Stages
Responsible businesses conduct annual financial planning. The book Results-Oriented Financial Management indicates that the type of annual financial planning depends on the business’s stage in its overall life. New businesses focus on preparing an initial financial plan. An initial plan creates a first budget, determines financial reporting, plans cash flow, acquires financing, determines owner compensation, and minimizes taxes. At the growth stage, established businesses focus on improving the planning process, ensuring appropriate financial management, meeting increased capital needs, clarifying ownership structures and interests, adopting retirement plans, acquiring marketing services, and adjusting compensation policies to reward innovation. Ensure that your planning covers these basics.
⤠ People with great wealth aren’t necessarily able to enjoy it. ⤟
Crises
Businesses can also encounter a crisis stage. Be aware of, and plan to avoid, financial crises. A financial crisis can arise from loss of a single major client or customer on which the business over relies. Overly democratic management can slow financial decisions and adjustments. Compensation expectations can substantially exceed financial resources. Business owners and managers can lack knowledge and transparency around financial information. Overly rigid compensation systems can subject a business to manipulation and may not compensate for necessary inputs. Over reliance on billing may inhibit business development. Undercapitalization can prevent growth and affect cash flow. Poorly defined ownership structure, relationships, rights, and interests can lead to leadership conflicts. And inadequate financial controls and budget review can lead to financial losses. Watch for these hazards, and plan to avoid them.
Balance Sheet
Businesses, like individuals, benefit from a balance sheet and budget or cash-flow statement. The balance sheet shows the business’s assets against obligations. The net of those figures reflect partner equity. The balance sheet in effect shows the value that the owners have built up in the business. Poorly managed businesses can have negative owner equity. Owners use the balance sheet to ensure that the business protects their capital contributions and their ownership interest in the business increases in value. Businesses use balance sheets to ensure that they have the capital, resources, and liquidity for continued operations. Businesses also use the balance sheet to recruit or retain owners and to secure and extend financing. Consider the following balance sheet for a small business having two partners, two associates, and two part-time staff. See if you can discern whether the business is protecting capital contributions, has necessary capital and liquidity, and is growing.
[Table omitted. See the print guide.]
Liquidity
Experience reviewing balance sheets will tell the discerning eye much about a business’s ability to pay its bills and sustain its operations. Calculating and benchmarking the firm’s liquidity ratio can provide even clearer indications. One common liquidity ratio compares current assets to current liabilities. To calculate that liquidity ratio, divide the firm’s current assets (cash, marketable securities, accounts receivable, prepaid services, and other things that the firm can convert to cash or use up in short-term operations) by current liabilities (accounts payable, credit-card debt, and other short-term obligations). A firm should have on hand at least as much as it owes in the short term. Thus a liquidity ratio of 1.0 would make a reasonable minimum benchmark. A liquidity ratio less than 1.0 would indicate more current liabilities than current assets and the prospect for a short-term cash shortage. A liquidity ratio higher than 1.0 would be better depending on what makes up the current assets. Cash and securities would be good. Accounts receivable could also be good, but a large accounts receivable figure could mean poor-quality work, aging accounts, and a collectability problem. Financial statements show symptoms, not causes. Yet knowing the symptoms can be important especially when they involve poor liquidity.
⤠ Giving when it’s hard is worth more than giving when it’s easy. ⤟
Bookkeeping
Financial statements prepared for businesses tend to use double-entry bookkeeping, where every positive entry finds its negative entry reported somewhere else in the statement. Double-entry bookkeeping helps ensure the accuracy of financial reporting. Double-entry bookkeeping also shows important aspects of a firm’s financial condition and the interests of its owners. Notice in the above balance sheet how total partner equity balances the large amount of assets against the small amount of liabilities. That balance may seem like a simple bookkeeping entry. Yet total partner equity is perhaps the most important of all pieces of information in the balance sheet, at least to the owners who hope for a larger rather than smaller figure. Value double-entry bookkeeping for the relationships it shows.
Budget
After the balance sheet, a business’s next key financial statement is the cash-flow statement or budget. The cash-flow statement projects the business’s incoming revenue versus outgoing expense. A cash-flow statement includes cash from operating, investing, and financing, showing whether the business is gaining or losing cash in any of those three areas. Firms use the cash-flow statement to plan financial transactions for the upcoming month, quarter, and year, projecting revenue against expenses for the coming period. Cash-flow statements include both the recent data (actual) and current projections (budget), allowing for comparisons. Businesses use the cash-flow statement to justify expenditure and other financial decisions. Consider the following cash-flow statement, again for a small business of two owners, two associates, and two part-time staff. Discern the business’s financial health with respect to cash flow. Would you want this statement to reflect your business’s finances?
[Table omitted. See the print guide.]
Significance
Do not underestimate the significance of cash flow to a business. The AMA Handbook of Financial Risk Management asserts that the number-one reason for business collapse is a cash-flow shortage. Businesses cannot afford to run out of cash. Doing so destroys the willingness of suppliers to continue to provide goods and services to the business. Watch closely how quickly your business reduces its available cash, what financial managers call their burn rate. Budgeting is to ensure continuing liquidity so as not to run out of cash. Risks that cause businesses to run out of cash include overly optimistic revenue forecasts, underestimating taxes or other compliance costs, underestimating expenses, maintaining only a short-term outlook, and over focusing on accruing profit rather than preserving and increasing available cash. Sound businesses engage in thoughtful revenue, expense, and profit planning, to ensure liquidity and reduce cash-flow risks. The number one responsibility of a financial manager is to ensure adequate cash flow, the oxygen of any business.
⤠ Let what you have satisfy you. You may not get more. ⤟
Employees
Even if you are not your employer’s financial manager, show significant concern for your employer’s cash flow. Look and listen carefully for information regarding the firm’s cash flow. Financial managers manage through others including you. Information that a manager shares about cash flow can help you identify the firm’s cash-flow position and how it plans to address and improve it. The more effective you are in addressing the firm’s cash-flow needs, the more responsibility the firm is likely to give you in financial and other matters. If you show no concern for cash flow, then expect not only to have less financial responsibility but less opportunity in general within the firm. Owners and managers hold their positions in large part because of their responsibility to the firm’s cash flow. If you want to be your employer’s champion, then consistently take positive actions improving its cash flow.
Profit
After balance sheets and budgets, businesses benefit from a third form of financial statement, the profit-and-loss statement, also known as a P&L, income statement, earnings statement, operating statement, statement of operations, or revenue-and-expense statement. The basic formula for a profit-and-loss statement is simply REVENUE – EXPENSES = NET INCOME. A profit-and-loss statement shows the business’s recent history on an accrual rather than cash basis over a specific time such as monthly, quarterly, or annually. Comparing recent profit-and-loss statements shows the direction of the firm’s finances. For example, revenue may look reasonable over the past month. Yet if the profit-and-loss statement reflects a substantial decline in revenue from prior months, then the firm’s managers may need to investigate that decline promptly. If the decline continues or accelerates a decline already reflected in prior profit-and-loss statements, then the firm’s managers may need to modify unsuccessful measures that they had already put in place to address those prior declines. Consider the following example, once again for a business of two partners, two associates, and two part-time staff.
[Table omitted. See the print guide.]
Margin
Together, the balance sheet, budget, and profit-and-loss statement enable a business to plan with respect to cash flow, liquidity, and profit. Profit is not simply having more revenue than expense. Profit also has to do with ensuring that profit is a reasonable percentage of total revenue, known as the profit margin. A $100,000 profit may be reasonable for a sole proprietor whose total revenues are $200,000. A $100,000 profit is not a reasonable figure for a 100-employee business with $30 million in revenue. Profit margin is simply the operating income (net revenue) divided by the total revenue. Reasonable profit also relates to the firm’s assets, known as the asset turnover. A $100,000 profit may be a reasonable figure for a sole proprietor whose total assets in the business have a $50,000 value but would not be at all reasonable for a 100-employee business having $10 million in total assets. Asset turnover is simply total revenue divided by total assets.
⤠ Fools with money in hand never buy wisdom. ⤟
Return
Profit margin fails to consider owner investment. Asset turnover considers only invested assets without considering profits. Financial managers combine profit margin and asset turnover to produce a more-helpful measure of return on investment (ROI). Return on investment is profit margin multiplied by asset turnover. Firms that use limited assets to produce substantial profits have high ROI. Firms that use substantial assets to produce limited profits have low ROI. Small reductions in the firm’s assets combined with small reductions in the firm’s costs can substantially increase ROI, even if revenue remains the same. The opposite is also true that deploying additional assets and increasing costs can substantially reduce ROI. That’s why managers turn off the lights in empty rooms. Frugality in assets and costs can help a firm’s finances.
Journals
Accurate financial statements depend on an accurate journal and ledger. A journal records financial transactions as they occur. A check register where you record each check when written and each deposit when made is a familiar form of journal. Businesses should promptly record receipts, such as when a customer pays for a good or client pays a bill, and expenditures, such as when the business pays a supplier. Journal entries represent the micro-level data on which the firm’s overall financial performance depends. Businesses today tend to use electronic bill paying and check generation, and hence electronic rather than paper journals. Consider the following example.
[Table omitted. See the print guide.]
Ledgers
A ledger sorts the journal entries into account categories so that financial managers can see where the revenue and expenses accumulate. Client ledgers in a service business are an example. Each client bill and payment will show up in the daily journal, but the ledger sorts the journal into client categories to see which clients are ahead or behind on their bills. Ledgers sort journal entries into other categories, too. A firm could have dozens of accounts in such areas as assets (cash, accounts receivable, furniture, equipment, software, hardware, vehicles, improvements, etc.), liabilities (accounts payable, payroll taxes, line of credit, notes payable, etc.), owner equity (member capital accounts), and expenses (compensation, bonuses, benefits, rent, storage, parking, utilities, depreciation, etc.). The general ledger reconciles the accounts into a summary of the firm’s financial transactions. Consider the following example of a client ledger for a specific matter in which the client retained the firm.
[Table omitted. See the print guide.]
Budgets
Develop and use annual budgets for your business. Budgeting becomes especially important in your first year of business in any new sector or geographic location, or where economic cycles, changes in the market, or other conditions increase financial uncertainty. Annual budgeting begins with planning expenses for the year while estimating revenue for the same period. The budget records the projections for the year’s anticipated revenue and expenses. A budget enables financial reporting as the year progresses, monitoring of budget variances, and adjustment throughout the year. Here are some budgeting recommendations:
personally sign each check for at least one month, so you know where the money is going;
watch expenditures closely whenever they vary from the budget;
avoid the tendency to solve every budget problem by cutting expenses, when cuts may lead to reduced productivity;
instead, devote more time to increasing revenue through marketing, client development, and revenue realization; and
every few years, start with a zero-based budget, requiring justification of every budgeted expense.
Components
Begin your annual budget with information on prior year sales, from which to estimate the coming year’s sales. Then include figures for the prior year and estimates for the coming year on beginning-year sales in progress, beginning-year accounts receivable, anticipated receivable write-offs, rate and billing realization percentages, months to bill, and days to collect. This information enables a coming-year revenue estimate to compare to the prior-year revenue figure. Then include prior year figures and coming year estimates for expenses. Estimate owner income using the total revenue and expense figures. Use historical data on monthly billings and collections to develop a month-by-month worksheet comparing prior years to the current year’s performance.
⤠ A community that shares generously leaves none in need. ⤟
Revenue
Estimating revenue is an inexact science, especially for new businesses with no revenue history. Make an estimate no matter how hard the challenge. Revenue targets enable budgeting while inspiring revenue pursuit and practice innovation. Then estimate likely revenue effects such as economic cycles, gain or loss of major customers or clients, trends within your sector, and trends within your customer or client base. Use national, state, and local data to inform your revenue projections. Adjust upward or downward for the skill, experience, reputation, and network of your business’s producer employees, and marketing initiatives your business plans to undertake. Reduce billings by historical or sector realization rates. Adjust for the lag in time between when the business does the work, bills for the work, and collects for the work.
Erin had worked closely for two years with her business’s accountant to develop a decent balance sheet and budget. The accountant from time to time mentioned the “P and Ls” that they should soon be producing and tracking each month. For a time, Erin did not know what the accountant meant, other than that the accountant was referring to profit-and-loss statements. Nor did Erin feel that they needed profit-and-loss statements, whatever those were. The budget seemed to work. Yet the accountant persisted, finally printing out a couple of profit-and-loss statements from prior months to highlight their differences and question Erin over trends. The accountant’s insight surprised and pleased Erin when it confirmed a trend that Erin had intuited from her vague sense of billings, revenue, earnings, and cash flow. From then on, Erin insisted on reviewing monthly profit-and-loss statements. Most often, the P&Ls needed only a glance. Occasionally, Erin caught things that even her older partners had missed. She began making decisions based on the P&Ls rather than on hunches and intuition.
Generation
Generally, businesses have no better way to improve their finances than to generate more revenue. Additional revenue tends to improve every other measure of a business’s financial health. Every business has a revenue capacity, meaning the revenue produced on maximum utilization of every resource. Estimate your business’s capacity, and then contrast it with your business’s revenue. You may find surprisingly substantial room for improving revenue. Do not expect to reach revenue capacity, at least not quickly. Do expect improvement. Set goals. Identify customer or client value, then develop and offer goods and services that add that value. Increase the level of expertise your business possesses, and then leverage that expertise. Leverage the skills of your personnel. Leverage technology. And exceed customer or client expectations.
⤠ Better to be happy with what you have than to always want more. ⤟
Mindset
A business’s success depends on the ability to generate revenue. In down times, financial managers tend to look first at cutting costs. Cost cutting is often wise and sometimes necessary. Yet a languishing business must give greater attention to increasing revenue. Businesses failing financially often do so because they lack a revenue mindset. Focus your efforts on increasing revenue capacity. Recruit, retain, train, and deploy skilled and productive workers. Use financial reports to assess revenue and modify practices to increase it. Manage customer or client expectations to ensure prompt payment. Maintain customer or client confidence in costs and value with customer- or client-centered approaches. Implement billing and collection practices that result in prompt payment. And strengthen customer or client relationships to develop more business and referrals.
Leverage
Businesses require owners and employees to develop the customer or client base. Maintaining a website is usually not enough. Customer or client development can involve a broad range of networking, marketing, social, educational, and other activities. Time devoted to customer or client development is time lost to producing goods or services. To enable those with customer or client development skills to devote time to that essential activity, others must produce enough excess revenue to compensate. Leverage is a business’s ability to generate excess revenue to reinvest in the business’s growth or to otherwise compensate customer- or client-development owners whose direct productivity is not sufficient to sustain their expected income. Businesses leverage the work of employees to maintain and increase the return to owners. Think constantly of developing and increasing your business’s leverage.
⤠ Chasing riches is like chasing the wind. ⤟
Expertise
Expertise is the primary resource that many businesses leverage. Leveraging expertise is one reason to hire skilled employees rather than train your own employees in the knowledge and skill they’ll need to support your business. When a business brings in a worker who already has a substantial customer or client base, the business banks on further leveraging that worker’s knowledge, skills, and engagement. Lateral hires do not just bring existing customers or clients to the business. They bring new opportunities to apply the lateral hire’s skills to expand the business’s existing business. Develop and apply your employee’s knowledge and skill in ever greater engagement. Consider these opportunities:
continuously train in emerging new business areas;
study employee performance to improve process efficiencies;
form, brand, and market new product or service groups;
deploy client-oriented newsletters touting goods and services;
encourage practical research and scholarship by employees; and
reward employees who pursue other new initiatives.
Technology
Businesses not only leverage their employees but also technology. Much technology goes underused. Employees carry smartphones and have tablets, laptop computers, and other mobile technology available to them but underuse the apps that make them so powerful. Search engines, research databases, voice-recognition applications, communications apps, and a host of other applications go unnoticed. You and your employees may be using barely a fraction of the available technology. Leverage technology resources into services that your business’s customers or clients value.
⤠ We are here to work at the things we have. ⤟
Staff
You and your business’s other high-expertise employees are your business’s key leverage points. But your business’s low-expertise employees can still contribute to the business’s bread and butter. The standard assumption is that customers or clients want experts doing all their work. Yet the standard assumption misses a critical point. Customers and clients need affordable goods and services, which depends on efficiency. Businesses should assign commoditized work that does not depend on the identity of the one who performs it to the least-skilled worker capable of it. Efficient businesses push work down to the least-compensated employee who can competently perform it. Efficiency prefers secretaries over associates and associates over partners, reversing the standard assumption. Let lower-level staff make the copies and deliveries, while higher-compensated employees do product design or service development. Let secretaries assemble documents while creators provide content. Encourage skilled workers to do higher-value work while delegating lower-value work to staff members.
Pat had begun his sole proprietorship on his own without an employee, secretary, bookkeeper, or other staff. Two things had made that staff-free start possible. One was Pat’s general competence in all things including using technology. His goal was a paper-free office, and his technology research and acumen had him well on the way toward meeting that goal. Yet Pat was realizing that he was still doing a good bit of work that other, less-skilled personnel could be doing to free him up for business development and other higher-value work. He could refer some of that lower-skill work to his new employee, but even then, the employee had more skill and value than much of the drudge work required. Pat finally gave in and hired an administrative assistant. His worries about carrying the administrative assistant’s costs evaporated within a month. He found not only that he and his other employee had more value-generating time but that the assistant was also a potential profit center.
Expenses
The book Results Oriented Financial Management and other sources stress increasing revenue more than reducing expenses. Yet sound businesses also manage expenses wisely. Estimate expenses similar to how you estimate revenue. If your business has an expense history, then start from that history and adjust for anticipated expense changes. If your firm has no expense history, then use national, state, and local data to estimate expenses. When allocating an annual expense budget across each month of the budget year, allow larger single-purchase expenses to accrue month by month so as not to distort the budget and surprise the financial manager. Make budget categories most relevant to your business. An office-based service business, for instance, might include the following categories:
rent, utilities, and other office lease expenses;
annual license fee and insurance;
professional conferences and subscriptions;
computer, scanner, and copying equipment;
software services and other technology expenses;
telephone and related communications expenses;
postage, paper, print cartridges, and other office supplies;
staff payroll and related staffing costs;
income, real-estate, and personal-property taxes;
accounting and tax-preparation services;
advertising and marketing expenses;
library and other subscription services;
furniture and other capital expenditures; and
write-downs for uncollected billings.
Bonuses
Businesses can take some control over the financial risk of a shortfall in revenue and excess of expenses, by moving part of employee compensation to a bonus structure. When a business has a shortfall, employee layoffs or compensation reductions are the most-painful response. To reduce the necessity of layoffs and compensation reduction, consider compensating employees using a mix of base wage plus annual bonus. Reserving bonus compensation for year-end distribution enables a business to reduce revenue’s volatility risk. Rather than having to cut base wages or lay off employees in a down year, the business can simply not pay substantial year-end bonuses. Merit bonuses also enable the business to create incentives. In an especially strong revenue year, employees who bore responsibility for the business’s financial success may receive distributions substantially exceeding base compensation.
⤠ Take breaks to refresh yourself before getting back after it. ⤟
Allocation
Allocating compensation among multiple owners is an important business issue. Allocation policies should match business goals. Some businesses allocate owner distributions equally or roughly so, while other businesses allocate distributions unequally based on each owner’s direct contribution toward business success. Those policies can influence culture and collegiality within the business. Entrepreneurial businesses use markedly unequal distributions to promote owner productivity, having more-competitive and engaged but less-supportive and collegial culture. Businesses balance allocation methods to achieve productivity and collegiality goals, rewarding owners’ long-term investment and short-term productivity. Governance structures and compensation processes have their own significance for a business’s management and success.
Erin learned a hard lesson. Her company’s financial performance had been so strong in its first years that in the current year’s budget, she had overestimated revenue. A severe downturn in the economy had affected her projection, too. The result was that all four partners in the company went without paychecks for the first time in the company’s five-year history. The payless paydays lasted only two months, and by year end they had each caught back up in their regular pay, but year’s end brought no bonuses, another first for the company. Erin remembered how cautious she had been in her early years of budgeting and resolved to return to that caution. Better to bring good news throughout the year and at year end than to be the bearer of bad tidings.
Succession
Business owners often leave a business with the expectation of continued support from it, either in installment sales payments, benefits, or income for part-time or consulting work. Make business succession planning part of your business’s annual financial review, if you have owners in their forties or older. Succession can sneak up on a business’s owners and managers. While age forty may seem young, interests, abilities, opportunities, and relationships can change quickly throughout a career. Business owners sometimes change careers for government positions, charitable leadership, teaching, or retirement at an earlier age than others. Identifying and preparing qualified successors can take years. Consider these steps:
identify and encourage employees who display ownership interest, attitude, and commitment;
train those employees in ownership skills, especially practice development, finances, and management;
begin transitioning customer or clients to those employees in order not to lose them when ownership changes;
begin to transition the business’s leadership to those employees before senior owners leave;
create financial incentives such as retirement plans for senior owners to step down from leadership and out of the business; and
create mentor and advisor roles for retiring senior owners to continue to inform the business.
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:
My business engages in annual financial planning that accounts for the business’s stage, growth, financial issues and stability, and major issues affecting its customer or client base.
Using accurate journals and ledgers, my business produces and consistently reviews balance sheets, cash-flow statements, and profit-and-loss statements, on which it then takes timely appropriate action to improve financial performance.
My business makes accurate expense estimates, tracks expenses against estimates, and regularly seeks to control and reduce expenses in responsible and innovative ways.
My business makes accurate revenue estimates, tracks revenue against estimates, and regularly seeks to increase revenue in responsible and innovative ways.
My business regularly explores ways to leverage its personnel, technology, and subordinate staff for improved financial performance.
My business allocates compensation in a manner that ensures regular compensation for all employees throughout the year while adequately rewarding superior financial performers.
My business has a succession plan that it reviews and updates at least annually to address all succession issues.