Financial Failure in Business – How to Avoid It
Business is the foundation of the world’s economy. Unfortunately many businesses fail due to financial reasons. In entrepreneurial ventures the failure rate is extremely high – especially in the first couple of years. This article highlights some of the key factors that need to be addressed in order to minimize the probability of financial failure in business. The discussion is done under the following headings:
- Financial Planning;
- Financial Management.
Financial planning should be done continually in any business. It should starts with the conception of a new venture and carries on till the business is closed down or merged into another business. Planning is, however, meaningless if the management of a business does not have the necessary business- and financial acumen. Management needs to understand the basics – even if the actual financial planning is outsourced. This includes an understanding of financial statements, cashflows and financial ratios. They should know if the company is making enough profits, if there is enough liquidity and solvency, where potential problems lie and how they can solve them.
Financial planning should include the following activities:
- Sales Planning. Without enough turnover no business can survive in the long run. Break-even sales should be known. Sales targets should be realistic and sustain the required growth and profits.
- Credit Policy. Credit is generally provided in order to achieve the required sales. This is, however, done at a risk (of debtors that fail to pay) and it cost money. It is therefore extremely important to have a proper credit policy that is strictly adhered to. The policy must include what type of people or institutions will get credit, under which circumstances, how much they will qualify for, guarantees that need to be in place, the credit terms and how payment (and the lack thereof) will be managed.
- Pricing. Pricing is a science in its own right. Too high prices deter customers and too low prices decrease the profitability of the business. Pricing should therefore be competitive. Gross margins of a business are the direct result of pricing. Gross profits are necessary to cover the financial obligations of a company and to allow for growth. Profitability of different products and services need to be analysed and they should only be kept as part of the offering if they provide sufficient margins or if they are of strategic importance.
- Cashflow Projections. Several aspects of a business impact on its cashflow. Many seemingly healthy businesses go bankrupt due to cashflow problems. It is of the utmost importance for a business to plan for sales and expenses and especially the timing thereof. Money that should be received in 90 days cannot pay for current expenses.
Business finances should continually be monitored and managed. Problems need to be identified and rectified as soon as possible. To be pro-active now can make a big difference later.
Financial aspects of a business, that needs to be managed, include the following:
- Financing. Capital expenditure and working capital need to be financed. The planning of a business and its cashflows should highlight the need and timing for financing. Financing can be done through the current shareholders, by selling new shares or by external financing. External financing is expensive and risky for the business. It can cause the financial downfall of a business when the commitments are not kept. On the other hand it can allow for much faster growth. Financing should form part of the broader strategy of a company and be in line with the risk profile of the business.
- Stock Holding. Inventory should be at optimum levels. Too little stock holding (with regular stock outages) can have negative effects on customer relationships and cause turnover to decrease. Too much stock holding is expensive and risky (for obsolescence and pilferage). Inventory levels should be determined and managed professionally (with the use of inventory optimisation models which take into account the importance of a product, the stock turnaround time and the lead times when ordering a product).
- Accounts Receivable. In general it is important to provide credit in today’s economy. The difference of debtors that pay on average after 30 days or 60 days can, however, make the difference between success and failure (this is clearly reflected in cashflow projections). Debtors should be analysed according to its aging and debtors that do not adhere to their credit terms should be diligently followed up and if necessary their credit allowances should be revoked.
- Business Growth. A business can only grow as fast as that it can generate enough money (through profits, investments or financing) to finance its working capital. Growth above this is not sustainable and in the long-term it will cause the financial failure of a business. The sustainable growth rate of a company is determined by a combination of its profitability, efficient utilisation of its assets, financial leverage (proportion of debt to equity) and retained earnings that is kept in the business. This rate should be closely monitored and its various determinants must be managed effectively.
- Expenditures. Expense items should be budgeted for. Substantial deviations of actual vs. budgeted figures need to be explained and its effects must be filtered through into new budgets, cashflows and other financial projections. In practice times of rapid growth and good economic conditions are dangerous in the sense that a tendency exists to increase expenses too much during this time. It can then be difficult to curb expenses (especially salary and wage related) in times of economic downturn.
- Financial Ratios. The proper usage of ratios can assist management in identifying problems and to take corrective action. It is important to know the company’s profitability, liquidity and solvency, to know where potential problems lie and then how to correct them. Ratio analysis should be done on a monthly basis (if applicable) and should be compared to other companies in the industry and especially to targeted- and past figures (previous period and same period last year).
- Cashflows. Everything in the success or failure of a business has the tendency of impacting on the cashflow. Cashflows should be scrutinized for any potential problems and need to be adjusted on a monthly basis. By ignoring cashflows for a few months a small problem can easily snowball into something that is out of control.
This article highlights only a few, but very important, issues that need to be planned for and managed within a business to decrease the risk of financial failure. In general the most important issue to be managed is the cashflow of a company. All incomes and expenditures and there actual timings are reflected in a cashflow statement. A causal relationship exists in both directions between all aspects (that are mentioned in this article) and the cashflow of a business.
Copyright© 2008 – Wim Venter