Managing Your New Business’ Finances

Bruce Barringer

A business owner’s ability to get a business up and running and to keep the business operating smoothly hinges largely on prudent financial management. Regardless of the quality of a product or service or how compelling of a need it fills, a company can’t be viable in the long run unless it is successful financially.

There are many practical issues involved in the prudent financial management of a business. A business owner must be aware of how much money the business has in the bank and if that amount is sufficient to satisfy the business’s financial obligations. Just because a business is successful doesn’t mean that it doesn’t face financial challenges. For example, many small businesses that sell their products to larger companies, such as Motorola, 3M, and Home Depot, don’t get paid for 30 to 60 days from the time they make a sale. Think about the difficulty this scenario creates. The small firm must buy parts, pay its employees, pay its routine bills, ship its products, and wait for one to two months for payment. Unless a business manages its money extremely carefully, it is easy to run out of cash, even if its products or services are selling like hotcakes. Similarly, as a company grows, its cash demands often increase to service a growing clientele. A business needs to accurately anticipate whether it will be able to fund its growth through earnings or if it will need to establish a line of credit at a bank or look for investment capital.

The financial management of a business deals with questions such as the following on an ongoing basis:

• How are we doing? Are we making or losing money?

• How much cash do we have on hand?

• Do we have enough cash to meet our short-term obligations?

• How efficiently are we utilizing our assets?

• How do our growth and net profits compare to those of our industry peers?

• Where will the funds we need for capital improvements come from?

• Are there ways we can partner with other firms to share risk and reduce the amount of cash we need?

• Overall, are we in good shape financially?

Particularly Important Issues for First-Time Business Owners

First-time business owners need to be aware of two additional issues that play a role in financial management.

First, many businesses are viable and ongoing once they get started. The trick is to get them started. Unless your business is cash flow positive from the beginning, which is rare, there will be a period when you’ll lose money while you’re ramping up the business. For example, you may be planning to open a fitness center and have determined that you’ll make money if you can sign up 1,200 or more members. But you won’t have 1,200 members the day you open. It may take you six months to a year to reach your membership goal. In the meantime, all your fixed expenses (and most of your variable expenses) will march on. Most businesses do experience a start-up period during which they lose money (or make little money) until they are fully up to speed and reach profitability. Businesses need to be fully aware that this period will take place and to plan for it. The worst time to go to a bank, family member, or investor to help meet a cash shortfall is when you’re facing a cash crisis.

The second thing to be mindful of if you are a first-time business owner is that most people are not familiar with how to complete the types of forecasts, budgets, and financial statements that are needed to prudently manage the finances of a growing business. If you fall into this category (as most people do), don’t wing it. Get help. The financial management of a business is too imperative not to take it seriously. A good source for one-on-one help is SCORE, an organization of “Counselors to America’s Small Businesses.” Small Business Develop Centers (SBDCs) frequently hold workshops on how to complete financial statements and learn accounting and budgeting software programs.

Financial Objectives of a Business

Before a business develops the types of forecasts, budgets, and financial statements that it needs to manage its finances, it must have a firm grasp of its financial objectives. Nearly all businesses have three main financial objectives: profitability, liquidity, and overall financial stability. Understanding these objectives sets a business on the right financial course and helps explain the need for forecasts, budgets, and financial statements in the next section, “The Nitty-Gritty: Forecasts, Budgets, and Financial Statements.”

Profitability

Profitability is the ability to earn a profit. Many start-ups are not profitable their first several months of operations, but they must become profitable to create a sustainable business and provide a return to their owners.

A business also must know if its profits are increasing or declining and whether they are leading or lagging industry averages. The first question, whether a business’s profits are increasing or declining, can be answered through the maintenance of accurate financial records. The second question, whether a business’s profits are leading or lagging industry averages, is tougher. Normally, businesses collect this information through informal conversations with industry peers or by joining an industry trade group, which typically collects information about the average profitability for businesses in the industry.

Obviously, if a business’s profits are declining (or are nonexistent) or if the business is lagging industry averages, corrective action is necessary. One thing that continually surprises small business counselors is the number of small business people who don’t have a good grasp on whether their profits are increasing or declining and how they stack up against their industry peers. Don’t fall into that group. Stay on top of these issues so you can take corrective action immediately if necessary.

Liquidity

Liquidity is a company’s ability to meet its short-term financial obligations. A business must carefully manage its cash to make sure it has enough money in the bank to meet its payroll and cover its short-term obligations.

Normally, the biggest culprits in straining a business’s liquidity are letting its accounts receivables or its inventory levels get too high. There are many colorful anecdotes about business owners who have had to rush to a bank and get a second mortgage on their houses to cover their business’s payroll. This set of events usually occurs when a business takes on too much work and its customers are slow to pay. A business can literally have a million dollars in accounts receivable but not be able to meet a $25,000 payroll. This is why almost any book you pick up about growing a business stresses the importance of properly managing your cash flow.

Some businesses deal with potential cash flow shortfalls by establishing a line of credit at a bank or by maintaining a healthy cash reserve. Other businesses are careful not to take on too much work, so their accounts receivable and inventory levels remain manageable.

Overall Financial Stability

Stability is the strength and vigor of the business’s overall financial posture. For a business to be stable, it must not only earn a profit and remain liquid but also keep its debt in check. If a firm continues to borrow from its lenders and its debt-to-asset ratio (which is calculated by dividing its total debt by its total assets) gets too high, it may have trouble meeting its obligations and securing the level of financing needed to fuel its growth.

Many business owners are caught off guard by the continuing need to remain vigilant regarding the overall financial stability of their business. You would think that if a business got off to a good start, increased its sales, and started making money, things would get progressively more stable. In many instances, however, just the opposite happens. Imagine the following scenario. A business gets off to a fast start and projects that its sales will double in the next two to three years. To make this happen, the business needs more people and additional equipment to handle the increased workload. The new equipment needs to be purchased, and the new people need to be hired and trained before the increased business generates additional income. Even though the business might be better off in the long run as a result of the increased business, it’s easy to see the strain that’s placed on the business in the short run to get there.

The Nitty-Gritty: Forecasts, Budgets, and Financial Statements

To assess whether its financial objectives are being met, businesses rely heavily on the preparation and the ongoing analysis of forecasts, budgets, and financial statements. In addition, it’s necessary for business owners to learn basic bookkeeping, to keep their records straight for tax and other reporting purposes.

Forecasts

A forecast is an estimate of a business’s future income and expenses. It’s the first step in completing a budget and a set of projected (or pro-forma) financial statements. A business that is already up and running bases its forecasts on its past performance, its current circumstances, and its future plans. So a business that grossed $250,000 last year would use that figure as a starting point for projecting next year’s sales and would then adjust the figure upward or downward based on current circumstances (that is, state of the economy, entrance of new competitors, buying mood of customers) and future plans. The same rationale applies for forecasting expenses.

It’s harder to forecast the initial sales and expenses for a start-up. There are four common ways to go about it:

• Contact the trade associations in your industry to ask if they track the annual sales and expense numbers for businesses that are similar to the one you plan to start.

• Find a comparable business and ask the owner if he or she would help you predict your initial sales and expenses.

• Conduct Internet searches to see if you can find articles about businesses that are similar to the one you plan to start. Occasionally, the articles will include sales and expense figures.

• Utilize the multiplication method to project sales. If you’re planning to sell a product on a national basis, like the Kitchen Sentry Smoke Detector, utilize a top-down approach: You estimate the total number of people who buy smoke detectors, estimate the average price they pay, and then estimate the percentage of the market you believe you will get. If you have a business that will sell on a local basis, like a restaurant or a clothing boutique, you utilize a bottom-up approach: You determine how many customers to expect and the average amount each one will spend.

Most experts feel that finding a business comparable to the one you plan to start and asking the owner for input is the most effective method for forecasting the initial sales and expenses for a new business.

Budgets

Budgets utilize the information generated by forecasts and organize a business’s income and expenses into specific categories. In most cases, a business completes its forecasts and budgets simultaneously. Organizing a business’s income and expenses into specific categories provides a practical way of tracking those numbers on an ongoing basis and helps a business answer the question, “Are we on track financially?”

Budgets also help a business in day-to-day decision making. For example, if a business budgets $10,000 a year for marketing, and midyear it has spent $5,000 of its budget, it knows that it can’t say yes to an advertising company that is trying to persuade it to buy a $7,500 marketing campaign for the remainder of the year without exceeding its budget.

Financial Statements

To further understand, track, and document their financial per-formance, businesses should also complete historical and projected financial statements on a regular basis. The statements include the income statement, balance sheet, and cash flow.

The historical income statement reflects the results of the operators for a business for a given period. It records all the projected sales and expenses and shows whether the business is making a profit or is experiencing a loss. The balance sheet is a snapshot of a business’s assets, liabilities, and owner’s equity at a specific point in time. It is an important tool for measuring a business’s overall financial stability. The cash flow shows the money that is flowing into and the money that is flowing out of a business on an ongoing basis; it provides a real-time picture of a business’s cash position. Projected financial statements are similar to historical statements except they look forward rather than backward.

Completing both historical and projected financial statements takes some practice, and most business owners buy books, attend workshops, or work with their accountants to learn how to prepare the statements. If you aspire to obtain a bank loan, seek investment capital, or sell your business at some point, you need to maintain accurate financial statements. It’s difficult for a banker, investor, or potential buyer to analyze your business without historical and projected incomes statements, balance sheets, and cash flows to go by.