SEVEN INGREDIENTS TO FINANCIAL SUCCESS
in this article:
Too many businesses decline or fail to perform as well as they could because the owners or managers lack financial skills and the ability to pay attention to the basic indicators that affect performance and profitability. The National Bank has provided this guide which outlines seven management skills to help you get the best out of your business.
Financial success is built on a foundation of good records. This table from The Small Business Book (Robert Hamilton and John English) reinforces the point:
Why reduce your odds of survival to only half through ‘average’ records, or only 20% through ‘inadequate’ records? In addition, Hamilton and English show that the frequency of accounting reports is also vital:
The message is clear. If you’re not good at keeping your own accounting records up to date, then find an accountant or bookkeeper who will do this for you. If you receive accounts only once a year, your survival odds are only 36%.
Note that most accounting software packages allow you to generate instant financial reports, increasing your chances dramatically. The more current your knowledge of what’s happening in your business, the better placed you will be to take any necessary action.
The three key financial statements that give you an insight into the current state of your business are:
- Balance Sheet
- Profit and Loss Statement
- Cashflow Forecast
Balance Sheet (Assets = Liabilities + Equity)
The Balance Sheet provides an overall ‘snapshot’ at a specific time (for example, 31 March) of the financial health and liquidity of your business. The Balance Sheet reveals the amount of equity that you hold in the business, and reveals also the ‘balance’ of the assets against the liabilities of the business. If the liabilities exceed the assets, the business is technically insolvent and may face serious problems.
More importantly from a day to day perspective your Current Assets should exceed your Current Liabilities. This will help avoid problems with your cashflow when, for instance, your monthly accounts are due.
The Balance Sheet is the most difficult of the three key financial statements for the inexperienced businessperson to interpret. It’s beyond the scope of this guide to provide detailed instruction on reading a Balance Sheet, but it is a task well worth your time and effort. Start by asking your accountant for help in interpreting your Balance Sheet. Some accountancy practices offer special seminars for their clients that deal with financial topics.
Profit and Loss Statement
The Profit and Loss statement, also known as a Statement of Financial Performance, shows the performance of your business over the trading period it covers (for example, a two-month or six-month period, or a whole financial year). Most people find the Profit and Loss report easier to interpret than a Balance Sheet, since it contrasts your revenue and sales with your expenses in a relatively self-explanatory manner. The key difference between a Profit and Loss Report and the Cashflow Statement is that the Profit and Loss Report is adjusted for accruals, i.e., Debtors, Creditors and Stock on Hand.
The main value of the Profit and Loss report is to show you if the business is producing a profit or a return on your investment as owner. A Profit and Loss report once a month is far better than one every six or 12 months, because the earlier you can detect trends (such as falling profits or accelerating expenses) the sooner you can take corrective action. A Profit and Loss report that also lists the figures from the previous year’s report alongside the current figures is even more valuable, because this format makes it easier for you to monitor changes that may need some investigation or action.
A major factor in many business failures is the lack of time and resources spent on monitoring cashflow. Cash is the life-blood of a business, and the cashflow forecast is the blood pressure monitor. This is essentially a month-by-month forecast of your (likely) cash income and your cash expenses for the next 12 months (or chosen period). The value of a regularly updated cashflow forecast is that it enables you to predict when you’ll have surplus cash, and when you’ll need to make special arrangements (such as a Bank loan) to meet your commitments. Any lending institution will treat your business skills with greater respect if you can foresee challenges rather than reacting to crises after they have occurred. Note that the cashflow forecast includes capital items, personal drawings and funds introduced.
Successful business owners keep a close watch on business expenses because uncontrolled expenses can quickly eat into profits. Expenses can be divided into two categories:
- Fixed expenses are those that remain fairly constant, such as rent and the associated monthly costs of maintaining an office, shop or factory. These are generally expenses that remain unchanged whether you sell nothing or $1 million a month.
- Variable expenses are those that vary with sales turnover. For example, if you manufacture more products to meet demand, your raw materials costs will go up. If you sell more goods in a shop, your stock purchasing costs will increase.
You need to keep an eye on all expenses. For example, if your stationery costs or communications costs have significantly increased (telephones, faxes, email and cell phone costs), you should ask why. But there is more scope for variable expenses to blow out, so these require closer scrutiny. As a guideline you should be aware of the percentage of variable expenses to sales turnover and investigate any large variations on this figure. Ask your accountant to help you spot anomalies, so you can take corrective action quickly.
Good business management involves setting operating budgets for you and your staff rather than making ad hoc decisions as you go along. Your final step is to set budgets for various business activities, based on the sound financial practices outlined in the rest of the guide.
For example, use the cashflow and profit and loss forecasts to establish budgets for such items as expenses, capital expenditure, marketing promotions and other activities. Advantages of budget use include:
- Set sales targets. A sales budget will include such items as the budgeted amount to be spent on marketing and the sales target you must reach to justify the promotional investment.
- Set expenses budgets to avoid blowouts. For example, establishing a budget for capital expenditure with the help of a cashflow forecast will help you plan when best to buy needed equipment (perhaps in the months when there is a genuine cash surplus) and avoid a possible cashflow crisis.
- Set savings targets. Budgeting for equipment purchase might lead to a regular amount being set aside each month in a savings account.
Monitoring your budgets
By comparing your actual results with the budgeted figures, you’ll gain greater control over various facets of your business and the ability to set better budgets for the next period.
Accounting ratios provide you with an indication of how well your business is performing, and expose any weaknesses that need to be addressed. Ratios enable you to monitor the earning capacity and the financial stability of your business. Ratio analysis allows you to compare periods and to compare your business with others. There are many different kinds of ratios (some more relevant to certain types of businesses than others) and it is not practical to monitor all of them.
A better solution is to select, with the help of your accountant, the four or six most critical ratios and concentrate on monitoring these.
Regularly updated cashflow forecasts and profit and loss forecasts (as opposed to profit and loss reports of what has already occurred) are crucial in planning the strategic direction and growth of your business.
Since no one can accurately determine what will happen in the future, there is an element of error in all forecasting. But the longer you’re in business, the better your ability should be to predict future sales and expenses because you have records to work from, and you can make the appropriate adjustments for quiet trading months or seasonality. By comparing your actual results with what you predicted, you’ll also learn much about the accuracy of your predictions.
If you’re just starting in business, your forecasts are likely to be less accurate, and you may have to base your figures on estimates or industry averages in the absence of any hard data. In this case it is more important for you to produce several forecast versions. For example, a cashflow forecast in three versions: optimistic, conservative and pessimistic forecasts.
Poor debtor control is a common feature in cashflow crises and business failure. In essence, good management of debtors is crucial to the financial well being of your business. This means invoicing promptly and collecting payments when they are due. The more efficient you are at this process, the healthier your cashflow position is likely to be.
All of the seven skills outlined in this guide are well within the capabilities for business owners and managers, helped by their accountants. Applying these seven steps in your business will greatly enhance your chances of success and improved profitability.
Disclaimer: This material is provided as a complimentary service of The National Bank of New Zealand, part of ANZ National Bank Limited (“Bank”). It is prepared based on information and sources the Bank believes to be reliable. Its content is for information only, is subject to change and is not a substitute for commercial judgement or professional advice, which should be sought prior to acting in reliance on it. To the extent permitted by law, the Bank disclaims liability or responsibility to any person for any direct or indirect loss or damage that may result from any act or omission by any person in relation to the material.
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