Financial failure in business – how to avoid it
Business is at the heart of the global economy. Unfortunately, many businesses fail due to financial reasons. In entrepreneurial endeavors, the failure rate is extremely high – especially in the first few years. This article highlights some of the key factors that need to be addressed to minimize the likelihood of financial business failure. The discussion takes place under the following headings:
- Financial planning;
- Financial management.
Financial planning should be done continuously in any business. It should begin with the concept of a new venture and continue until the business is closed or merged with another business. However, planning is meaningless if the management of a business does not have the necessary business and financial acumen. Management needs to understand the basics—even if the actual financial planning is outsourced. This includes understanding financial statements, cash flows and financial ratios. They need to know if the company is making enough profits, if it has enough liquidity and solvency, where the potential problems are and how they can solve them.
Financial planning should include the following activities:
- Sales planning. Without sufficient turnover, no business can survive in the long term. Profitable sales must be known. Sales targets must be realistic and support the necessary growth and profits.
- Credit policy. Credit is usually provided to achieve the required sales. However, this is done at risk (from defaulting debtors) and costs money. That is why it is extremely important to have a proper credit policy that is strictly followed. The policy should include what type of people or institutions will receive credit, under what circumstances, for what amount they will qualify, guarantees to be put in place, the terms of the credit and how payment (and lack thereof) will be managed.
- Pricing. Pricing is a science in itself. Prices that are too high deter customers and prices that are too low reduce the profitability of the business. Therefore, pricing must be competitive. Business gross profits are a direct result of pricing. Gross profits are necessary to cover a company’s financial obligations and allow for growth. The profitability of different products and services should be analyzed and they should be kept as part of the offer only if they provide sufficient margins or if they are of strategic importance.
- Cash flow forecasts. Several aspects of a business affect its cash flow. Many seemingly healthy businesses fail due to cash flow problems. It is extremely important for a business to plan sales and expenses and especially their schedule. The money to be received after 90 days cannot cover running costs.
Business finances must be continuously monitored and managed. Problems should be identified and fixed as soon as possible. Being proactive now can make a big difference later.
The financial aspects of the business that need to be managed include the following:
- Financing. Capital expenditure and working capital must be financed. Planning a business and its cash flows should emphasize the need and timing of financing. Financing can be done through existing shareholders, through the sale of new shares or through external financing. External financing is expensive and risky for businesses. This can lead to financial ruin for the business when commitments are not kept. On the other hand, it can allow much faster growth. Funding must be part of the company’s broader strategy and be consistent with the business’s risk profile.
- Farming. Stocks should be at optimal levels. Too little inventory (with regular stock outages) can have a negative impact on customer relationships and lead to reduced turnover. Too much inventory is expensive and risky (for obsolescence and theft). Inventory levels must be determined and managed professionally (using inventory optimization models that consider product importance, inventory lead times, and product order lead times).
- Receivables. In general, it is important to provide credit in today’s economy. However, the difference between debtors paying on average after 30 days or 60 days can make the difference between success and failure (this is clearly reflected in the cash flow projections). Borrowers should be analyzed according to their age, and borrowers who do not comply with their credit conditions should be closely monitored and, if necessary, their credit reductions should be reversed.
- Business growth. A business can grow as fast as it can generate enough cash (through profits, investments or financing) to finance its working capital. Growth beyond this is not sustainable and will lead to the financial bankruptcy of the 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 (debt-to-equity ratio), and retained earnings that are retained in the business. This rate needs to be closely monitored and its various determinants need to be effectively managed.
- Expenses. Expenditure items must be budgeted. Significant deviations of actual versus projected figures must be explained and their effects filtered into new budgets, cash flows, and other financial projections. In practice, times of rapid growth and good economic conditions are dangerous in the sense that there is a tendency for spending to increase too much during these times. It can then be difficult to contain costs (especially related to salary and wages) during an economic downturn.
- Financial ratios. Proper use of ratios can help management identify problems and take corrective action. It is important to know the profitability, liquidity and solvency of the company, to know where the potential problems lie and then how to correct them. Ratio analysis should be done on a monthly basis (if applicable) and should be compared with other companies in the industry and especially with target and past figures (prior period and same period last year).
- Cash flows. Everything about the success or failure of a business tends to affect cash flow. Cash flows should be scrutinized for potential problems and should be adjusted on a monthly basis. By ignoring cash flow for a few months, a small problem can easily turn into something that is out of control.
This article highlights just a few but very important issues that must be planned and managed within a business to reduce the risk of financial failure. Generally, the most important issue to manage is a company’s cash flow. All income and expenses and their actual timing are reflected in a statement of cash flows. There is a two-way causality between all the aspects (which are mentioned in this article) and the cash flow of a business.
Copyright © 2008 – Wim Venter
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