The Principles of Good Financial Management

If there’s an upside to any economic downturn, it’s that it can force owners to refocus on the fundamentals of their business, basic tenets like delivering quality products and great customer service.

Quality financial management can help a business adhere to these fundamentals.

Tough economic times also prompt business owners to take a hard look at how they’re handling their finances. Is inventory being managed efficiently? Are receivable turns stretching out too far? Is monthly cash flow positive or negative? Where is money being spent wastefully? Is debt getting out of hand? These are core financial management questions that every business owner must address.

When times get tough and sales start slowing down, most companies find it beneficial to go back to the basics of sound financial management. Here are five key areas you should examine.

Keep a Close Eye on Inventory

Think of poorly managed inventory as a pool of trapped cash that you can see but can’t get your hands on. Excess inventory ties up cash in the form of goods sitting on your shelves, as well as money spent on storage space, insurance, and other overhead. The cost of carrying excess inventory can be as high as 30 percent of the value of the inventory per year when you factor in storage and handling costs, obsolescence, and damage.

Make a commitment to scrutinizing your inventory. When you view excess inventory as cash sitting on your shelves, it looks a whole lot different. It’s especially important to monitor your inventory turnover ratio, which is a measure of how often your inventory turns over in the course of a year. To calculate it, divide your average inventory value by the cost of goods sold.

Speed Up Your Accounts Receivable Collections

Collecting accounts receivable promptly should always be a priority, but it’s especially important during a slow economy, when everyone is holding on to their money a little longer. Try to avoid the domino effect of delayed payments: Your customers are getting paid more slowly, so they pay you more slowly. Before you know it, your cash flow has slowed to a trickle.

To stay on top of collections, examine the current status of your receivables. This means you need to create and maintain an accounts receivable aging report to track the payment status of all your customers. An aging report will categorize customers by their status, such as current, 0 to 30 days, 30 to 60 days, 60 to 90 days, and past 90 days. Your aging report should also indicate how much each customer currently owes so you can prioritize your collection efforts.

It’s also important to establish credit files on all those customers with whom you work on open-account terms. Their credit should be monitored on an ongoing basis and their files updated regularly to reflect their current credit status, which can change quickly and without warning during a volatile economic climate.

Cash Flow vs. Profit

Many business owners don’t understand the fundamental difference between cash flow and profit. Cash flow is the actual cash (or checks) collected by your business each month and deposited in your bank account. Profit is the cash that you get to keep after you’ve paid all the expenses incurred in the manufacture and delivery of your product or service.

The Principles of Good Financial Management

Companies that collect cash at or near the point of sale sometimes find themselves cash flush. Restaurants are a good example of this type of business. They usually receive cash from customers before they leave the restaurant or, at the latest, from the credit card processor a day or two later. But expenses must be paid out of this cash, everything from rent and utilities to labor and ingredients. Understanding the difference between cash flow and profit is a sound financial management technique any business owner should be aware of.

Conversely, lots of other companies don’t collect their cash until 30, 60, or 90 days or more after they’ve delivered a product or service. While these companies may look at their operating statements and see a nice profit, they’re out on a limb until they receive that cash.

Ways to Cut Expenses

Cost-cutting has taken on new urgency at most businesses as owners and managers look high and low for ways to shave expenses. Here are a few ideas.

• Talk to your vendors about ways that they can help you save money. Remind them that your success contributes to their success.
• Try to renegotiate your office lease with your landlord. It’s a tenant’s market in many regions of the country today.
• Scrutinize travel and entertainment expenses and pare them back when possible.
• Reexamine subscriptions to publications and memberships in trade and industry associations to make sure they’re worth the cost.
• Raise your insurance deductibles, which can immediately cut your auto and property insurance premiums by 10 percent or more.

Get a Handle on Debt

Financial ratios can help you determine how much debt your company should be able to handle comfortably. One primary debt ratio is what’s known as your debt-service coverage ratio. The calculation is net income plus amortization/depreciation plus other noncash and discretionary items divided by principle, interest, and lease repayments.

In general, lenders prefer that a company’s debt-service coverage ratio not exceed 1-to-25. One alternative for companies with a high ratio is factoring, whereby they sell their outstanding accounts receivable to a commercial finance company at a discount of generally 2 percent to 5 percent. In return, the business gets cash right away instead of waiting 30, 60, or 90 days or more. Factoring companies also perform credit checks and analyze credit reports to uncover bad risks and set appropriate credit limits.

It's always a good idea to refocus on sound financial management, regardless of the state of the economy. These five key areas are a good place to start.