash flow. Cash flow needs to be checked for any potential problems and needs to be adjusted on a monthly basis. Ignoring cash flow for a few months can easily make a small problem spiral out of control.
Summary
This article highlights only a few, but very important issues that need to be planned and managed within a business to reduce the risk of financial failure. In general the most important issue to be managed is the company’s cash flow. All income and expenses are reflected in there real time cash flow statement. A causal relationship exists in both directions between all the aspects (that are mentioned in this article) and the cash flow of the business.
Copyright © 2008 – Wim Venter
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