Relevance

If you own a business, company, or firm you need to know the financial management of your enterprise. Your business won’t survive long without your exercising that knowledge. Business finances carry far greater risk than household finances. Bureau of Labor Statistics show 20% of new businesses failing in the first two years, 45% in the first five years, and 65% in the first 10 years. Inadequate revenue, poor planning, and inadequate capital are the top reasons why new businesses fail. If you don’t own a business but are an employee, consider reading this part anyway. You’ll learn your employer’s financial concerns and your own place within them. You may perform better, well enough to take an ownership interest or start your own business.

⤠  Build wealth, just not at another’s expense. ⤟

Theory

Think first of the reasons why individuals form business companies or firms with others. In theory, each individual could operate alone, buying from suppliers and selling to clients and customers based on the most efficient exchanges. Yet identifying the goods and services, determining their value, adopting the systems to produce them, and discerning the lowest cost require sellers to incur substantial costs. It’s hard and expensive to do it all alone. When individuals form companies or firms with others, they share and reduce those costs. Individuals share with their business partners and associates what goods or services to offer, in what form, produced by what systems, having what value, to which clients or customers, at what price, and by what delivery system. That’s the economic theory of a company or firm.

⤠   You can’t serve money and mastery at the same time. ⤟

Solos

The economic advantage of companies or firms does not mean that solo practitioners remain at a cost disadvantage. Solo practitioners have ways to obtain the needed market and systems information. They can join business, trade, or professional associations, attend practice-management institutes, seek mentor relationships, and do networking and research. Solo practitioners can also operate through mutual referral arrangements as if they were members of informal companies or firms. Each solo practitioner knows the market and systems information within their practice niche and can use their mutual referral network to connect clients and customers with other solo practitioners for goods and services they do not supply. The financial principles in this part apply equally to large firms, small firms, and solo practices. 

Pat had taken the proverbial plunge into his own sales-rep business, leaving his employer one year ago. Yet his transition never really felt like going solo. He had leased space in an office suite that had several other tenants. He knew most of the tenants before he ever thought of leaving his employer and joining their office suite. He also respected them, and they respected him. Within a short while of starting solo, Pat felt as if he had simply joined another company. He shared no finances, files, or confidential information with the others in the office suite. Yet he and they certainly shared back-and-forth referrals. Pat also had several willing mentors among them, just as they had the general benefit of Pat’s own knowledge and expertise. Solo practice was working for Pat, and he knew it.

Mismanagement

Sound financial management is critical for companies or firms and for the security of those whom they employ. Financial instability due to poor management increases the risk to the firm, its employees, and its customers or clients. A firm’s inability to meet short-term financial obligations undermines the firm’s creditworthiness among suppliers and with lenders. The firm may find itself unable to obtain supplier goods and services. The firm may also lose customers and clients. Financial mismanagement also creates incentives to engage in risky practices like pursuing doubtful business beyond the firm’s expertise and exhausting lines of credit. Financial mismanagement can also be an unfortunate first step toward rank misconduct like consumer or insurance fraud, regulatory violations, failure to pay employment taxes, and other misappropriation.

Statements

Consider the basic steps of sound financial management. You must first identify the critical financial information. You must then acquire financial statements showing that information. You must then discern key indicators within those statements including discerning each indicator’s significance. You should then be able to analyze those indicators using ratios, variances, and trends. Ratios have you compare the size of one indicator against the size of another indicator to maintain a proper balance. Variances have you compare expected data against actual data. Trends have you compare changes in indicators over time. Together, ratios, variances, and trends give you powerful tools for financial analysis. 

⤠  Don’t put up security for another. You’ll pay for it. ⤟

Bookkeeping

Companies and firms of any size typically retain or employ finance professionals to assist them with financial reporting. All firms, even solo practices, will have a bookkeeper making the entries necessary for financial statements. The bookkeeper may be the owner or owner’s family member, a full-time or part-time staff member, a secretary or administrative assistant who doubles in that role, or a retained service. Bookkeeping software has made keeping books both easier (the programs do the complex work) and harder (you have to learn the program). Whom to hire for bookkeeping and how to equip that person are important management questions. Be wise in your selection.

Accountants

Don’t confuse a bookkeeper with an accountant. Bookkeepers typically have rudimentary financial skills necessary to keep basic accounts, making timely and accurate entries. They often have little training to intuit a firm’s financial condition. By contrast, accountants ensure that a firm’s financial records represent the firm’s financial condition in ways that satisfy tax authorities and enable owners to manage the firm. Accountants have substantial education and training, and often have substantial skill in discerning a firm’s financial condition. But even so, do not cede judgment to accountants. Your firm’s finances are your concern. Make your own judgments, even with an accountant’s review and insight.

Evaluation

Evaluate indicators against industry norms. Norms will tell you what constitutes adequate income, capital reserve, available credit, cash reserve, equity, return rates, overhead costs, accounts aging, revenue per employee, and collection rates. Many factors can determine whether your firm’s finances are sound. Consider firm size, geographic location, the current economic cycle, and industry trends. Do not evaluate financial data in a vacuum. Measure financial performance in the full context, as a whole. Data requires context. What might be alarming or reassuring can change in different contexts.

⤠  The rich have more power than the poor. ⤟

Tendencies

The American Management Association’s Essentials of Finance and Accounting for Nonfinancial Managers warns against certain characteristics that distort business financial planning. Non-financial managers tend to be overly optimistic in predictions, especially in the short term. They tend to hold to assumptions well after contrary evidence would have them modify or abandon them. They tend to underestimate risks and variances, whether in revenue, expenses, earnings, or other categories. They also tend to accept and follow what others do, in a sort of herd mentality, even when having evidence to proceed differently. Financial planning takes discipline to see through cognitive, emotional, and subjective distortions. 

Erin had finally left the company that she had joined years earlier, in a transition that was both easier and harder than Pat’s transition into solo practice. Rather than going solo, though, Erin had joined with two other partners and an associate who also left her former company, the four of them forming a new partnership. The transition had been easy in that they had managed to keep their core clients. They did not lack for work, which had been her greatest fear. Yet a different challenge had snuck up on and almost overtaken them. None of them had been involved in the financial management of their former company. The complexity of their new finances had surprised them. The others had turned to Erin to take on that management. Her personal financial discipline had won her the respect of her partners. Yet she still had a steep learning curve to become her new company’s financial manager. She would have declined except that the financial work gave her an opportunity to work from home with more-flexible hours, which had been her primary goal in the new venture.

Cash

Managers untrained in finance tend to think that money is money. You either have it or you don’t. When you have money, you spend it. When you don’t have money but you think you soon will, you may charge expenses on credit cards. When you do not have money and cannot see it coming soon, you do not spend it or incur credit-card debt. Yet for management purposes, simply having or expecting money is not enough. The cash that flows into a business at any one time may have little to do with whether the business is profiting. Cash in hand may simply mean that money reached the business before the expenses incurred to earn it. While cash is important, so too is insight into whether the business is profitable and the owner is building value. Budgeting by cash collection alone misses the level of revenue relative to expenses. Budgeting on both the cash basis as the firm actually collects accounts and on the accrual basis as the business earns obligations that it should collect reveals the full picture necessary for astute management.

⤠  The borrower is a slave to the lender. ⤟

Profit

Businesses should classify and view money in these four ways: (1) income, (2) profit, (3) cash flow, and (4) equity. Income is simply the revenue that the company’s productive activities generate. Companies need income. Managers must direct labor and capital toward producing income. If business activity does not generate income, then the company will likely not survive. Yet income alone is not sufficient, when the expenses to generate that income exceed reasonable ratios. Companies also need profit, with profit being the gain of revenue over expenses. Both income and profit are important. A firm can have income without profit though not profit without income. 

Flow

Income and profit are not enough for financial stability. Businesses may have substantial income and substantial profit but have problems with the timing of income and profit. Some matters require companies to incur substantial expenses months and even years in advance of the same matters generating income and profit. Cash flow tracks the timing of income against expenses, helping the company measure whether it has money on hand when needed. Beware mistaking a healthy cash flow for profit, though. Companies acquire cash not only from profit but also lines of credit or other borrowing, capital contributions by owners, and using depreciation rather than funding the repurchase of depreciating items. Poor cash flow can strangle an otherwise financially healthy business, preventing it from pursuing potentially profitable matters. 

Depreciation

Know how depreciation affects finances and cash flow. Nonfinancial managers tend to think of any outflow of cash as an expense. Say that your firm started the day with $10,000 in its business account but that day paid $1,000 for business airfare, $1,000 for a scanner/copier, and $1,000 for a vehicle lease. A nonfinancial manager might consider all three to be expenses. Financial managers, though, would distinguish the airfare as a straightforward expense from the copier as a capital transaction. The airfare is gone, but the firm still has the copier. The firm might sell the copier for much of its initial cost. Over time, though, the copier would decrease in value. That decrease in value is its depreciation. In theory, a business should set funds aside to represent the depreciation to be able to replace the depreciating item.

⤠  Give as security only that which you can do without. ⤟

Characterization

The characterization of a cash outflow as either an expense or purchase of a depreciable asset depends on tax rules. For tax purposes, the business does not get to choose. Thus in the example just given, the vehicle lease might well be an expense rather than a capital transaction, although you can see how close a call these characterizations can be, and you must follow tax regulations closely. If the business instead finances the vehicle in an acquisition, then the vehicle is a depreciable asset. Business owners care about whether one characterizes a transaction as an expense or purchase of a depreciable asset. To reduce taxable income, firms generally favor treating outflows as expenses rather than asset purchases.  

Advantages

Depreciation has its cash-flow advantages. A firm represents depreciation as an expense on its books even though no cash flows out with that depreciation. While depreciation is an expense charge on the firm’s books, the firm does not actually pay that charge. The firm should perhaps be setting money aside in a capital account to replace the copier someday. But even if the firm does so, the firm still retains and controls that money. Depreciation is important because it represents a decline in asset value and, as an expense, reduces taxable income but does not otherwise affect cash flow. From the cash-flow standpoint, depreciation slowly turns a firm’s depreciable assets back into cash, a little bit each year.  Financial managers can more than live with depreciation. Business owners may love it.

Equity

Income, profit, and cash flow do not alone depict a company’s full financial picture. Equity is part of the equation, too. Equity is the company’s accumulated assets over debts. A firm might have substantial income and profit, and good cash flow, but because of excess expenditures or distributions, not have substantial equity. A company can make lots of money but remain poor because of excess owner draws and manager expenditures. Equity is important to attract and retain owners and employees, maintain loans and lines of credit, and enable retiring or departing owners to realize value.

⤠  A good manager leaves a legacy for grandchildren. ⤟

Planning

Financial planning for firms differs from financial planning for individuals and households. Larger firms will need communication and control strategies to ensure managers and employees follow financial directives. The firm must also consider the strengths and weaknesses of managers, employees, departments, and functions within the firm. The firm may also have more options and significantly greater resources, adding to the complexity of planning. The American Management Association’s Essentials of Finance and Accounting lists the following planning steps for firms in general:

• study the firm’s performance and prospects to develop and adopt a financial plan;

• communicate among members of the firm to focus resources and actions on the plan;

• research to ensure that the firm’s managers are using current knowledge;

• choose among available options consistent with the firm’s plan;

• implement the chosen actions that pursue the firm’s plan;

• develop and deploy budgets that accomplish the plan;  and

• assess plan progress to ensure that resources produce the warranted return.

Reviews

Financial management requires consistent activity and attention. Businesses traditionally review financial reports monthly, take a closer look quarterly, and take a deep dive annually. Weekly review of key variable indicators may also be appropriate. Waiting another month to adjust ongoing practices and address pending issues can be costly. Communicating analyses to firm personnel, especially managers and producers, monthly is appropriate. If billing and realization trend down while costs trend up, then don’t wait until the end of the quarter or year to communicate the necessary actions. Accelerate financial-management activities until you discern no additional advantage to more-frequent review and action.

⤠  A wrongdoer stores up wealth for those who do good. ⤟

Sampling

While the schedule on which you review business finances is important, also sample and evaluate financial information. With each monthly analysis, investigate and confirm the reliability of at least one piece of financial information. List the information summaries on which you rely each month, not only financial statements and cash-flow reports but subsidiary sources like deposit records and the separate reconciliations that are necessary for credit-card accounts, trust accounts, and checking accounts. Ask your office manager, administrative assistant, or bookkeeper who supplies you with that information for the underlying registers, receipts, or other individual records supporting the information summary. Then spend a few minutes sampling and reconciling at least some of those records. 

Risk

The above practices may teach you surprising things about your company’s finances that you may need to address. They also reduce risks associated with errors and intentional wrongs. Be proactively responsible in those financial-management practices, especially if your business handles financial assets belonging to others. Open your own mail, or require two assistants to do so together as a standard office practice to ensure appropriate handling of checks for deposit. Explain to staff that sound and ethical practice requires such systems and checks. Encourage staff members to adopt their own security practices.

Erin had quickly established what she felt were the right relationships and practices with her finance team for her new company. One of her partners had hired a part-time bookkeeper and chosen an accounting firm. Erin had quickly worked out with the bookkeeper and accounting firm the documents and reports that she wanted to see and when she wanted to see them. She had also confirmed that at least for a time, she was going to open every envelope containing bills and payments before routing them to the bookkeeper with instructions for handling. Erin was sure that she would change those practices over time, but she was just as sure that she needed to know everything going on with her new company’s finances. The company had chosen the right partner to manage its finances.

Insurance

Just as insurance spreads risk for individuals, so too insurance spreads risk for businesses. Commercial-general-liability (CGL) insurance begins with building-and-contents coverage insuring against fire, flood, theft, or other damage to or loss or destruction of physical property including premises, improvements, furniture, and equipment. CGL insurance next covers personal-injury liability for those whom the negligence of the company’s employees or defects in the company’s premises may hurt. CGL insurance also typically covers what insurers call advertising injury, such as defamation and invasion of privacy. Firms may buy business-interruption coverage as a part of their CGL insurance, to pay for loss of income in the event of damage to the firm’s premises. State law will also require that the firm carry worker’s compensation insurance to cover employee injury. Managers should consider these risks, estimate losses, evaluate available resources to cover loss, price coverage, and insure against risk where appropriate.

Checklist

Reflect, research, investigate, and act until you are able to confirm each of the following statements summarizing the advice and counsel in this section:

• Responsible financial management of my business is critical to my business success.

• I periodically and consistently review financial reports on my business, looking for performance indicators that I evaluate against benchmarks.

• I review and am routinely aware of my law business’s income, profit, cash flow, and equity, from which I take frequent action to improve its financial performance.

• While I rely in part on others for routine financial tasks, I frequently sample underlying records to ensure the integrity and security of financial systems.

Read the next chapter.