Chapter 26
Financial Management

IN This Chapter
Financial management basics
Financial ratios
Surviving downturns

Introduction
As the leader of a growing business, you should be able to read financial statements as easily as you’re reading these words. This is the life’s blood of your venture, after all. If you hire sloppy people to do your accounting, you’re in trouble. If you’re using the wrong accounting software, you’re in trouble. But if you don’t know enough about financial management to recognize sloppy accounting and inadequate software, you’re really in trouble!
The best way to avoid these serious errors is to study, understand and practice financial management skills. Even if you get outside help, there’s no substitute for hands-on financial management.
Financial Management Basics
A growing business presents many challenges. The first step in keeping your business afloat is staying on top of budgeting, cash flow management, and sources and uses of funding.
Remember: There’s a financial component to every decision you make in your business. If you’re not getting the right financial information when you need it, or you don’t have the skills you need to interpret it, you have no reliable basis for assessing whether your decisions are wise.
Budgeting
Budgets forecast sales, collections, purchases and expenses in order to anticipate surpluses and deficits over a given period. Although budgets are usually annual, small and growing businesses may need to budget more often to stay on top of changing cost, revenue and sales trends.
The traditional budgeting model is based on revenues from the preceding year. The problem with this is that some expenses—or departments, or processes—may end up snowballing as time goes on.
If last year’s advertising efforts paid off, should you automatically increase your advertising budget this year? Not necessarily. It may be that given your niche and location, the money you spent last year is more than sufficient for this year. Don’t let budget expenditures become mindless traditions.
Zero-based budgeting—which requires you to justify all expenditures for each new period, instead of just looking at amounts in excess of the previous period’s funding—can be a good way of avoiding such mistakes. However, it requires extra paperwork and time, which may be costly.
Review your budgets monthly—or weekly, for crucial or high-risk budgets—and think about what they’re telling you. Are you carrying expenses out of habit? Are your sales goals too low? Should you update your costs to reflect market conditions? Are your variable costs in line with your budget?
Based on what your budget reviews are telling you, you may wish to update your annual budget. Halfway through the year is a common adjustment point, but some businesses adjust their numbers quarterly.
If possible, build some cushioning into your budgets, so you can deal with unforeseen expenses or take advantage of opportunities that come your way.
Cash Flow Management
For growing companies, no skill is more critical than the ability to manage cash. You should analyze your cash flow on a weekly basis. In your first few years of operation, comparing your monthly cash flow statement against actual inflows and outflows can help you assess how well you’ve planned. This is an essential exercise for entrepreneurs who are managing a growing company.
Remember that when sales go up, expenses often follow. Any time expenses are rising faster than sales, you have a problem; look for the cause, and take steps to fix it.
And of course, using the cash flow statement to determine how much capital you need for growth is an absolute must.
…
Max Scheler and Ernie Cassirer had worked for years in graphics software development, and they eventually came to a point where they wanted to put the software they’d made to work for them. They understood the programs and the systems, after all, and they were both skilled graphic artists. Max also had a flair for writing.
They decided to pool their skills and their money, and formed a graphic arts partnership called Diamond Lens. They rented space in a standalone building near a mall in their hometown of Zanesville, Ohio.
Ernie and I already had a pool of clients we knew from freelance jobs. Once we began to advertise, we quickly found that there was plenty of business out there, both individual and corporate.
That whole first year, we couldn’t believe our luck. We were definitely in the right place at the right time. We found outside investors to back our first expansion, and within a couple months we had 15 employees and we were talking about renting a bigger office space.
Everything just kept falling into place like magic. I remember Ernie saying, “I thought this was supposed to be hard.”
…
Sources of Funds
The major sources of business funds are sales revenues, equity capital, debt capital, and proceeds from the sale of assets.
Sales revenues make up the largest part of any company’s financing. Ideally, they’ll cover your expenses and provide a healthy profit margin. However, projected sales figures can’t take market fluctuations into account. Therefore, planning for and minimizing the effects of downturns—seasonal or otherwise— is central to financial management.
Equity capital comes either from a business’s owners or from the sale of ownership shares. As such, it’s appropriate primarily for long-term needs. Meeting short-term financing needs with equity capital shows a dangerous lack of planning.
Debt capital is borrowed money. Obviously, you don’t want to borrow money unless there’s something to be gained. The creation of a good credit rating is a consideration. A line of credit from a lending institution is often the most effective and profitable option.
Sale of assets is appropriate primarily when neither equity nor debt capital is available. For example, you might sell one of your delivery vehicles to buy a new piece of manufacturing equipment. (Obviously, you shouldn’t sell off assets you need to run your business.)
Venture capital is most frequently used by second-stage growth businesses. It’s usually provided by a firm that specializes in loans to ventures it considers promising. Venture capital success is measured in terms of rapid expansion and quickly escalating sales and profits.
Financial Ratios
As we learned earlier, financial ratio analysis measures the health of your business by looking at data from its financial statements.
Financial ratios can tell you a lot about your business’s strengths and weaknesses. They can tell you whether your financial condition is getting better or worse, and help you identify problems before they spiral out of control. They can also tell you whether you’re holding too much or too little inventory, or collecting receivables too slowly.
There are four basic types of ratios:
Liquidity ratios analyze your business’s ability to meet short-term obligations and unexpected debts.
Asset management ratios show how efficiently your company uses its assets to generate sales.
Profitability ratios show your return on sales and capital.
Capital structure ratios show the extent to which your business is financed by debt.
Credit analysts look at liquidity and capital structure ratios to assess a company’s financial risk. Equity analysts are more interested in asset management and profitability ratios, which help them to assess the business’s potential for success.
Benchmarking
A ratio is simply one number divided by another. It becomes meaningful only through careful comparison to pertinent data. Benchmarking is the process of comparing your current data with that of other businesses in your industry, with industry averages, or with your own past or projected data.
Internal ratio analysis compares a present ratio for your business to a past (or expected) ratio for your business in order to see changes over time.
External ratio analysis compares your business’s ratios with those of competing firms, or with industry averages, in order to see whether you’re doing better or worse than average.
If you want to compare your business to other companies, or to industry norms, there are a number of sources:
Trade associations within a specific industry routinely publish pertinent data for and about their members.
Private firms such as Dun & Bradstreet and Standard & Poor’s.
U.S. government agencies offer all sorts of industry data, including ratios.
Of course, comparing your business to someone else’s is not useful unless the comparison is justifiable. For example, suppose ratio analysis tells you that your customers take an average of 22 days to pay. If you sell funnel manifolds for lab filtration, you’re probably in pretty good shape. If you run a corner grocery store, you’re in serious trouble! Understanding what ratios are telling you requires you to understand the norms in your industry for businesses of your type and size.
Liquidity Ratios
Liquidity ratios measure your business’s ability to meet its short-term obligations. Banks typically use them to evaluate loan applications; loan terms often require the borrower to maintain a minimum ratio.
Current ratio
This is the standard measure of a firm’s ability to meet current and short-term obligations. A ratio of 2 is usually healthy; it means your business has $2 of assets (i.e., cash, inventory and accounts receivable) for every $1 of debt. A ratio of 1 or less indicates financial problems, while a ratio above 3 may indicate that you’re not using your capital to its full advantage by investing it in profitable new products, markets or resources. It’s a good idea to analyze your current ratio monthly.
If you need to improve this ratio, you can do so by paying off your liabilities, speeding up your collection of accounts receivable, or using long-term financing instead of cash.
Quick Ratio
The quick ratio is identical to the current ratio, except that it excludes inventory, which is usually a business’s least liquid asset. It should be 1 or higher; the higher it is, the greater your company’s liquidity. Again, a higher number can also mean that you’re not making the most effective use of your assets.
Inventory to net working capital
This ratio shows how much of your funds are tied up in inventory. Keeping track of this ratio is vital to the financial health of your business. If this number is higher than average for your industry, you may be carrying too much inventory.
Fixed Assets to Net Worth
This ratio calculates your percentage of fixed assets compared to total equity. When this percentage rises above 75 percent, it may indicate vulnerability to market fluctuations and unforeseen expenses, because capital is tied up in things like machinery and property instead of being available for everyday needs.
…
As I say, we were very busy that first year. We made a lot of contacts, and we had to juggle a lot of client relationships. Apart from design and writing jobs, we had to come up with promotional materials. And not just brochures and so forth, but also Web content that ranged from weekly designs on Tumblr to a house blog that sort of curated old and new graphics and typography that inspired us.
The online content was surprisingly popular—we regularly got linked by design sites—and it also brought in some jobs. But it was time-consuming, and there was no one to bill for that time. Plus, the interactive nature of those channels meant we had to be engaging all the time with commenters. Some of them were peers and potential clients, and other people were just looking for free advice on design problems. It really took on a life of its own!
To make a long story short, we had to spread ourselves and our money very thin. Ernie was spending a lot of time on the road trying to drum up extra business, meeting with clients in Cleveland, Cincinnati, Pittsburgh, even Chicago. He got some great clients that way, but our hotel, gasoline and restaurant costs were out of control. No matter what sales level we reached, it seemed like our expenses were right behind us and catching up.
“Burn rate” is the pace at which a venture consumes cash. Diamond Lens had a burn rate that was off the charts. On top of the money that was flying out the door for travel expenses, promotions and salaries, they had earmarked almost $75,000 for new office space and equipment.
Still, their rising expenses could easily be covered as long as good jobs kept rolling in. At least, that’s what their optimistic projections told them.
…
Asset Management Ratios
Asset management ratios measure whether your operations are providing the most benefit for the lowest cost. For this reason, they’re sometimes called efficiency ratios.
Inventory turnover ratio
This ratio tells you how often your inventory turns over in the course of a year. Again, inventory is usually the least liquid form of asset, so a high ratio is a sign of business health. That said, a very high ratio may indicate that you’re not keeping enough inventory on hand. This could leave you vulnerable to stockouts and other supply chain problems, as well as to surges in consumer demand. Then again, it may simply mean that you sell perishable or seasonal goods. As always, knowing your industry is integral to interpreting ratios.
Conversely, a low inventory turnover is worrisome because inventory that sits on the shelf costs money without earning revenues. Also, some products may expire or otherwise lose value if they sit for too long.
Improving a low inventory turnover ratio might entail increasing sales, selling off outdated or slow-moving inventory, or keeping less inventory on hand.
If your inventory turnover is high, it may indicate that you need to boost production to meet demand.
To calculate your inventory turnover ratio, add beginning inventory and ending inventory, and divide the sum by two. This will give you your average inventory. Then, divide cost of goods sold by average inventory.
If you can’t figure out your beginning and ending inventory, simply divide net sales by inventory.
Average Collection Period Ratio
This ratio tells you how many days credit customers take to pay their bills. Normally, your average collections period shouldn’t be more than 10 to 15 days longer than your credit terms. If you allow different credit terms for different transactions, calculate the average collection periods separately.
To improve this ratio, it’s usually best to offer an incentive—such as a discount of 2- to 5-percent—for customers who pay early, while also staying on top of collections.
Receivables turnover ratio
This ratio reveals how quickly customers pay you, on average. A high ratio suggests that your credit and collection policies are effective. If it’s much higher than the industry average, overly strict policies may be costing you sales.
If this ratio is below the industry average, your terms or collection policies may be unclear or too lenient, or your customers may be strapped for cash. It could also indicate inefficiencies or errors in your ordering, shipping or invoicing processes. If your customers aren’t receiving goods or invoices on time, they may pay more slowly.
Payables Turnover Ratio
How quickly does your company pay its bills? A high payables turnover ratio means there is a relatively short time between your purchases and payments. If you’re taking advantage of early-payment discounts, this is probably good. However, paying bills well before they’re due can lead to liquidity problems. A low ratio may indicate cash flow problems or poor accounting. Note that your payables turnover ratio should be longer than your receivables turnover ratio.
Working Capital Turnover Ratio
This ratio measures how efficiently you’re using your working capital (i.e., current assets minus current liabilities) to generate sales. A higher ratio is usually positive; however, an unusually high ratio may indicate that your working capital is being stretched too thin and your business is in danger of failing. A lower ratio suggests an inefficient use of working capital.
Average working capital for the year is usually calculated by adding beginning working capital to ending working capital and dividing the sum by two.
Asset Turnover Ratio
This ratio shows the amount of sales you generate for every dollar of assets. A higher number is desirable here, but the appropriate ratio varies by industry and business type. A low ratio may indicate overproduction, poor inventory management or sluggish collections.
This ratio reflects pricing strategy: A low profit margin typically leads to high turnover, while high profit margins lead to low turnover.
Fixed Asset Turnover Ratio
This ratio shows how efficiently your business is using its fixed assets (i.e., property, plant and equipment) to generate sales. When compared to other businesses in your industry, or to your own business in past years, a higher ratio usually indicates efficient use of fixed assets to generate sales.
However, a high ratio can also result from high accumulated depreciation on older fixed assets that may be nearing the end of their useful life. Therefore, it’s often necessary to subtract accumulated depreciation from gross fixed assets before calculating turnover.
A lower ratio indicates that you may have too much money tied up in buildings, machinery or other fixed assets.
Profitability Ratios
These ratios measure the financial performance and growth potential of your business. They’re one of the most important methods of assessing your business’s financial health and measuring its performance, both over time and against competing businesses.
Again, profitability ratios are most useful when compared to current industry ratios and norms. As an example, suppose your profitability declines by 8 percent during an economic downturn. Although this is certainly grounds for concern, it’s important to look at this number in its larger context: How are other businesses in your industry faring? If their average drop in profitability is two or three times higher than yours, you’re in relatively good shape.
When looking at your business’s performance over time, remember to take seasonality into account. If you sell ice cream, it probably won’t make sense to measure winter profits against summer profits. Instead, you’ll want to compare summer profits from one year to the next.
Gross Profit Margin Ratio
This ratio shows the percentage of profit you earn on sales. Gross profit is the amount of sales dollars left after you deduct the cost of goods sold. This ratio should remain stable over time. A higher percentage usually means your business is efficient at using resources and controlling costs. However, it can also indicate overpricing or the use of low-cost, low-quality inputs.
A decline in your gross profit margin may mean that your product costs are rising faster than your prices.
Net Profit Margin Ratio
This ratio tells you how much net profit you generate for each dollar of sales. For example, if your net profit margin is 25 percent, then you will earn 25 cents for each dollar of sales. The higher your net profit margin is, the more effective your company is at converting revenues into profit. If your business is having cash flow problems, calculating your net profit margin can help you set prices that generate an adequate profit. If this ratio declines, it may indicate sluggish sales, an inadequate gross profit margin, poor cost controls or a spike in operating expenses.
Return on Capital Employed Ratio
This is a measure of the profit your company earns from each dollar of equity and debt capital employed. Obviously, this return should always be higher than the cost of capital. The higher it is, the more efficiently your business uses capital to generate profits. However, note that for older companies, the accumulated depreciation of assets may inflate this ratio without reflecting an actual rise in profitability.
To calculate return on capital employed, divide earnings before interest and tax (EBIT) by the difference between total assets and current liabilities.
Return on Assets Ratio
This ratio measures the per-dollar earning power of your assets, compared to those of similar businesses in your industry. A higher return is positive, but appropriate ratios vary considerably by industry. For example, a manufacturing business will have much higher asset requirements than an accountant who works from a home office. A ratio below your industry average may indicate inadequate productivity or poor asset management.
Return on Investment Ratio
This ratio shows you what you’ve earned on your investment in the business during a given accounting period. You can compare this return to potential earnings from the stock market, T-bills, CDs and the like. As an active investment that’s risky and labor-intensive, your business should give you a much better return on investment than passive investments like stocks and bonds.
Capital Structure Ratios
Capital structure ratios measure the degree of financial risk your business faces (or poses, for a lender or investor), based on your level of debt.
Debt to Equity Ratio
This ratio compares what your company owes (debt) to what it owns (equity). If it’s higher than 1, your business owes more than it owns. As an example, a ratio of 2 means that your business owes $2 for every $1 of equity you hold. Lower debt normally means lower risk. But a very low ratio may indicate that a risk-averse business is avoiding opportunities for profitable growth. Healthy debt to equity ratios vary considerably by industry.
If necessary, you can improve this ratio by paying off debt or retaining a higher amount of earnings in the business until after the balance sheet date. Another option is to repay revolving debt (e.g., a line of credit) before the balance sheet date and borrow it again after the balance sheet date.
Debt to Assets Ratio
This ratio reveals the proportion of your company’s assets that are financed with debt. A ratio below 1 means most of your assets are financed through equity. If the ratio is above 1, most of your assets are financed through debt. A rising debt to asset ratio may indicate a serious danger of bankruptcy.
Interest Coverage Ratio
This ratio measures whether profits are sufficient to cover interest payments on outstanding debt. Ideally, it should be above 1.5. A very high ratio may indicate an overly conservative business. A ratio below 1 suggests that a company is not generating enough revenues to cover interest.
Coverage of Fixed Charges Ratio
This ratio measures your firm’s ability to pay lease payments, as well as interest on outstanding debt. Working capital loans often require you to maintain this ratio at a specific level. As with the interest coverage ratio, a low ratio indicates a risk of business failure, and an unusually high ratio indicates risk aversion that may be limiting profitability and growth.
…
While business was good, Diamond Lens got away—more or less—with its less than ideal cash management policies. But when the market started to slump, cash flow problems came to the fore.
Finally, Max took the time to conduct some ratio analyses. He looked at a variety of capital structure, profitability, liquidity, and asset management ratios. He compared them to the previous year’s numbers, and to industry ratios, and they confirmed the sinking feeling he’d had for a while. Their money was going out faster than it was coming in—a lot faster.
There was no getting around it: Diamond Lens was dangerously overextended. Fortunately, Max knew a good accountant from the old days at the software company. He’d be just the person to help them take a hard look at their revenues, assets and expenditures.
When Ernie and I sat down with our accountant, it was scary. We knew it wasn’t an ordinary meeting. This was a sink-or-swim moment for our business and our partnership.
We heard the bad news first: The ratios were right; we were very close to the edge. Getting back on track would not be easy, and success wasn’t guaranteed. But if it mattered enough to us, and we were willing to do the work, we had a shot at pulling out of our nosedive.
It did matter to us. A lot. So we got busy on a plan that afternoon.
…
Surviving Downturns
Here are some basic rules for managing your finances in a shaky market:
Revisit your budget and your business plan. When the economy changes, your plan needs to change with it. Expenses may need to be cut, scaled back or postponed. New markets may need to be abandoned or approached differently. Don’t approach this task in a strictly negative mindset by looking for costs to slash and dreams to abandon. Revising your plans may lead to positive ideas you wouldn’t have thought of in better times.
Don’t stop advertising. When times are tough, the last thing you want to do is reduce your visibility. On the contrary, you need to make customers more aware that you offer great service and exceptional value. Look for low-cost guerilla marketing techniques to keep your business in the public eye.
Innovate. Consumers may welcome new tactics and new approaches during a downturn, not least because they find it inspiring to see someone overcome adversity in a clever way. Since recessions are partly psychological, businesses that present themselves as part of the solution may do better than those that don’t. Also, when the economy is doing badly, journalists tend to look for stories about local businesses that are holding their own. Come up with an interesting promotion and you could find yourself getting lots of free publicity.
Reduce inventory. This can free up space, time and money when you need it most. If you have products that aren’t moving, consider holding a sale or an auction, or returning them to the suppliers. You may also need to consider discontinuing a product line in order to focus on your most profitable products.
Keep your team informed and inspired. They have a vested interest in your success and may be willing to tighten their belt if the alternative is being laid off. They may also have good ideas for cutting costs or boosting sales. If they do stand by you, be sure to reward them when things get back to normal.
Keep an eye on your supply chain. If vendors, customers or partners are having financial problems, it may affect your ability to fill orders or get paid. Consider asking them directly how things stand. Failing that, run a credit report or look them up on Dun & Bradstreet.
Form alliances. Other businesses are also looking for ways to weather the storm. You may be able to cut costs by sharing a space or an ad campaign. Maybe you can split the cost of equipment you both need, or cut costs by exchanging services. A weekly meeting with likeminded business owners could help your morale, and may lead to new opportunities when things improve.
Offer incentives. Special offers, contests, reduced prices, free services and added value can attract customers who are worried about their own finances.
Prioritize overdue bills. Some debts can cause more problems than others. Don’t cut corners by ignoring payroll taxes, property taxes, license fees and other payments to the government. These agencies can impose fines, place a lien on your property, or even shut you down. It’s also wise to keep your lawyer and accountant happy, for obvious reasons.
Keep your creditors informed. If you’re having trouble paying your bills, be honest about the problem. Stay in close contact with creditors, and offer them a realistic payment schedule. Their survival may be at stake too, so look for solutions that will help both businesses.
…
Once we’d worked out a plausible recovery plan with our accountant, the first thing we did was contact our funders to let them know what was going on. They weren’t thrilled. But being able to send them our plan softened the blow.
I’d say the overall mood was cautiously optimistic, which was a lot better than Ernie and I expected. Our fast growth may have caused problems, but it also created a sense that we had real potential if we could just get stabilized. I think that helped us out a lot.
Next, we contacted our clients and made a serious effort to get caught up on receivables. One thing our accountant noticed was that our average payables turnover was totally out of sync with our receivables turnover. So in addition to all our other dumb moves, we’d been sending money out before it came in.
They also contacted their suppliers and negotiated discount terms as customers of long standing (this was something they should have done much earlier).
They gave up on buying new equipment and leased it instead. They streamlined their office operations so that they could postpone moving to a new facility. And Ernie cut his travel expenses by using videoconferencing and content collaboration apps to work with clients. Last, they reduced their content marketing to weekly posts.
It took us four difficult months, but we cut our burn rate in half and got our debts squared away. When business picked up again, we were ready to roll.
The experience made us stronger, but not as strong as we would’ve been if we’d stayed on top of our cash flow from day one. I’m just glad we got a second chance to put first things first.
…
Conclusion
The amount and quality of knowledge you have about your financial situation determines the upward or downward path of your business. Planning for growth, in particular, requires ongoing, accurate financial information.
As an entrepreneur, you need to base your decisions on current, relevant, accurate data. Your commitment to gathering, understanding and using these data will help to ensure that the growth you plan for will become a profitable reality.

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Liquidity Ratios
Current Ratio |  | Balance Sheet
Quick Ratio |  | Balance Sheet
Inventory to Net Working Capital |  | Balance Sheet
Fixed Assets to Net Worth | x 100 | Balance Sheet
Asset Management Ratios
Inventory Turnover
Average Collection Period (in days) | x 365
Receivables Turnover
Payables Turnover | x 365
Working Capital Turnover
Asset Turnover
Fixed Asset Turnover
Profitability Ratios
Gross Profit Margin | x 100 | Income Statement
Net Profit Margin | x 100 | Balance Sheet
Return on Capital Employed | x 100
Return on Assets | x 100
Return on Investment | x 100 | Balance Sheet
Capital Structure Ratios
Debt to Equity | x 100 | Income Statement
Debt to Assets | x 100 | Balance Sheet
Interest Coverage |  | Income Statement
Coverage of Fixed Charges |  | Income Statement
Current Assets
Current Liabilities
Current Assets - Inventory
Current Liabilities
Inventory
Current Assets - Liabilities
Net Fixed Assets
Net Worth
Net Sales
Inventory
Income Statement
Balance Sheet
Accounts Receivable
Annual Sales
Balance Sheet
Income Statement
Net Credit Sales
Average Receivables
Ledger
Balance Sheet
Accounts Payable
Purchases for Year
Balance Sheet
Ledger
Net Sales
Average Working Capital
Net Sales
Total Assets
Net Sales
Fixed Assets
Gross Profit
Revenue
Net Profit
Net Sales
EBIT
Current Assets - Liabilities
Net Income
Total Assets
Net Profit
Net Worth
Total Debt
Total Equity
Total Debt
Total Assets
EBIT
Interest Expense
EBIT + Lease
Interest + Lease

| NxLeveL® TECH TIP BUSINESS RESOURCES AND THE WEB
Online Industry Ratios and Tools The following online ratio sources offers tools and tips that make ratio analysis and benchmarking much easier. You can access these resources through most public libraries. Bizminer is a wide-ranging source of industry ratios and benchmarking tools. They also offer a Micro Firm Profit-Loss Report, which focuses on sole proprietorships and startups.  www.bizminer.com eStatement Studies offers downloadable financial ratio benchmarks for almost 800 industries, based on a database of nearly 300,000 financial statements. The site’s Client Comparison Worksheet is a spreadsheet that you can use to compare your company’s financial data with industry standards. estatementstudies.com FactSheets Express from Mergent Online compiles key industry ratios for more than 10,000 North American companies. www.mergentonline.com