How small businesses can achieve their financial objectives? Not an easy question to answer. This becomes even harder to small business owner who’s not literally with financial works. But there is some good clues that you can follow. There are no dark, deep secrets to financial management. The techniques are straightforward. Your accountant can help you in executing your financial management strategy. You can hire outside consultants to advise you on occasion. But it really comes down to you. You should understand and take the time to perform your critical strategy to achieve financial objectives of your business.
Through this post, I am going to summarize the clues for achieving your financial objectives. Follow on…
Financial Strategy-1. Understand Profit Mechanics
It may seem unnecessary to say so, you are in a business for profit, so you must understand how to make profit. You need a good business model to make profit, of course. And you need a profit model that you see clearly in your mind’s eye.
Your regular profit and loss [P&L] report is indispensable for tracking your profit performance. But the P&L has too much detail for strategic level profit analysis. A good profit model should be small enough to reveal the following three key factors drive profit:
Key Factor-1. Unit margin (or, margin per unit): Equals the net price received from selling one unit of product or service, minus all variable expenses of selling the unit.
- Net price equals list price less all sales price reductions (discounts, rebates, and so on) and less expenses that come off the top of sales revenue (sales commissions, credit card fees, and so on).
- The main variable expense of a business that sells products is cost of goods (products) sold. A business may have other significant variable expenses, such as packing and shipping costs.
Key Factor-2. Sales volume: Equals the total quantity sold during the period. Unit margin times sales volume generates the margin earned from each product and service sold. All sources of sales combined generate the total margin of the business for the period, which equals profit before fixed expenses are considered.
Key Factor-3. Fixed expenses: Equals total amount of cost commitments that you can’t escape or decrease during the period. Examples are rents paid under lease contracts, depreciation, employees paid fixed salaries and wages, property taxes, and so on. Fixed costs provide sales capacity, which is the maximum volume that you can sell during the period.
Increasing sales volume increases profit — as long as you don’t sacrifice unit margins on the products/services you sell and assuming that you stay within the sales capacity provided by your fixed expenses. Of course, it’s better to increase sales of higher unit margin items than lower unit margin items.
Improving unit margin is challenging. You have to increase sales prices or reduce the variable costs of making sales, which are daunting tasks. But improving unit margin by say, 5 percent, may be more realistic than improving sales volume 5 percent. And, besides, you don’t have to worry about crowding the limit of your sales capacity by improving unit margin.
Financial Strategy-2. Know Your Sources of Profit
Most small businesses consist of two or more parts. Our local cleaner, for example, does both laundry and dry cleaning, and the prices are very different between the two. Clothing stores have men and women’s departments. New car dealers operate a service department as well as sell new and used vehicles. Many restaurants and coffeehouses sell T-shirts and other souvenirs. You got the point.
Your accounting system should be organized to provide information for each major profit center of your business. Basically, a profit center is a separate source of sales revenue that you can assign direct costs to, in order to determine the margin earned for each part of your business. Margin is a measure of profit before considering the fixed expenses of the business.
You need a P&L report [or income statement] for your business as a whole, of course, but it’s just the tip of the iceberg. What’s under the water line is just as important. You need to know the profitability of each location, each product line, and each department for each mainstream revenue source of your business. In a nut- shell, you should know the margin ratios and the amount of margin earned for every significant part of your business. The problem is how much detail to delve into. A local hardware store carries more than 100,000 different items.
The general manager doesn’t have the time (or patience) to read through margin reports for all 100,000 items, of course. Generally, profit centers reflect the organizational structure of the business. For example: if you have two locations, you should get a separate margin report for each. If you make both wholesale and retail sales, you should treat each as a separate profit center. Within each profit center, you need further breakdown by products, customers, or on some other basis of making sales (over the Internet versus in-store, for example). Dividing your business into the right categories of sales and profit centers for management analysis and control is never easy. Consider getting the opinion of an outside consultant on how best to organize the reporting of profit centers.
Financial Startegy-3. Analyze Year-to-Year Profit Change
Suppose that your profit decreased 50 percent this year compared with last year. Shouldn’t you know why? Shouldn’t you find out the exact reasons for such a large drop in profit? Did sales volume shrink in some profit centers? Did unit margins change significantly? What happened to fixed expenses?
I don’t mean that you should take the time to do the detailed analysis. Ask your accountant to sort out the big changes from the small changes and to prepare a neat explanation of the key changes that caused the significant change in your profit.
In my experience, small business managers don’t ask their accountants for a detailed year-to-year comparative analysis of profit. They rely on their gut feeling regarding the main reasons for the profit change. But without a thorough analysis, you can’t be sure what caused the profit change. Spending time analyzing the change in profit from period to period is quite valuable. For one thing, it encourages you and your accountant to develop an analytical profit model. Furthermore, doing a comparative profit analysis helps in budgeting next year’s profit plan.
Financial Strategy-4. Budget Profit and Cash
I have discussed about budgeting and forecasting a lot [you can find them through categories available on the right sidebar]. So I won’t repeat them here. I just want to remind you of the critical importance of forecasting and budgeting profit, cash flow, and financial condition for the coming year.
Your budgeted statement of cash flow for the coming year is especially important. It may reveal that you’ll have to raise additional capital to finance your growth, and the earlier you get started on this task, the better.
I strongly urge you to give your accountant at least estimates of sales volume, sales prices, costs, and major changes you’re planning in the coming year. With this information, your accountant can whip out an impressive set of pro forma budgeted financial statements for the coming year.
Financial Strategy-5. Understand the Cash Flow
Hypothetically, you can run your business so that cash flow equals profit [or loss] for the period. A dollar of profit would yield a dollar of cash inflow, or a dollar of loss would cause a dollar of cash outflow. You wouldn’t own any fixed assets on which depreciation is recorded; rather, you’d have to lease all your long-term operating assets. You’d make only cash sales, or if you extend credit to customers, you’d have to collect all receivables by the end of the period. You’d carry no inventory of products for sale, or if you did, you’d have to sell all products by the end of the period. You wouldn’t prepay any expenses. And you’d pay all expenses by the end of the period and have no accounts payable or accrued expenses payable on the books. In this theoretical case, cash flow equals profit (or loss).
Of course, you can’t really restrict your business that way. You may have to carry inventory; you may have receivables from credit sales; you may invest in fixed assets; and you may have unpaid bills and other unpaid expenses at the end of the period. These factors cause cash flow to differ from your bottom line profit or loss for the period.
Here are two principal examples of why cash flow differs from profit:
- Suppose that your accounts receivable (uncollected receivables from credit sales) increases $50,000 during the year, and annual sales revenue is $1,000,000. Therefore, cash flow from sales through the end of the year is $50,000 less than sales revenue. In other words, profit includes $50,000 of uncollected sales revenue.
- Suppose that $85,000 depreciation expense is recorded for the year. The cost balance of your fixed assets was written down $85,000 to recognize the use of your fixed assets during the year, and the fixed assets moved one year closer to their eventual disposal. The fixed assets were bought and paid for years ago. Therefore, profit includes an expense that required no cash outlay during the year.
The bottom line on cash flow is this;
- Start with net income or loss for the period, as if this amount were your cash flow for the period (but remember that it isn’t).
- Next, add back depreciation. Don’t stop here.
- Deduct increases in accounts receivable, inventory, and prepaid expenses.
- Or, add back decreases in these assets.
- Add back increases in accounts payable and accrued expenses payable.
- Or, deduct decreases in these two types of operating liabilities.
Now wasn’t that easy? Of course, you don’t do all this arithmetic; that’s the job for your accountant. Your job is to understand why these adjustments are made to profit to determine cash flow.
Financial Strategy-6. Keep Sizes of Assets Under Control
Marketing types like to say that nothing happens until you sell it. Sales and marketing is the heart of every successful business. You make profit by making sales. But you can’t make sales without assets. You need a working cash balance. You need inventory if you sell products and receivables if you sell on credit. You need to own a variety of fixed assets (although you can lease many of them). Your short-term operating liabilities (accounts payable and unpaid accrued expenses) supply part of your total assets.
The rest comes from debt and equity capital. Suppose that your total asset minus your total operating liabilities equals $500,000. So you have to raise $500,000 capital. The owners [the partners in a partnership, the shareowners in a limited liability company, or the stockholders of a corporation] can put up the entire $500,000 capital.
However, you probably would go to debt sources for part of your total capital. Both sources of capital have a cost. The cost of debt is interest, as you know. The cost of equity capital is higher; it’s the rate of return that you should earn on the equity capital invested in the business. If your interest rate on debt is 8 percent, the owners expect you to earn an annual profit equal to 10, 15, or an even higher percent of return on their capital.
Don’t overindulge in assets. Keep the sizes of your assets to no more than they have to be to make sales and conduct the operations of the business. Like people, businesses tend to get fat if they don’t watch their weight.
Financial Strategy-7. Stabilize Your Sources of Capital
Raising capital is always a challenge for most startup business ventures. Raising capital during the early days of a business may be done in fits and starts and often lacks an overall cohesion and sense of continuity. This situation may be unavoidable during the hectic startup period of a new business. Once your business gets traction, it’s very important to settle down on a steady policy for your sources of capital. Your lenders and owners will demand that you develop a predictable capital strategy for operating and growing your business.
Financial Strategy-8. Choose the Right Legal Entity
Certain types of legal organizations are treated as pass-through entities for income tax purposes. The business doesn’t itself pay income tax. A pass-through entity must determine its annual taxable income. Its taxable income is divided up among its owners in proportion to the ownership shares of each, and the owners include their shares of the business’s taxable income in their individual income tax returns.
In contrast, a regular, or so-called C-corporation doesn’t have this advantage. It’s subject to income tax on its taxable income. Distributions from its after-tax net income to its stockholders are subject to a second income tax in the hands of the individual stockholders. As you probably know, the income tax law is complex. You should get the advice of an income tax professional on the best legal form of organization.
Strategy-9. Understand Internal Controls
Last [but not least] is internal control. I have talked about internal controls a lot too. Small businesses are notorious for having weak internal controls and, therefore, are vulnerable to errors and fraud. Your business may be the exception, but don’t bet on it. Although this strategy is on the last paragraph, it does not necessarily mean it is the least important. You lock the doors at the end of the day, don’t you? In like manner, you should institute protective procedures to prevent fraud and establish checks and balances to minimize errors. My advice [if you need it] is to hire a CPA to do a critical examination of your internal controls. It is money well spent.