The Fundamentals of Business – Pt 2

Intro

This post is specifically for those who have been in business for over a year. That may mean you’re still flying solo or you may have built up a team due to the nature or success of your business. No matter what the business looks like, I guarantee that you’ve started developing bad habits. It’s natural. Entrepreneurs tend to gravitate to those practices that they enjoy and are good at. So, the details that they don’t like tend to get swept under the rug until the wind of adverse conditions starts blowing and all the dust chokes them. I am absolutely NOT advocating that business owners spend large amounts of time doing tasks that are not the highest and best uses of their time. That’s why you create leverage and surround yourself with individuals that allow you to do more “on your business” rather than “in your business”. Yet, you absolutely must stay in tune with the basics of your financial foundation and the overall health of the business. Failing to review this information monthly, if not weekly, is setting you up for a major problem in the future.

Surveying the Land

Looking at the path ahead

Since it’s the end of the year, now is a perfect time to take stock of how you and your business performed this year. Did you hit the goals you set? If not, how badly did you miss? If you did reach them, why were you actually successful? In order to set yourself up for long-term success, you must know why you succeed or failed. It’s easy to dig into failures and determine the cause. It’s rare for someone to dig into why they succeed. This truly separates the long-term winners from those that limp along or succeed in spite of themselves. It’s not enough to realize that you sold more, made more, expanded, etc. That’s great. But if you’re not sure why you did, you’re missing opportunities to capitalize on that success, or, more importantly, to realize that it was a fluke. What if you were only successful because the market improved for all? As President JFK once said, “a rising tide lifts all boats”. Don’t get lazy and fail to analyze why you were successful. The reason may surprise you.

It’s also important to take this time to assess if the business is meeting your intended personal goals. More often than not, an individual starts a business for two reasons: 1) to make more money and realize financial freedom and 2) to control their schedule and not have to answer to someone else. Both of these are perfectly legitimate reasons to go into business. I will tell you that reason #1 can be harder to sustain. For that reason, it’s very important to have clear financial goals that allow you to gauge whether being in business is even worth it. This is especially important if you happen to be in a cash flow business which may appear to be profitable because you are flush with cash, yet you’re actually making little to no true profit when you properly account for where that cash must go. Construction related businesses are notorious for this. If you started the business for reason #2, you need to take a step back and determine if you actually were as free as you thought you would be. Running a business can be a cruel task master. It’s easy to go into business so that you can have more flexibility to spend time with family and pursue personal goals, yet you find yourself 100% consumed with the state of the business and whether it’s going to make it. Don’t sacrifice your family at the altar of “a better life”. It’s never worth it. You’ll look back on the missed games, missed dates, missed laughter and despise your company. Especially if it ultimately fails which is a fairly high probability.

The Rat’s Nest

This section will cover the most important balance sheet accounts. If you’ve made it a year or longer in business, it’s critical to stay dialed in to your numbers. This can be akin to unraveling a tightly knotted mess. Surviving simply because you can “kite money around” is a dangerous game and you’re ultimately going to have to pay the piper. That can get you into legal trouble if you’re not careful.

The Balance Sheet

The balance sheet of a business is one of the least appreciated tools for a business owner. It’s also dangerous to overlook. A balance sheet is a snapshot of a business at any point in time, typically the end of the month. Beyond cash and net income, a balance sheet also carries future cash inflows and outflows.

Accounts Receivable

Outside of Accounts Receivable (A/R), there are very few balance sheet accounts more critical to the life of a business. Most businesses run on the accrual method of accounting or don’t deal directly in cash point of sale systems. This means you’re floating your customers on YOUR credit and in order for you to stay in business, you must collect on these customers. Typical payment terms average 30 days, but you can incentive quicker payment with a slight discount for 15 or 20 day terms. You will need to assess what makes sense for your industry. It’s not always 15 or 30 days that really matter, but rather whether a business collects the payment at all. That may sound crazy, but as you attain more customers and move beyond the “every sale counts” phase of your company, you may discover that you have massive leakage from customers that don’t pay in full, pay very late, or don’t pay at all. This account needs to be audited monthly. There are no exceptions to this rule. If you fail to audit this account monthly, you may find that your sales have dried up, yet you’ve been banking on collecting your AR for cash, but there’s really nothing left to collect. Yikes. That’s a terrifying proposition. In performing your audit, retrieve all of your invoices or bills of sale and make sure that whoever you billed is included in your AR. If they’re in your AR, are they late? Can you trace that money into your cash account? If you show them as paid, yet the cash never hit your account, you’ve just been embezzled from. Congratulations. Unfortunately, a slight level of paranoia and distrust must be present at all times when dealing with accounting and cash. As a business grows, it’s very easy to conceal items at the surface level to hide fraud and stealing. Dig deeper and make sure that the sales cycle fully completes. In reviewing your AR, you may find there are customers that you need to cut, have a difficult conversation with, or even praise. Timely paying customers are a major asset to a business. Slow paying customers can be a detriment because you’re basing future expansion and spending on their payment. Don’t be afraid to cut a customer for poor payment. Or, just charge them more. Supply and demand will take care of itself.

Inventory

Similar to AR, this must be audited at least quarterly. For businesses that maintain inventory, this can be a massive area of waste or theft. Unfortunately, inventory can spoil or walk off. Having tight controls over your inventory can save you heaps of money each year. It can also tighten up your cash flow. A growing inventory balance can be dangerous. Your cash is tied up in your inventory. Turning that inventory may take a long time. Don’t allow your inventory to build to unacceptable levels. Additionally, don’t allow your inventory to not properly cycle through your accounting system. This means that a quantity of item A should not hang around for months on end if this is not typical. This may mean that you’ve already sold item A and you’ve overstated your balance sheet. If you can’t locate item A, it’s been stolen or discarded. Keep your inventory balance clean and tight and you’ll run a more profitable, cash flowing business.

Fixed Assets

If you own a building, computers, furniture, or vehicles, you have fixed assets. These are legitimate assets that can be sold. However, they are also declining in value each day that they are used. Some business owners fail to properly depreciate their fixed assets and thus think that their business is worth more than it is. They may say, “hey, we own this building and these 10 cars and these 5 computers, so my business is worth at least $200,000.” That’s faulty thinking. You have to think about what you could achieve upon the sale or liquidation of the business. You’re not going to get $200,000. As a business owner, never consider your fixed assets as something that you can liquidate and take off the table. You’ll be in for a big surprise.

Accounts Payable

Coupled with AR, Accounts Payable (AP) is the life blood of a company. You should conduct a weekly audit of your AP. No exceptions. This is the money that you owe to suppliers, landlords, utility companies, etc. Failing to pay these vendors timely can result in a bad reputation along with less favorable credit terms. As a business owner, the better you manage your credit, the better your cash flow and net income will be. Businesses that pay timely receive lower interest terms, longer payment periods, and can work with vendors if they get into a crunch. Allowing your AP to increase past your AR and cash means that you’re upside down. You’re on a quick path to going out of business. You owe others more than you’re bringing in. This may be typical for a start up, but if you’ve been in business a few years, this is a major warning sign. Your AP is also a perfect area for fraud. Separation of duties is critical. The person putting in the AP needs to be different than the person cutting the check. It would be very easy for vendor Jones Electric and Lighting to be entered as a valid vendor and receive a monthly check. Audit your vendors a few times a year by paying someone hourly to call and verify invoices, addresses, etc. This is the #1 way to catch fraud.

Summary

By performing monthly business reviews, you keep your balance sheet tight and clean. A major problem for companies is allowing their balance sheet to grow by not cleaning up old information or by allowing accounts to languish and get missed. You will massively outperform your peers if you will stay dialed in to the financial metrics of your business. On the next Fundamentals post, we’ll cover analyzing key business metrics and leveraging a business intelligence tool.

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