Financial Management
There is a misconception by many small business owners and students when they first signed up for the course that Financial Management was just accounting, which it is not. Understanding the basics of accounting and financial statements help, but the financial management of a business is so much more. While I was teaching the course, which was focused on Non-Financial Managers, I thought having this course would benefit every business owner.
Financial Management is about analyzing where you are and looking forward, including strategic planning and controlling and reporting financial undertakings in a business. The techniques deal with management accounting, which is more forward-looking in the business and financial accounting, which is more focused on looking at what has already happened. It is vital to know and understand the past as there is information from the past that will help you plan appropriately for its future.
ANALYZING FINANCIAL STATEMENTS
As a business owner, you must read and understand the financial statements that your financial accountant prepared for you. This includes the income statement, which main components are revenue, cost of sales, expenses, taxes, net income, and the balance sheet, which includes assets, liabilities, and shareholder's equity. In some cases, an accountant will provide you with a statement of cash flows as well.
Income Statement
The first item on the income statement is revenue, which is all of the sales you made for the year at a top-line for all of your products and services. Cost of Sales includes direct costs attributable to the production of goods or services. What is included may differ based on your business. Expenses are the indirect costs you spend on running your business, such as rent, utilities, supplies, salaries, and marketing. Net Income is what is left of your revenue after you subtract the cost of sales, expenses and taxes.
Vertical and Horizontal Analysis
Horizontal analysis of an income statement looks at how you perform year over year and allows you to determine the increase or decrease in revenue, cost of sales, and expenses. Hence, you can adjust accordingly, going forward. Vertical analysis compares each line item on the income statement to a percentage of revenue. There are charts available online by an industry in which you can then compare your business to others. One resource that provides this data is available through Industry Canada Financial Performance online.
Break-Even Analysis
Break-even analysis is based on the income statement and determines the number of units or dollars needed to cover all of your costs (variable and fixed). Break-even analysis can also help you determine your product's correct pricing and whether you are covering your costs adequately to make money.
Balance Sheet
First on the balance sheet are assets that play a part in the value of your business's worth. Short-term assets include items such as cash and accounts receivables, and long-term assets that include buildings, land, and equipment. Liabilities are next on the balance sheet and are the debts that your business owes. Short-term liabilities are items that will be paid off within the year, which include accounts payables and taxes, whereas long-term liabilities are those debts that will not get paid off within a year, such as a mortgage or a loan. Equity is the value that is returned to the shareholders of the business. Assets are equal to Liabilities + Equity.
Vertical and Horizontal Analysis
As with the income statement, the horizontal analysis compares years and whether there was an increase or decrease in each line item in the balance sheet. Vertical analysis on the balance sheet is calculated as a % of Total Assets for all individual asset lines. In contrast, Liabilities and Equity line items are calculated as a % of Total Equity and Liabilities.
FINANCIAL RATIOS
Financial ratios help determine your liquidity and profitability and help you manage your debt coverage and assets. These ratios should be used internally to help you determine your financial viability to figure out what measures you need to put in place to get them within an acceptable range. It is essential you know your business ratios, as these are the same ratios that lenders and investors use to determine if you are a risk.
Listed below is just one of each type of ratio and the calculation.
Liquidity Ratio
Current Ratio = Current Assets / Current Liabilities
This will show whether your current assets cover your current liabilities. An acceptable current ratio is 2:1.
Debt Coverage Ratio
Debt to Equity Ratio = Total Liabilities / Equity
This will show whether you have too much debt compared to equity in your business. This ratio acceptable range will differ based on your industry. An acceptable range for most lenders is under 1.
Asset Management Ratio
Average Collection Period = Current Assets / Current Liabilities
This will show how long it takes on average for you to collect your receivables. In most cases, you will want this to be 30 days or less, but it may depend on your industry and the types of customers your business has.
Profitability Ratio
Return on Equity = Profit (Net Income) / Equity
This will show shareholders how much they are earning on their investment.
There are 3-4 of each type of ratios, which will provide you with different information on your business.
WORKING CAPITAL
Working capital is your current assets minus your current liabilities and is controlled by how you manage both within your business. If your average collection period is high, then there is money in the hands of your customers, that is yours. If your average payables period is low and you are paying your bills before they come due, you are taking money out of the business that could be used. If you are carrying too much inventory and are not turning it quickly, that is money you could lose because the inventory depreciates or spoils, and it is money you could have used in your business.
PLANNING, BUDGETING AND CONTROLLING
Every business must have a strategic plan. Most businesses know they need a business plan but do not understand that the business plan is their strategic plan's implementation plan, and the strategy must come first. Many business owners have "the plan" in their heads, but not on paper. Budgeting and setting financial goals and objectives are also crucial to the planning process within a business. Controlling, which is reporting and measuring how you perform in relation to the goals and objectives set, is imperative. Without controls, you have no way to determine how you are performing.
BUSINESS VALUATION
Too often, a business owner waits until they want to sell their business to get a business valuation and find out their business is not what they thought it was worth. There are multiple methods to determine valuation depending on the circumstances of the sale. If a business needs to sell immediately, their valuation could be based on the liquidation of assets versus a growing business and includes goodwill such as patents, customer contracts, and image. That valuation would also include the buyer paying for the expectations of the future. Understanding your business value long before you sell can benefit you as it gives you time to make changes in your business to improve your long-term value when you actually sell.
SUMMARY
These are just some of the most important financial management topics that benefit a business owner to know and understand. Others include Financing, Costing, Capital Budgeting, and Investments.
At RK Fischer & Associates, we can help business owners with learning and gaining insight and knowledge of financial management in their business through the following engagements and tools:
- Business Coaching, we can provide business owners interested in learning the concepts themselves to manage their business.
- A Financial Review is a consulting engagement that will assess 3-5 years of your financials with recommendations on improving your current situation.
- We have a Financial Analysis Tool that will allow you to enter 2 years of financials. It performs horizontal and vertical analysis and automatically calculates the majority of the used financial ratios.
- We provide Strategic Planning Engagements, which look 3-5 years out.
- We provide Business Plans for Financing.
- We perform Business Valuations for those who want to understand the current valuation of their business.
