COMMON FINANCIAL MISTAKES OF SMALL BUSINESSES
written by: Reynaldo P. Mallari
THE WRITER
Reynaldo P. Mallari is a Management Accountant & Financial Consultant to small and medium sized businesses since 1982. The asset size of his clients ranges from 50 thousand to 100 million pesos. R.P. Mallari is a C.P.A. and has a masters degree in
Business Administration. He has special studies in Advanced Management, Industrial Management, Marketing Management. Just like you, he is also a small businessman presently engaged in tree farming. R.P. Mallari was a former proprietor/ partner in businesses engaged in construction, medical supplies marketing & marine products
processing.
INTRODUCTION
Business failure, who wants it? Definitely not you, but it is a business reality. Year after year, businesses of all sizes goes bankrupt. A big percentage of these failed businesses are small and medium in size. A major cause of business failure is the lack or inadequate use of financial principles and techniques.
For a small business manager to take corrective measures on his current financial problems or avoid them, he should be aware of its causes. Small entrepreneurs often commit the following errors.
UNDERCAPITALIZATION FROM THE START
Often time due to over enthusiasm of a small business entrepreneur, he under-estimates the initial capital needed for efficient operations. Often overlooked in estimating initial capital requirements are:
- Funds needed to cover the period between cash expenditures and collection of credit sales.
- Funds to cover the period to implement business plans and produce defect-free products/ service.
- Funds needed to cover customer development.
- Cash needed to purchase inventories until trade credits have been established.
- Funds needed to cover unforeseen expenditures during the learning period of the new business.
In estimating initial capital needs:
- Be conservative in estimating sales and cost. In estimating sales, use lower assumed sales volume and prices, and longer collection period.
- Assumptions must be realistic.
- Provide adequate contingency fund for miscalculations and unforeseen expenditures.
As a financial adviser, I have seen many businesses going bankrupt after only several months from start of operations. What is regrettable is just as the entrepreneur is about to solve his operational problems or just about to establish his regular customer base, he runs out of money. In addition to the entrepreneur, I would advise that a knowledgeable person also evaluate the funding requirements of the proposed business venture. These knowledgeable persons could be a businessman already in the same line of business or a management accountant servicing small entrepreneurs. A detailed projected cash flow analysis for the first 12 months of operations is highly recommended.
Should present available funds be inadequate, it is better to delay the project until adequate funds have been raised. The entrepreneur should not be impatient and take the "bahala na" attitude. Remember the saying, "haste makes waste."
But if the business is already in a situation of under- capitalization, raising the required capital either through loans, trade credits or taking in a capitalist partner, should be a priority objective of the business owner in order to cover the funding shortage.
OVER-DEPENDENCE ON DEBT
Debt is a double edge sword for a business. If used properly, it will finance the growth of the business. If abused, it could lead to financial troubles.
Once a small business has established its trade credits, it easier to ask other suppliers for an increase in its credit line. Even new suppliers maybe willing to give credit to a business which have establish credit with other suppliers. But ready availability of trade credit may result to inventories over-stocking.
During period of economic slow down and credit market contraction, trade suppliers would likely reduce their credit limit amounts and/or shorten their payment period terms. These actions of trade suppliers may lead to cash flow problems for the small business leading to delays in its payments to its trade creditors. Recurring delays in payment to trade suppliers will lead to strained relationship and might lead to a total cut-off of credit purchases.
A small business owner should also be careful with its loans from financial institutions. The business owner should remember that loans have fixed interest charges or installment payments that must be paid on a fixed date whether business is good or bad. A delay of payment for installment amortization or interests for two months could spell trouble for the small businessman. Should the loan be delinquent for six months, the financial institution will most likely refer your loan account to its legal department for appropriate action.
If cash is readily available or there are excess inventories, the entrepreneur tends to be more aggressive in extending credit sales even to new customers. Indiscriminate extension of credit sales may result to collection and cash flow problems.
INADEQUATE ACCOUNTING SYSTEM
The small businessperson must know what is happening to his business. The business manager must know how much is his sales amount? Is he making a profit or incurring losses? How much is his payables? Are receivables collected promptly? What is his level of inventories? Are sales, costs & profit targets being achieved?
Every day, decisions have to be made that are vital to business survival. The basis of management decisions is information. For a manager to make the right decisions, his basis should be reliable. A functioning accounting system is vital to any business operations for it provides accurate financial information at the time it is needed A sound accounting system is also the foundation of a profit planning and control system.
Inadequate accounting system means unreliable and untimely financial records and reports. It is also a fertile ground for committing fraud without the business owner immediately realizing the malfeasance. Unfortunately, most small businesses have inadequate accounting and internal control systems.
A simple accounting system should provide the following:
- Daily up-dated cash position report
- Accurate accounts receivable records.
- An adequate system of payable that identifies bills to be paid and assures payment on time and availment of cash discounts.
- Statement Financial Condition; Profit & Loss Statement;
- Cash Flow Statement.
Since accounting is the language of business, the small entrepreneur should familiarize himself, with the assistance of his management accountant, with basic financial reports and how to use these reports in decision-making.
LACK OF FINANCIAL PLANNING
Planning is crucial to business of any size. Planning is the reverse of business gambling. When you fail to plan, you are planning to fail.
Although profit planning and control is a powerful management tool even for small businesses, many business managers do not systematically plan their business operations. A usual practice of a small business manager is to make estimates for his level on a week- to-week basis. The missing factor in this method of forecasting is the lack of commitment to achieve forecasted amounts. At most, this style of forecasting is wishful thinking.
A small business manager only takes a hard look on his operations and attends to his financial future when a major problem develops. By this time, it maybe late or costly to correct the problems.
Important to planning is deciding your key business objectives. Once objectives have been set, supporting plans on how to achieve such objectives should be prepared. The necessary resources will also be identified. The financial results of the plan should be stated through the following budgeted financial reports:
- Cash Flow Statements
- Statements of Financial Condition
- Profit & Loss Statements
- Financial Schedule
- Fixed Assets Expenditures Schedule.
A detailed plan on a monthly basis should be developed for one year and in rough form for the next two years.
POOR CASH MANAGEMENT
Cash is the lifeblood of any business, so it is important to manage it efficiently. A cash budget is a powerful business planning and control tool. A cash budget will show the small business owner any cash shortages in advance, say one month before it will happen. It will also show if there will be permanent excess cash that could be used for additional acquisition of fixed assets; payment of loans; or put into short-term investments.
A cash budget presents the weekly or monthly cash receipts, cash disbursements, beginning and ending cash balances. Cash receipts includes: sales collections, owner's investments, loan proceeds, others. Cash disbursements includes: merchandise purchases, productions costs, general expenses, loan payments, fixed assets investments, owner's withdrawals, other expenditures.
A cash budget encourages "active budgeting" by providing a tool to determine any need to change the timing of cash receipts and disbursements. For example, a planned purchase of equipment could be delayed until permanent excess cash is available. If there is a forecasted cash shortage within one month, action could be made to avert such shortage like: more aggressive receivable collection; asking a payment extension; applying for a loan. A cash budget is also a useful tool in analyzing the timing differences of cash inflows and cash outflows.
A good cash management system ensures that there is adequate cash to pay maturing financial obligations and funds to cover contingencies.
POOR CREDIT MANAGEMENT
Oftentimes, just to make a sale, a small businessman relaxes its credit policies. Some individuals think that profit could be made by selling to anybody. This is correct if sales were on a cash basis or all credit sales were collected on due dates. From a conservative financial point of view, a sales transaction is not yet consummated until it is collected.
Right from the start, a small business must have credit policies that balances sales objectives and financial objectives. It is better to have a smaller sales amount with manageable uncollectible receivable rather than a big sales amount with a large amount of uncollectible receivables.
CONFUSING NET PROFIT AND CASH
Often times, a small businessman would say ."I know that I am making a profit, but how come I am always in a tight cash situation." Most new businessmen confuse net profit with cash.
Net profit does not stay long as cash. Net profit is used to finance trade receivable and inventories. It is used to service financial payments like: loan payable amortization, acquisition of fixed assets, and owner's capital withdrawals. It is unwise to take-out substantial amount of money from operations of finance major fixed assets acquisition based only on the income statement. This may lead to cash deficiencies in the near future. In making a major cash disbursement decision, a projected cash flow statement should be used as a basis in making such decision.
As for the periodic analyses of business' operations, in addition to the basic financial statements, a cash flow statement a is very useful financial report.
POOR HANDLING OF PAYABLES
If a company's receivables and inventories are substantially financed by trade credits, it is crucial that the flow of trade credit is continuous. A sudden cut-off in trade of trade credit will lead to a company's non-delivery of sales orders and subsequently result to cash flow problems.
The small business must strive to be up-dated in the payment of its payables with its trade creditors. Prompt payment of trade payables fosters better relationship with suppliers. Prompt payment of bills indicates financial strength and improves the firm's credit rating.
If the cash condition of the company allows it, cash discounts should be availed. Cash discounts may seem small but if annualized, they represent interest charges ranging from 36% to 60% for use of supplier's money.
For example, a 2% discount for payment made within 10 days with full payment in 30 days, is in effect a 2% interest charge for using the funds for 20 days. This is an effective interest rate of 36% per year.
An example in not taking the cash discounts is say your monthly purchase is Php 500,000; you are given a 2% discount if paid within 10 days. This amounts to a P= 10,000 peso discount every month or Php 120,000 discount for one year. This amount is already an addition to your net profit.
OVERLOOKING THE RISK-RETURN TRADE-OFF
Risk is inherent in any business endeavor. It is the understanding of risk that enables an entrepreneur to manage it and profit from it.
When contemplating to increase the company's level of operations or targeted profits, remember the economic maxim . "The higher the profit, the higher the risk." A major deviation from the normal course of business entails risks still unknown to the manager. Before embarking on a new course to increase profit that requires significant expansion of operations, the manager must first assess all probable key scenarios that could affect the expansion program's viability.
When embarking on a major business expansion, new market segments have to be developed and served wherein the business has little Information and no service experience.
A probabilistic decision tree is a useful tool in analyzing the risk-profit trade-off of a contemplated business action. A decision tree is a schematic representation of the manner in which a particular decision's consequences are related to alternative decisions and to uncertain events. An entrepreneur could consult his management accountant for a better understanding of a probabilistic decision tree and evaluate if applicable to his proposed expansion program.
INSUFFICIENT CAPITAL TO FINANCE GROWTH AND EXPANSION
Although expansion is a basic business objective, it should be properly planned and controlled. Rapid expansion of operations should be supported by a proportionate increase in the company's capital base
Growth in sales increases the need for funds to finance increases in trade receivable and inventories. If funds are not sufficient to finance additional receivables and inventories, this will lead to cash flow problems which in turn leads to delays in payment of trade credits and other cash disbursements.
Expansion entails increases in fixed period costs. Fixed period costs almost remain constant within a certain range of operations. Fixed period costs include: rent, salaries, communications, utilities. When sales goes down significantly due to market contraction, fixed costs does not proportionally goes down; the company then ends in financial trouble.
A manager contemplating a major expansion should first determine the detailed additional investment amount required and analyze alternative actions. By doing an in-depth expansion study, he may decide to grow at a slower pace and concentrate in improving profitability and increasing utilization of existing assets and holding off major expansion until sufficient permanent funds are accumulated.
OVER EMPHASIS ON SALES VOLUME AT THE EXPENSE OF PROFITABILITY RATIO
A higher sales volume require bigger capital needed to finance additional working capital and fixed assets investments.
More sales volume and amount does not necessarily mean higher net profit. There are instances where an increase in sales amount will result in a decreased net profit amount. This happen when there is a decrease in gross profit ratio brought about by lower sales prices or higher cost of sales coupled by increases in fixed general and financial costs. In business, the name of the game is "Return-on-investment." Net profit should always be analyzed in conjunction with assets used in generating sales.
An increase in sales does not necessarily mean maintaining or improving the current profit ratios. A significant increase in sales may result in increases in fixed period costs or direct variable costs, altering the company's cost structure.
The danger in emphasizing sales volume at the expense of a very low rate-of-return-on-assets ratio is it decreases your margin-of-safety ratio between sales break-even amount and targeted sales. This is also true for the price break-even point. With a low margin-or-safety ratio, a small decrease in sales volume results in an operating loss.
OVER WITHDRAWAL OF MONEY FROM THE BUSINESS
During the first year of operations of a small business, its access to the credit (loan) market is very limited. A major portion of the profit must be reinvested back into operations either to finance growth or to cushion unexpected expenditures.
Retained profits must be used to cushion cyclical market contractions; unexpected increase in the company's working capital conversion cycle; or catastrophe that may hit the business.
CONCLUSION
Financial errors are a major cause of business failure. Correction of financial errors or poor financial management practices often times does not require complicated solutions, only common business sense and familiarity with basic financial principles and techniques. If you are presently experiencing any of the said financial errors and wanted to solve said problems , simply contact RPM Financial Consultants at rpm_finconsult@yahoo.com
