Mention finance, and MBA students starting looking around the room. It’s too complicated, and too hard to understand. But there’s a reason that finance is a required course in MBA programs.
We make financial decisions all the time, in our personal lives:
Given the differences in payment terms and interest rates, which credit card should I chose?
Which bank has the best terms for a home mortgage?
Am I saving enough for my retirement?
When you’re through making financial decisions for you and your family, you can go to the office and make more decisions there:
Should I lease or buy the new service truck?
Is it time to expand the operation into more space?
How much do I need to invest in training for my technicians?
Can I afford to hire additional employees?
A sound understanding of basic financial principles can help you make better decisions. As you consider your business, you can look at three (3) general areas that require some financial acumen.
Investments
Every business must invest to grow. Do we need a new truck, additional equipment, more space, or more personnel? Investment decisions are based on the availability, and source of funds. In most cases, you are taking money today, and investing it for some future return. These decisions require an understanding of the time value of money (today’s dollars versus tomorrow’s dollars), tax effects, and expected rates of return.
Financing
Investing is one decision. Where the funds will come from is another decision. You have a choice of taking money from two different buckets, namely debt or equity, or some from each. This is usually called the company’s capital plan. As a business owner, you are going to decide how much debt, and how much equity you will use to finance investments. This is the business’s debt to equity ratio.
Equity comes from the owner or owners of the business. It has the rights associated with ownership, and it is not necessary to repay it. In the financial package, you can look at the statement of retained earnings. This is the amount of net income that you decide to keep in the business for continuing operations, and future investments. Retained earnings is internally generated cash, because it was earned from business operations.
Debt is borrowed money. Again, you have some choices, or financial decisions to make here. For example, do you need short-term or long-term financing? Can use sign a note, or have you established a line of credit with your local bank? Each option has advantages and disadvantages to the company.
Cash Management
Every business must have access to a certain amount of cash to fund day-to-day
operations. You must plan for payroll, rent, marketing, supplies, etc. To be successful, your business should not wait to see if there is enough cash to meet the business requirements on a week by week basis. You will need to have a cash budget, which provides a forecast of money coming in, and money going out, and when these transactions will occur. This budget can help you plan for cash shortfalls that are budgeted to occur in the future, perhaps by setting up a line of credit with your bank.
Remember, banks are not terribly impressed with making you a loan, because you can’t meet the payroll this week, unless you were able to support the need with a cash budget, prepared in advance, and shared with your bank. It is the difference between showing that you understand your business, and have planned for cash needs, as opposed to being surprised that you have a problem.
Stakeholders
The company is your creation, and you probably spent considerable time thinking about the risks that you would be taking, and weighing those risks against the potential benefits you could receive. The business is your vision, and you had the courage to act on that vision. You’ve invested your time and hard earned money. But you’re not alone.
Stakeholders represent the group of people that will be affected by your business.
Your stakeholders are:
Employees
Their Expectations are:
- job security
- good wages
- benefits
- opportunities for advancement
Customers
- quality work
- fair prices
Lenders
- solid business performance
- appropriate budgets & forecasts
- timely payment
You & Your Family
- regular income
- work-life balance
- future security
These stakeholders know that they are much better off if management makes financially sound decisions. Decisions that create value today, and that increase the value of the business over time.
Financial Performance
To reach financial security today, a business needs to focus on consistently achieving “better than average results”. Note that I didn’t say as good as the competition…why?
Better than average results provide the business with security in tough markets, and better than expected returns in a good market. The first step is knowing what your performance is today.
We can start evaluating your financial performance by reviewing your Financial Statements.
The business prepares financial statements to provide a ‘report card’ on the company’s performance. It reflects outcomes that resulted from decisions that you made. As you hire employees, determine what they will be paid, purchase equipment, parts, and supplies, establish price lists, and all the other numerous decisions that you make on a daily basis, you can see how well you’ve done by reviewing the financials.
The financial package contains:
Income Statement
Shows what came in and what went out for a stated period of time. This is a record of the revenue that you earned, from all sources, and the money that you spent to earn that revenue. Net profit, also known as earnings or net income, is the bottom line. After all revenue has been counted, and you have covered all of your expenses, including your taxes, what’s left is yours. Either a profit, or a loss.
Statement of Retained Earnings
Let’s look at the earnings from the income statement. It’s decision time again. This money is yours, and your shareholders, so you can put it in your pocket. But if you want to keep operating this business, you may need to keep, or retain, some of these earnings. The statement of retained earnings records the amount of profit, or earnings, that you decided to keep in the business.
Balance Sheet
A summary of what you own, and what that you owe. The difference belongs to the owners…owner’s equity. The basic accounting equation is:
Assets = Liabilities + Owners’ Equity or Owners’ Equity = Assets – Liabilities
The important take away here is to understand the story behind the numbers. The numbers, by themselves, do not necessarily tell us what’s going on with this business. For example, inventory is an asset, or something that you own. It has a positive impact on the business, right? After all, you need inventory to meet customer demands. However, what if the story behind the numbers ids that this inventory is obsolete? Suddenly, this inventory is creating a loss for the business as you must write it down, and sell it for pennies on the dollar.
Statement of Cash Flows
Remember our discussion on the importance of managing your cash flow? Well, the statement of cash flows breaks down where cash is coming from, and going to, by the three main activities of your business…operations, investments, and financing. This statement is useful in understanding more about the income statement and the balance sheet.
While an understanding of your company’s financial package is important, you must also remember that the statements are a history lesson…the results reported have already occurred. These results can be studied to evaluate your decisions, but they can’t be changed. Now, the hard work begins.
The financial report reflects what has already occurred, but it can be used to start the forecasting process…with a great deal of additional information.
To forecast where your business is going, you need to know where you’ve been. In addition, you need to know what is happening in your business environment that can influence or impact your business.
Are there: more competitors, new rules & regulations, new products & services, additional training needs, technological advances, changes in customer wants & needs, price pressures….
The good news is that there is a logical process for getting from here…to there!