Understanding Financial Principles - A Key to Success in Business
You do not need to be a finance expert to manage cash flow from your business operations and investments; however, a basic knowledge in finance is important to running a successful business.
Follow these financial principles both in your business and investment endeavors, and over time you will see an increase in the value of your business and your overall net worth.
Cash Flow Management
Cash flows in (sources) and out (uses) of a business. Sources of cash include the sale of products and services and the collection of accounts receivables. Cash usages include payments for expenses, taxes, accounts payable, and loan payoffs.
Businesses strive to be cash flow positive, but you may see a fluctuation in your cash situation (not necessarily positive) when investing in future gains such as long-term growth. Check out this Forbes article to learn more about the benefits of exchanging capital for growth.
A company needs to evaluate cash flow needs, particularly during down markets, if their industry is subject to seasonality or is in the midst of making investment's today in the hopes of future gains.
The lack of cash is a primary reason why small businesses fail.
Cash flow management involves planning for your needs as well as unforeseen events. It involves safeguarding against a cash shortage by utilizing cost control measures and ensuring you can access other funds, debt-financing, or equity if necessary.
Time Value of Money
Have you ever heard the phrase Cash is King? Well, it is true. A dollar today is typically worth more than a dollar in the future, as money decreases as time moves on. With retirement planning, money is invested with the intent of growing our assets so we have funds once we stop working. Retirement assets increase from added contributions but also from the compounding effect of positive investment yields.
When you make a cash investment or take out a loan to invest in your business, be aware of the net rate of return from the sources and uses of funds. When borrowing money, you need to generate enough rate of return to justify paying the cost to borrow. Is your business providing enough ROI to offset the interest rate you are paying to borrow money? Stay attuned as to inflation rates as well.
Profits & Liquidity
Revenues minus expenses equal profits. While a good indicator whether a company is succeeding, profits are not necessarily indicative of a company's actual value. For example, some businesses are more asset-based and have a stronger balance sheet at the "expense" of a good income statement, such as an equipment rental company or real estate investment firm.
Liquidity focuses on the immediate marketability of an investment and how quickly you can turn an asset into cash. Companies with cash flow concerns need to be extremely mindful of their liquidity and whether they could generate enough cash to pay off short-term obligations by selling assets without losing value if need be.
Routinely, all business owners need to ask themselves, how long would it take to sell business assets or their entire business for what they are worth?
The Risk of Rewards
As both a business owner and an investor, you need to be consciously managing risk and return. Evaluate risks and rewards associated with how many quantities to produce or how much inventory to purchase. Should I take advantage of quantity discounts, or is there a way that I can negotiate price reductions as we buy more?
An investment portfolio will vary depending on your desired gain and the risk you are willing to take to achieve it. The upside of taking risks can be substantial; however, the downside of assuming a financial risk can be shattering. Hedging, another financial principle discussed below, is a way to manage your risk exposure. However, being completely risk-averse can be seen as a missed opportunity or even a loss when inflation is high.
A money mindset built around proper balancing between risk and rewards is essential to your long-term success in business and your overall net worth. Read this Entrepreneur article to determine your money mindset type and what you can do to improve or change it.
Debt Versus Equity Financing
Debt involves borrowing money. Before borrowing funds, be knowledgeable of the terms and conditions, particularly the interest rate. Compare it to other rates available in the marketplace to ensure it's a competitive rate. Know whether you are paying fees, or whether there are costs associated with early payoff. Do not borrow funds that you do not need, but instead considering a business line of credit, where you borrow on and as needed basis only. And, never borrow what you can't repay!
Equity financing is received by selling shares of your company to investors. Entrepreneurs become business owners for a reason. Be careful not to dilute the value of your shares to the point you are no longer in charge of your own company.
Small business owners also contributed their own money. This is called a capital contribution. One of the most common ways that small business owners "finance" there business is by not drawing a salary. Sweat equity is the time, devotion and other resources that you give your business without pay.
Diversification
A diversified portfolio builds upon the theory of creating an optimized portfolio. The saying "Don't put all your eggs in one basket" applies to business and investments. Balance risky investments with risk-free investments to minimize your overall exposure to risk. When was the last time to assess the diversification of your business? Do you make a point to assess your personal portfolio such as whether you may be too heavy in stocks or real estate? Maybe it's that you are not taking advantage of tax strategies that can save you money like a 529 savings plan for your children?
Hedging
Hedging is a financial strategy used to offset the risk of adverse price movements. It involves hedging one investment by making another. People hedge their bets all the time, whether by remembering to pack a sweater, jeans, and a raincoat on a tropical vacation just in case of unexpected weather, or putting a scarf and other accessories in their purse so they can spruce up in the ladies' room, should they arrive a little underdressed for a happy hour event.
An example of hedging in business might include prepaying for materials at today's price when prices are expected to increase or including in your service agreement the right to increase pricing if you experience an unexpected price increase due to inflation or market conditions.
Risk Management & Succession Planning
Just like you protect our family with life insurance, your business needs protection from unforeseen events. There are different types of coverages to consider, including but not limited to general insurance, workers compensation, business interruption, professional liability, property insurance, casualty insurance and key man insurance.
Risk management also involves having a contingencies in place. Your business is its own entity and if anything were to happen to you, a contingency plan creates an opportunity for your business to maintain its value even if you are no longer able to run the company. A contingency plan may have a buy-out agreement with your business partner or a friendly competitor, where you would buy them out or they would buy you out should there be a death or career-ending injury or medical diagnosis.
Know Your Take Home Pay | Pay Yourself First
When budgeting for the year, you start with how much money you need to pay for your living expenses and lifestyle. Your opportunity costs are too great not to be protecting your own wealth. Sure, if you have already accumulated enough wealth outside your business than your situation might be different. However, most small business owners fall short when they fail to properly plan and budget for their own salary. If you are not taking how what you are worth, or what you need to pay your bills, your business is not profitable and you likely will not stay in business much longer if you cannot pay yourself.
Knowing the basics of finance and financial principles will allow you to make fiscally responsible decisions. Sound financial choices will increase the value of your business and allow you to generate greater wealth from your investments.
Everyone's finances are different on a business and personal level. Seek the advice of your professional advisor when making decisions that have financial or legal consequences for you and your business.
Did you know that Centered CEOs offers 90-minute coaching sessions? Here is a link to learn more about how Centered CEOs can help you gain a new perspective on using financial data to make better business decisions that will allow you to excel in business!
Authored by Angela Rice, Co-Founder of Centered CEOs.
