Knowledge Is Power – Understanding Your Finances

We have all seen the global financial crisis (GFC) change the financial landscape and the associated impact that this phenomenon has had on our businesses and on the business of our suppliers and competitors.  Consumer buying patterns have also changed, probably forever.  You should not assume business conditions will return to the levels experienced prior to the GFC.

As such, you can no longer sit back and leave financial decisions to others.  People who are complacent and do not take an active interest in their financial well-being run a real risk of losing their business. Competition is increasing across the board. Business owners who will succeed in this climate are smart and take no prisoners. To take advantage of potential opportunities, it’s more important than ever that financial decisions can be made quickly and with confidence.

Knowledge is power when it comes to understanding your financial statements. From here you can make better, more-informed decisions about your business.  

You need to be able to answer questions like, “Should you employ that additional staff member?  How much will they need to sell per day/hour to cover their costs and make a contribution to your profit?”

There are a number of ways you can do this. For example, if you spell out on paper the reasons and business case behind buying a new piece of equipment or changing a production process, you can calculate whether the savings this strategy will generate make the investment worthwhile – before actually spending the money.

Alternatively, imagine having a discussion with your accountant which actually focuses on the strategic direction of your business, rather than simply asking, “How much money did I make last year?” or “How much tax do I have to pay?”

When it comes to finance, business owners can be split into two groups – ‘passive owners’ and ’active owners’.

Passive owners are those who simply file their financial statements in the bottom drawer.  Their only interest rests with satisfying the tax man and potential shareholders.

Conversely, active owners are those who understand and use their financial statements to identify the strengths and weaknesses in current operations and, more importantly, devise strategies to significantly improve the financial position of the business.  Which owner do you think has the greater chance of success?

Statements you need

There are three financial statements that will be the most help to you in your quest to understand your business better:

1. The Income Statement

The Income Statement tells you how much money your business earned during a given period – normally a financial year (1 July-30 June).  This statement also tells you:

•                      how efficient you are at managing expenses

•                      how many sales you have generated 

•                      how profitable you are

•                      how efficient is your ability to sustain that profit over time

 

By understanding your income statement, you are able to focus on the controllable aspects of your business and set future budgets and other business goals.

By analysing your actual performance against your budget, variances can be identified for closer examination.  You are then in a position to make decisions to correct unsatisfactory performance. Other tools (such as financial-ratio analysis) will also assist in this examination.

2. The Balance Sheet

The Balance Sheet tells you what assets your business has and where the money comes from to pay for those assets.

Assets can in the form of:

•                       cash

•                      plant and equipment

•                       buildings

•                      money that our customers owe us (debtors) Assets are paid for in one of two ways:

•                      your money (equity),

•                      someone else’s money (liabilities)

Understanding the relationship between how much you owe, how much you own, and your current assets helps you plan future operations more effectively.  The better the plan, the more opportunity there is for you to use available assets to develop more sustainable profits.

3. The Cash Flow Statement

The Cash Flow Statement helps you understand how to fund the sales you make, and tracks your cash inflows and outflows for the year. Understanding this statement is critical, as no business can afford to run out of cash.

Even profitable businesses can fail if the owners cannot properly manage the cash flow. Profit and cash flow are not the same thing.  While it is true that in the long term, businesses need profit to fund reinvestment and reward, the owners’ poor short-term cash flow management may mean a supplier refuses to provide the goods and services necessary to keep the business running.

Working capital

You also need to ensure that your business has a sufficient level of working capital. Working capital can be likened to your business’ life-blood.  No working capital means your business may quickly go onto life-support. Working capital funds are used to purchase stock.  This stock is sold to customers who pay the business owner. The business owner then uses the money to buy more stock and the cycle continues. This is known as the ‘working capital cycle’, and understanding this cycle can help secure otherwise tied-up money to build the business. 

Break even point

This leads us to some other financial decisions you may need to make.  For example, business owners must understand how to calculate their ‘break-even’ point. This is the amount of sales required to cover both the fixed and variable costs of your business. Will those additional sales be made at a loss? What is the real cost of doing business?

 

Improving your financial knowledge lets you have better quality discussions with your accountants, lawyers and business advisors.  It gives you the confidence to negotiate with suppliers and customers, knowing the potential financial impacts that your decision-making may have on your future.

No one is born a financial expert. To get a better understanding of your financial position, you can complete further education programs and related courses or speak to your accountant and other business advisors.

Phil Smith is Westpac National Manager, Franchising.  Over the past 20 years, Phil has worked with major banks in Australia, the United Kingdom, South Africa, and the United States. He has also spent time working in the SME sector.

Westpac runs a series of financial education workshops on a wide range of topics including cash flow management and financial decision making.  Details of the next workshop in your area can be provided by your local Westpac Business Banker or found at www.westpac.com.au.

For more information please contact: Phil Smith Phone: 03 9608 4578 Web: www.westpac.com.au