Basic Concepts In Financial Management

Five Strategies To Strengthen Your Company’s Financial Management
 by: Jeff Schein

Too many businesses wait until a crisis occurs before they start to focus on improving their financial management. Often, by that time, it can be too late. By setting aside an hour now to evaluate the strengths and weaknesses of your company’s financial management activities and systems you can save a lot of time and aggravation. It can also help increase your profits, and at the end of the day that is what it is all about.

The following are five strategies that will help you start to build a strong financial foundation and build value in your company.

1. Set up a financial control system

The first thing you need to start with is a control system so that there is consistency in your process and procedures. A control system is designed to prevent and detect errors in your daily activities. For example, is there is a standard way of processing your receivables, payables and inventory? If there are no standard guidelines to follow, there is probably no control system.

2. Have daily access to your account information

Make sure that you can access your account information every day; it is invaluable to managing your cash effectively. With most banks providing internet access at a reasonable cost, there is no reason not to have instant access to account information.

3. Manage your cash components

Concentrate on managing your three main cash components: accounts receivable, accounts payable and inventory.

Let’s take a look at each component:

Accounts Receivable                 

Make sure your credit and collection system is working efficiently. Any excess investment in accounts receivable increases the need to borrow more money to avoid a cash flow deficit. That means that if you are carrying excess receivables you are probably carrying excess debt and you have a direct cost of having to carry that extra debt in interest payments. Even if you finance the receivables through internal equity, there is still an indirect cost; the opportunity cost of using that equity elsewhere which could include expanding your inventory to increase sales, reducing debt or earning interest on cash balances.

Your accounts receivable collection period defines the relationship with the cash flow process. Every month you should be calculating your collection period and comparing with previous periods and relating those results to industry averages. Any material differences should be investigated.

Your credit policy can influence your cash flow and earnings. Longer credit terms can increase sales and earnings, but any decision to offer more liberal terms requires an estimate of the trade-off between the cost of the larger investment in accounts receivable and the bottom-line benefits of a higher sales volume. Remember that increasing your credit terms will bring in less credit worthy customers which can increase your bad debt expense. You can, however, use price increases to offset more liberal credit terms.

When you develop a receivable policy, consider the following:

• Check the financial health of customers before offering them credit. Consider obtaining cash on the first order.
• Do not make your invoice terms too generous.
• Charge interest to customers who pay late.
• Give discounts for early payment.
• If you are offering discounts, the terms should be attractive enough to encourage customers to take the discount. This can also serve as an early warning signal; if a customer doesn’t take the discount, or all of a sudden stops taking the discount, then you may want to investigate further before extending credit as it could be a sign of financial trouble.
• Do not wait longer than 30 days for a late payment before you take action; you need to minimize your company’s exposure to bad credit. Put it into dollar terms, if you have a $1,000 bad debt write-off and a 10% profit margin, you need to generate an addition $10,000 in sales just to make it back.

Inventory              

First, keep in mind that because of carrying costs such as warehousing and insurance it is more expensive to carry inventory than to carry accounts receivable. That is, reducing an investment in inventory provides you a larger bottom-line benefit than a comparable reduction in accounts receivable because you are also reducing the carrying costs.

As with your receivables, it is important to complete a monthly analysis of average inventory held in days. Compare to previous months and industry averages and investigate any material difference or change.

A periodic inventory count is a fundamental requirement; any items that are overstocked should be investigated.

A sales forecast is vital, without it you lack the necessary management information for inventory control.

Your target inventory investment should equal your normal investment for core sales plus a built in safety stock (for example if a re-order is delayed you want some extra stock on hand) plus some amount for any anticipated growth in sales.

You can use the following equation to determine your economic ordering quantity: SQRT (2SO/CP) where

SQRT = square root
S = anticipated annual unit sales
O = fixed costs per order
C = annual inventory carrying cost, as a % of a products purchase price
P = unit purchase price for product

Note that the above equation attempts to minimize inventory cost by answering the question of how much and how often you should order inventory. It is not perfect; the equation does not take into account volume discounts and assumes that your demand is constant. However it is a tool that can be used to help in your decision making process.

The following are 10 questions you can use to review you inventory process:

1.     Do you have a sales forecast? Do you compare forecast to actual sales and adjust the next forecast accordingly?

2.     Do you know which items account for 80% of your sales? These items should be managed closely.

3.     How fast can you get inventory?

4.     How do you order inventory?

5.     How much inventory do you order? Do you order extra just to save a few extra cents?

6.     Do you know the cost of holding your inventory?

7.     Do you rely on just one or two suppliers?

8.     How frequently is inventory analyzed to determine obsolescence and makeup?

9.     Do you have a policy of determining what is obsolete inventory and how and when to get rid of it?

10. Do you have an inventory reporting system to provide the necessary tracking information?

Accounts Payable           

Although you want to stretch your payables as long as possible, much like you offer attractive discounts to your buyers you should also take supplier discounts as often as possible if the terms are attractive enough.

Make sure your payables are tracked on a regular basis - such as weekly - and that your payment system runs smoothly.

As with receivables and inventory, complete a monthly analysis of your accounts payable and compare to previous periods and industry averages. Any material difference or change should be investigated.

Make sure vendors understand your company in case there is a situation where you need to stretch your payables. You need a plan to deal with those situations where you may have an unexpected spike in your payables.

You should re-evaluate you vendors on a regular basis to make sure you are getting the best value.

4. Budget

It is fundamental, you need to plan for growth and you need to forecast for problems. You need to prepare a budget. Besides completing a budget for expected sales, you should also complete a budget for a disaster situation, like your sales are cut in half. The benefit is very straight forward; it forces you to ask yourself how you will be able to keep the company running in such a situation. It will also point to areas where you may be able to save money right away and free up cash flow. It’s like having a disaster plan; you only have to act on it when disaster strikes, but it is much easier to concentrate when you do not have a crisis at hand.

5. Develop a strong relationship with your Bank

Devote attention to building relationships with your bank. Always keep them up to date on where your company stands. If you hit a difficult patch it is much easier to get your bank on board if they understand your business. Contrary to opinion, banks do not necessarily jump ship as soon as you fall into trouble. They are willing to work with small business through tough times, and gaining their trust to do so is much easier the more confidence they have in you and your company. They way to accomplish this is to be transparent in your dealings and to give them timely financial information.

Use you bank as a resource for cash management. There are products available that can increase your cash flow, or arrangements that can be put in place to increase your interest returns. But you still need to make sure they are cost effective.

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