Here’s one thing about the end of the financial year that most people don’t think of: It forces most business owners to focus like a laser on the fundamentals of their business. You know, things like making sure you deliver quality products and great customer service.
Perhaps most importantly, the end of the financial year often prompts many owners and entrepreneurs to take a hard look at how they’re managing their business finances. Is inventory being managed efficiently? Are receivables turns stretching out too far? Is monthly cash flow positive or negative? Where is money being spent wastefully? Is debt getting out of hand?
When the good times are rollin’, it can be easy to let the financial side of things slip a little. But when times get tough and sales start slowing down, most companies find it beneficial to go back to the basics of sound financial management. Here are five key areas you might want to go back and reexamine if you haven’t lately:
Think of poorly managed inventory as a pool of trapped cash that you can see but you can’t put your hands on. Excess inventory ties up cash in the form of goods sitting on your shelves, as well as wasted money spent on storage space, insurance and other overhead. The cost of carrying excess inventory can be as high as 30 percent of the initial value of the inventory per year when you factor in storage and handling costs, obsolescence and damage.
Make a commitment now to scrutinizing your inventory with a fine-tooth comb. When you view excess inventory as cash sitting on your shelves—which is what it really is—it looks a whole lot different. It’s especially important to monitor your inventory turnover ratio, which measures how often your entire stock of inventory turns over during the course of the year. To find out, divide your average inventory value by the cost of goods sold.
Collecting accounts receivable promptly should always be a priority, but it’s especially important during a slow economy when everyone is holding onto their money a little longer. The result can be a domino effect that looks like this: Your customers are getting paid slower, so they pay you slower—and before you know it, your cash is no longer flowing, but just trickling.
In order to stay on top of collections, you must first know the current status of your receivables. This requires that you create and maintain an accounts receivable aging report to track the payment status of all your customers. An aging report will categorize customers by their payment status—for example, current, 0-30 days, 30-60 days, 60-90 days, and past 90 days. It should also indicate how much each customer currently owes so you can prioritize your collection efforts.
It’s also important to establish credit files on all of your customers with whom you work on open account terms. These customers’ credit should be monitored on an ongoing basis and their files updated regularly to reflect their current credit status, which can change quickly and without warning during volatile economic times like these.
3. Cash flow—
Unfortunately, many business owners don’t understand the fundamental difference between cash flow and profits. So, to recap briefly: Cash flow is the actual cash (or checks) that’s collected by your business each month and deposited into your bank account. Profit is the cash left over that you get to keep after you’ve paid all of the expenses incurred in the manufacture and delivery of your product or service.
Companies that collect cash at or near the point of sale sometimes find themselves cash-flush. Restaurants are a good example: They usually receive cash from customers before they leave the restaurant, or at worse, from the credit card processor within a day or two. However, expenses must be paid out of this cash—everything from rent, utilities and labor to the food and ingredients themselves. Not understanding the difference between cash flow and profit is one of the main reasons so many restaurants fail.
Conversely, lots of other companies don’t collect their cash until 30, 60 or even 90 days or longer after they’ve delivered a product or service. These companies may look at their operating statement and see a nice profit, but the business could fail before it’s ever realized because cash flow is insufficient to keep operations going.
As noted above, your receivables management will have a direct impact on your cash flow, which makes improving collections vital to improving overall cash flow. And never forget one thing: While profits are always nice, cash is the undisputed King.
Cost-cutting has taken on a new meaning within most companies these days as owners and managers look high and low for ways to shave expenses. A few ideas:
- Talk to your vendors about ways they can help save you money. Remind them that your success is ultimately their success as well.
- Try to renegotiate your office lease with your landlord, if possible. It’s a tenant’s market in many regions of the country today.
- Scrutinize travel and entertainment expenses and pare them back, where possible.
- Reexamine subscriptions to publications and memberships within trade and industry associations to make sure they’re worth the cost.
- Raise your insurance deductibles, which can cut your auto and property insurance premiums by 10 percent or more immediately.
Financial ratios can help you determine how much debt your company should be able to handle comfortably. The main one is what’s known as your debt service coverage ratio. Here’s the calculation:
Net income + amortization/depreciation + other non-cash and discretionary items
Principle, interest and lease repayments
In general, lenders prefer that a company’s debt service coverage ratio not exceed 1:25. One alternative for companies with a high ratio is factoring, whereby they would sell their outstanding accounts receivables to a commercial finance company at a discount of usually between 2-5%. In exchange, the business would receive cash right away, instead of waiting 30, 60 or 90 days (or longer). Factoring companies also perform credit checks and analyze credit reports to uncover bad risks and set appropriate credit limits.
While it’s beginning to look like the worst of the economic crisis may be behind us, it’s always a good idea to focus on the fundamentals of your business —regardless of the time of the year or the state of the economy. These five key areas are a good place to start.