Achieving Financial Success

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Achieving Financial Success Big ideas. Small business. Financial Success – an essential guide for small business Introduction Small business is often driven by a passion for achieving the owners’ desired outcomes. They may want to watch a business grow from the start, be keen to enter into an industry that provides great challenge, or be motivated by personal reasons such as wanting to turn a hobby into a business or develop a long-term retirement plan. Whatever their reason, many small business owners do not have formal financial management training (that is they are not an accountant or bookkeeper) and usually are limited in resources to fund this type of assistance. For the success of any business, good financial management is necessary. Good financial management will go a long way in helping you ensure all your available business resources are used efficiently and effectively and provide an optimum return to you. This guide has been designed to help those in small business develop the financial management skills that are an essential part of business success. Presented in easy-to-understand language, this guide discusses the key financial aspects small business should focus on to ensure good financial management is in place. The areas discussed in the guide address the financial aspects your business should consider and understand as part of good financial management. If these practices are implemented early, your business will benefit from strong financial management and you will be equipped with the financial tools to operate and grow a successful business. Of course, for each business, some of the areas may not be relevant. For instance, if you are providing a service, then discussion of stock management will not be relevant. Also, you will need to keep in mind the type of industry you operate in when considering good financial management. For example, if you run a café, you will probably be reviewing stock levels every week; however, a small retail toy shop may only do a stock count once a year. This guide has five sections, each with a number of chapters that provide discussion on the key topics. There are hints and tips along the way to help you focus on the important messages and these are summarised in Appendix 1 for easy reference. Section One Business Finance Basics Section Two Improving Business Finance Section Three Financing Your Business Section Four Managing Lenders Section Five Better Business Financial Management The guide is designed to provide an overview, and, in most topics covered, there are references to further information that can be found on Small Business Victoria or CPA Australia’s websites. 1. Achieving Financial Success – an essential guide for small business Glossary of Terms Used in This Guide As with any topic, there is a wealth of jargon and terminology associated with financial management. It is helpful for you to understand these terms when reading financial statements or when talking to finance professionals such as bank managers. This will make you feel more confident and comfortable. The most basic and useful of these terms are set out below. Accrual Accounting Recognising income and expenses when they occur rather than when they are received or paid for Accounting Entry The basic recording of business transactions as debits and credits Accounting Period A period for which financial statements are prepared – normally monthly and then annually Asset Anything having a commercial value that is owned by the business Break Even The amount, in either units or dollar value, that the business needs to achieve before a profit is generated Budget A financial plan for a business (setting out money the business forecasts it will receive and spend); typically done once a year Capital Expenditure The amount of money that is allocated or spent on assets Cash Accounting Accounting for transactions as they are received or paid Cash Conversion Rate The overall number of days to convert your trade from the cash outflow at the beginning of the working capital cycle to cash received at the end of the cycle Cashflow The flow of cash into and out of the business Cost of Goods Sold The total cost of all goods sold during the period (COGS) Creditors The money which you owe your suppliers Current Assets Are assets that are likely to be turned into cash within a twelve month period Current Liabilities Are liabilities that are required to be paid within a twelve month period Debtors The money which is owed by your customers to you Depreciation The write-off of a portion of a fixed asset’s value in a financial period 2. Achieving Financial Success – an essential guide for small business Drawings Where the owner/s of the business take something of monetary value permanently out of the business – can be cash or other assets Equity The amount that the business owes the owners Expenses The costs associated with earning the business income Financial Ratio The method by which business can measure the financial health and compare their business operations to similar businesses in the same industry Financial Statements Financial Statements (Profit and Loss Statement, Balance Sheet and Statement of Cash Flows) record the financial performance and health of your business for a given period Forecasting The process of predicting the future financial performance of a business Inventory The stock that a business holds to sell Intangibles Assets that don’t have a physical form e.g. patents, goodwill Liability The amount the business owes external stakeholders Margin Profit from sales before deducting overheads Mark-up The percentage by which the sales price exceeds the cost Owners’ Equity The amount of capital contributed to form the business or added later Overheads Costs not directly associated with the products or services sold by the business Profit Revenue minus expenses Purchase Order A commercial document issued by a buyer to a seller, indicating the type, quantities and agreed prices for products or services the seller will provide to the buyer Receivables Amounts that are owed to a business; also known as debtors Revenue The income the business earns from its operations Retained Profit Profits that have not been distributed to the owners Reserves Retained profits that are held for a specific purpose or the result of a revaluation of assets Working Capital The excess of current assets over current liabilities Work in Progress Where an order has been taken from the customer and the business is in the process of “working” to complete the order. 3. Achieving Financial Success – an essential guide for small business Business Finance Basics Keeping the books for your business can provide valuable Implementing good information to enable you not only to prepare the Business Activity Statements (BAS), but also to gain a clear picture of financial practices in the financial position of your business and an insight into your business will how to improve business operations. Good financial provide sound financial systems will assist in monitoring the financial situation, information that can managing the financial position and measuring the success identify current issues of your business. and be used to plan for In this first section, we will look at the three key financial the successful financial statements and then discuss how you can use this future of your business. information to improve business operations through ratio analysis and preparing an operating budget. Chapter 1: Understanding Financial Statements Please note this chapter is not designed to assist you with the preparation of financial statements but to introduce you to what they look like and how they can be used to benefit Financial statements your business. provide information on how the business is Every business requires some assets to be able to run the operating financially operations and ultimately make a profit. This could be as and why. Ensuring simple as having cash in the bank, but is more likely to be a financial statements are number of assets, such as stock (only unsold stock is an produced regularly will asset), office equipment and perhaps even commercial premises. All of these items need to be paid for, so, when provide financial starting up a small business, the owner or owners will need information for to invest some of their own money as well as perhaps continual improvement borrowing some from a lender (e.g. bank) or investor. of business operations. There are three financial statements that record financial information on your business. They are: • Profit and loss statement (sometimes referred to as statement of financial performance or income statement) • Balance sheet (sometimes referred to as the statement of financial position) • Statement of cashflows. Financial statements record the performance of your business and allow you and others to diagnose the strengths and weaknesses by providing a written summary of the financial activities for a given period. To proactively manage your business, you should plan to generate these financial statements on a monthly basis, review the results and analyse for improvements. Let’s look at the financial statements and see how they can assist in monitoring your businesses financial performance. 4. Achieving Financial Success – an essential guide for small business Profit and loss statement The profit and loss statement is a summary of a business’s income and expenses over a specific period. It should be prepared at regular intervals (usually monthly and at financial year end) to show the results of operations for a given period. Profit or loss is calculated in the following way: TIP Sales Regularly (monthly) produce profit and loss information and compare against previous month’s activities to ensure Less your profit expectations are being met. Sales Discounts Sales Commissions HINT Calculating the cost of goods sold varies Only those businesses depending on whether Equals the business is retail, that have goods wholesale, (products) to sell will use manufacturing, or a Net Sales the calculation of cost of service business. In goods sold retailing and wholesaling, computing the cost of goods sold Less during the reporting period involves Opening Stock Cost of Goods Sold beginning and ending Equals inventories. This, of course, includes purchases made during the reporting period. In Equals manufacturing, it Plus involves finished-goods inventories, plus raw Gross Profit materials inventories, Stock Purchases goods-in-process inventories, direct labour, and direct factory Less overhead costs. Equals Expenses In the case of a service (Fixed & Variable) business, the revenue is Stock available for sale being derived from the activities of individuals rather than the sale of a product and hence the Net Profit calculation of cost of Less goods sold is a smaller task due to the low-level use of materials required Closing Stock to earn the income. 5. Achieving Financial Success – an essential guide for small business Case Study – Joe’s Motorbike Tyres Joe has decided to start up his own business and has been doing some research. He will sell motorbike tyres to motorbike manufacturers. He is going to leave his employment and has saved some money to help him through the start phase. He has decided that in the first year, he is going to focus on getting the business established, so he believes that a small profit (before interest and tax) of 5,000 should be achievable. His research has shown him that the expenses to set up and operate the business will be approximately 15,600 for the year. Profit 5,000 plus operating expenses 15,600 Total cash needs 20,600 From this information, Joe can see that he will need at least 20,600 to cover the operating expenses and achieve his profit goal. This is called the gross profit. Joe’s research has also highlighted that it is reasonable to expect to sell at least 1000 tyres in the first year. Joe has negotiated with a supplier to provide the tyres for cost price of 31.20 each. Now we can work out according to Joe’s estimates, what sales need to be made to reach the profit goal. Profit 5,000 plus operating expenses 15,600 Plus cost of 1000 tyres 31,200 (cost of goods sold) Joe will need a total of 51,800 to achieve his targeted profit Minimum selling price (51,800 divided by the 1000 tyres he will sell) equals 51.80 per tyre. 6. Achieving Financial Success – an essential guide for small business Joe thinks he will be able to sell the tyres for 52.00 per tyre, so, at the end of the first year, if all goes according to plan, his profit and loss statement would look like this: Joe’s Motorbike Tyres Profit and Loss Statement As at end of Year One Income Sales 52,000 (1,000 tyres 52 each) Total sales 52,000 Cost of goods sold Opening stock - Stock purchases 34,320 Less closing stock 3,120 Total cost of goods sold (COGS) 31,200 (See note below) Gross profit 20,800 Expenses Advertising 500 Bank service charges 120 Insurance 500 Payroll 13,000 Professional fees (legal, accounting) 200 Utilities & telephone 800 Other: computer software 480 Expenses total 15,600 Net profit before tax 5,200 Note: Towards the end of the year, Joe purchases 100 more tyres on credit from his supplier for an order in the new year. This leaves 3,120 of stock on hand at the end of the year. Joe’s cost of goods calculation Opening stock Nil Add stock purchased during the year 34,320 (1100 tyres 31.20 each) Equals stock available to sell 34,320 Less stock on hand at end of year 3,120 (100 tyres 31.20 each) Cost of goods sold 31,200 If your business is a service business, (i.e. selling services not goods or products), the profit and loss statement will generally not have a cost of goods sold calculation. In some instances, where labour costs can be directly attributed to sales, then you may consider including these costs as a cost of goods (services) sold. 7. Achieving Financial Success – an essential guide for small business Balance sheet The balance sheet provides a picture of the financial health of a business at a given moment in time (usually the end of a month or financial year). It lists in detail the various assets the business owns, the liabilities owed by the business, and the value of the shareholders' equity (or net worth of the business). • Assets are the items of value owned by the business • Liabilities are the amounts owed to external stakeholders of the business • Shareholders equity is the amount the business owes the owners. HINT Liabilities This diagram shows how the 9,620 Funded balance sheet works. The Assets through: business requires assets to 54,820 operate and these assets will Shareholders’ be funded from the equity in Funds 45,200 the business, the profit from the operations of the business or by borrowing money from external parties. The balance sheet can also be illustrated as: Shareholders’ Assets Liabilities Minus Equals Funds 54,820 45,200 9,620 The diagram above shows that the value of all of the assets of the business less the value owed to external stakeholders (liabilities) will equal the net worth of the business – that is, the value of the business after all debts have been paid. 8. Achieving Financial Success – an essential guide for small business Balance Sheet Categories • Assets can include cash, stock, land, buildings, equipment, machinery, furniture, patents, and trademarks, as well as money due from individuals or other businesses (known as debtors or accounts receivable). • Liabilities can include funds made available to the business from external stakeholders by way of loans, overdrafts and other credit used to fund the activities of the business including the purchase of capital assets and stock, and for the payment of general business expenses. • Shareholders' equity (or net worth or capital) is money put into a business by its owners for use by the business in acquiring assets and paying for the (sometimes ongoing) cash requirements of the business. Balance Sheet Classifications For assets and liabilities, a further classification is made to assist in monitoring the financial position of your business. These classifications are referred to as “current’ and “non-current”. Current refers to a period of less than twelve months and non-current is any period greater than twelve months. Current assets will include items that are likely to be turned into cash within a twelve- month period – cash in the bank, monies owed from customers (referred to as debtors), stock and any other asset that will turn into cash within twelve months. Fixed assets are shown next on the balance sheet and are assets that will continue to exist in their current form for more than twelve months. These can include furniture and fittings, office equipment, company vehicles etc. In the same way, liabilities are listed in order of how soon they must be repaid with current liabilities (less than 12 months) coming first, then non-current liabilities (longer than 12 months), followed by shareholders’ funds (equity). Current liabilities are all those monies that must be repaid within twelve months and would typically include bank overdrafts, credit card debt and monies owed to suppliers. Non-current liabilities are all the loans from external stakeholders that do not have to be repaid within the next twelve months. TIP A prosperous business will have assets of the business funded by profits rather than being heavily reliant on funding from either external parties (liabilities) or continual cash injections from the owner (equity). 9. Achieving Financial Success – an essential guide for small business Following on from the case study of Joe’s Motorbike Tyres, this is what Joe’s balance sheet would look like at the end of year one: Joe’s Motorbike Tyres Balance Sheet As at end of Year One Current Assets Cash 5,100 Debtors 18,000 Stock 3,120 Total Current Assets 26,220 Non-current Assets Computer 5,500 Store Fit Out 8,100 Office Equipment 15,000 Total Non-current Assets 28,600 TOTAL ASSETS 54,820 Current Liabilities Credit Card 5,500 Creditors 4,120 Total Current Liabilities 9,620 Non-current Liabilities Total Non-current Liabilities TOTAL LIABILITIES 9,620 NET ASSETS 45,200 Shareholders’ Equity Owners’ Funds 40,000 Current Year Profit 5,200 TOTAL SHAREHOLDERS’ EQUITY 45,200 10. Achieving Financial Success – an essential guide for small business HINT Statement of cashflows Statement of The statement of cashflows is a summary of money coming into, cashflows only and going out of, the business over a specific period. It is also shows the prepared at regular intervals (usually monthly and at financial year historical data and end) to show the sources and uses of cash for a given period. differs from a The cashflows (in and out) are summarised on the statement into cashflow forecast three categories: operating activities, investing activities and financing activities. Operating activities: These are the day-to-day activities that arise from the selling of goods and services and usually include: • Receipts from income • Payment for expenses and employees • Payments received from customers (debtors) • Payments made to suppliers (creditors) • Stock movements. Investing activities: These are the investments in items that will support or promote the future activities of the business. They are the purchase and sale of fixed assets, investments or other assets and can include such items as: • Payment for purchase of plant, equipment and property • Proceeds from the sale of the above • Payment for new investments, such as shares or term deposits • Proceeds from the sale of investments. Financing activities: These are the methods by which a business finances its operations through borrowings from external stakeholders and equity injections, the repayment of debt or equity, and the payment of dividends. Following are examples of the types of cashflow included in financing activities: • Proceeds from the additional injection of funds into the business from the owners • Money received from borrowings • Repayment of borrowings • Payment of drawings (payments taken by the owners). As already mentioned, the statement of cashflows can be a useful tool to measure the financial health of a business and can provide helpful warning signals. Three potential warning signs which, in combination, can indicate the potential for a business to fail are: TIP • Cash receipts are less than cash payments (i.e. you are running out of money) Use the cashflow statement to • Net operating cashflow is an “outflow” i.e. it is analyse if you are spending negative more than you are earning or • Net operating cashflow is less than profit after tax (i.e. you are spending more than you earn). drawing out too much cash from the business. 11. Achieving Financial Success – an essential guide for small business Here is an example of Joe’s cashflow statement, showing the relationship between the profit and loss statement and the balance sheet. 12. Achieving Financial Success – an essential guide for small business Chapter 2: Assessing Your Business’s Financial Health A helpful tool that can be used to predict the success, potential failure and progress of your business is financial ratio analysis. Financial ratio By spending time doing financial ratio analysis, you will be able analysis will to spot trends in your business and compare the financial performance and condition with the average performance of provide the all- similar businesses in the same industry. Small Business important warning Victoria has access to industry information provided by signs that could IBISWorld. CPA Australia also has similar industry information allow you to solve provided by benchmarking company FRMC which can be your business accessed through CPA Australia’s library. problems before Although there are many financial ratios you can use to assess they destroy your the health of the business, in this chapter we will focus on the business. main ones you can use easily. The ratios are grouped together under the key areas you should focus on. Liquidity ratios HINT These ratios will assess your business's ability to pay its bills as they Use these ratios fall due. They indicate the ease of turning assets into cash. They to assess if your include the current ratio, quick ratio, and working capital (which is discussed in detail in Chapter 5). business has adequate cash In general, it is better to have higher ratios in this category, that is, to pay debts as more current assets than current liabilities as an indication of sound they fall due. business activities and an ability to withstand tight cashflow periods. Current ratio = Total current assets Total current liabilities One of the most common measures of financial strength, this ratio measures whether the business has enough current assets to meet its due debts with a margin of safety. A generally acceptable current ratio is 2 to 1; however, this will depend on the nature of the industry and the form of its current assets and liabilities. For example, the business may have current assets made up predominantly of cash and would therefore survive with a relatively lower ratio. Quick ratio = Current assets – inventory Current liabilities – overdraft Sometimes called the “acid test ratio”, this is one of the best measures of liquidity. By excluding inventories which could take some time to turn into cash unless the price is “knocked down,” it concentrates on real, liquid assets. It helps answer the question: If the business does not receive income for a period, can it meet its current obligations with the readily convertible “quick” funds on hand? TIP The quick ratio will give you a good indication of the “readily” available cash to meet current debt obligations. 13. Achieving Financial Success – an essential guide for small business Solvency ratios HINT These ratios indicate the extent to which the business is able to meet all its debt obligations from sources other These ratios measure if your than cashflow. In essence, it answers the question: If business has adequate long- the business suffers from reduced cashflow, will it be able to continue to meet the debt and interest expense term cash resources to cover obligations from other sources? Commonly used all debt obligations. solvency ratios are: Leverage ratio = Total liabilities Equity The leverage (or gearing) ratio indicates the extent to which the business is reliant on debt financing versus equity to fund the assets of the business. Generally speaking, the higher the ratio, the more difficult it will be to obtain further borrowings. Debt to assets = Total liabilities Total assets This measures the percentage of assets being financed by liabilities. Generally speaking, this ratio should be less than 1, indicating adequacy of total assets to finance all debt. TIP These ratios indicate the extent to which the business is able to meet the debt obligations from all sources, other than just cashflow, as is the case with liquidity ratios. 14. Achieving Financial Success – an essential guide for small business Profitability ratios HINT These ratios will measure your business performance and ultimately indicate the level of Use gross and net margin success of your operations. More discussion on calculations to measure and these measures is detailed in Chapter Four. monitor the profitability of your business operations. Gross margin ratio = Gross profit Net income This measures the percentage of sales dollars remaining (after obtaining or manufacturing the goods sold) available to pay the overhead expenses of the business. Net margin ratio = Net profit Net income This measures the percentage of sales dollars left after all expenses (including stock), except income taxes. It provides a good opportunity to compare the business’s return on income with the performance of similar businesses. TIP Comparing your net and gross margin calculations to those of other businesses within the same industry will provide you with comparative information and may highlight possible scope for improvement in your margins. 15. Achieving Financial Success – an essential guide for small business Management ratios HINT Management ratios monitor how effectively you are managing your working capital, that is, how quickly you Use the number of days for are replacing your stock, how often you are collecting stock, debtors and creditors debts outstanding from customers and how often you are paying your suppliers. These calculations provide to calculate the cash an average that can be used to improve business conversion rate for your performance and measure your business against trading. activities. industry averages. (Refer to Chapter 5 for more detail.) Days inventory = Inventory x 365 Cost of goods sold This ratio reveals how well your stock is being managed. It is important because it will indicate how quickly stock is being replaced. Usually, the more times inventory can be turned in a given operating cycle, the greater the profit. Days debtors = Debtors x 365 Net income This ratio indicates how well the cash from customers is being collected - referred to as accounts receivable. If accounts receivables are excessively slow in being converted to cash, the liquidity of your business will be severely affected. (Accounts receivable is the total outstanding amount owed to you by your customers.) Days creditors = Creditors x 365 Cost of goods sold This ratio indicates how well accounts payable are being managed. If payables are being paid on average before agreed payment terms and/or before debts are being collected, cashflow will be impacted. If payments to suppliers are excessively slow, there is a possibility that the supplier relationships will be damaged. TIP Comparing your management ratio calculations to those of other businesses within the same industry will provide you with comparative information that may highlight possible scope for improvement in your trading activities. 16. Achieving Financial Success – an essential guide for small business Balance sheet ratios HINT These ratios indicate how efficiently your business is Use the return on assets and using assets and equity to make a profit. investment ratios to assess the efficiency of the use of your business resources. Return on assets = Net profit before tax x 100 Total assets This measures how efficiently profits are being generated from the assets employed in the business. The ratio will only have meaning when compared with the ratios of others in similar organisations. A low ratio in comparison with industry averages indicates an inefficient use of business assets. Return on Investment = Net profit before tax x 100 Equity The return on investments (ROI) is perhaps the most important ratio of all as it tells you whether or not all the effort put into the business is, in addition to achieving the strategic objective, returning an appropriate return on the equity generated. TIP These ratios will provide an indication of how effective your investment in the business is. 17. Achieving Financial Success – an essential guide for small business Chapter 3: Budgeting Budgeting is the tool that develops the strategic plans of the business into a financial statement setting out A budget is the future forecasted income, expenses and investments for a given financial plan of the period. Budgets enable you to evaluate and monitor the effectiveness of these strategic plans as they are business. It is where implemented and to adapt the plan where necessary. the strategic plans are translated into Most small businesses operate without large cash reserves financial numbers to to draw on; therefore, budgeting will provide the financial ensure that these information required to assess if your strategic plans will plans are financially support the ongoing operations. In short, budgeting is the process of planning your finances over a period. viable. Budgeting can also provide an opportunity to plan for several years ahead in an effort to identify changing conditions that may impact on the business operations and cause unexpected financial difficulty. Good practice budgeting requires the following: • Preparation of strategic goals • Budgeted timelines that align to the preparation of financial statements • Regular comparison of budgets against actual financial results as disclosed in the financial statements • Scope for amending activities and targets where actual results indicate that budgeted outcomes will not be met In short, budgets are one of the most important financial statements, as they provide information on the future financial performance of the business and, if planned and managed well, will be the central financial statement that allows you to monitor the financial impact of the implementation of your strategic plans. Profit and loss budget HINT A profit and loss budget is an important tool for all businesses because where activities can generate profit, your business will By preparing a profit be less reliant on external funding. The budget is a summary of and loss budget expected income and expenses set against the strategic plans for annually, you will be the budget period. This is usually one year, although, in some in a position to cases, the period can be shorter or longer, depending on what determine if your you are going to use the budget for. future business plans Although your accountant can be of assistance in the preparation will support the of this budget, it is important that you understand how it has been ongoing activities of developed and know how to monitor the outcomes against the your business. prepared budget to ensure your business will achieve the required financial outcomes. 18. Achieving Financial Success – an essential guide for small business Preparing Profit and Loss Budget The key to successful preparation of a profit and loss budget is to undertake the process in an orderly manner, involving all key staff and ensuring the goals of the business are clearly understood prior to the preparation. There are two methods of preparing a profit and loss budget: • Incremental – where the previous year’s activities are used as the basis for preparation • Zero-based – where all the financials are prepared without consideration of past activities. For annual budgeting, the preferred method would be incremental, as zero-based would require an enormous amount of dedicated resources and time to prepare. In the case of project- or activity-based budgets, zero-based may be more suitable, particularly for new projects where there is no previous financial data. An annual budget preparation policy should be documented and followed, and could include some or all of the following steps: 1. Review the approved strategic plan and note all required activities for the budget period 2. Separate activities into existing and new for the new budget period 3. Identify and document all assumptions that have been made for the budget period 4. Review prior year’s profit and loss statements by regular periods (monthly, quarterly etc.) 5. Prepare the profit and loss budget for the selected period using all the steps listed above. TIP An independent profit and loss budget can be developed for separate projects to assess the financial viability of each project Assumptions To ensure your budget will be a useful tool, you need to spend some HINT time planning what you think is going to happen in your business in the future. As you are preparing your estimates on income and expenditure, All assumptions you will be estimating how your business will operate in the future and made during the these are referred to as assumptions. When determining your planning process assumptions, it would be best to use realistic targets that you believe will of preparing be achievable. Using your historic financial information and looking for budgets should any trends in this information is a good place to start. Also, any industry be realistic and information provided by independent reputable companies will give your documented. assumptions credibility. This is particularly useful where you are going to provide your budget to a potential or current lender or investor. 19.

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