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Sound finance and credit practices and management
are essential to the health of your business.
Finance means the management of money with respect
to operating your business.
Credit means your ability to obtain funds, typically
by borrowing money, from other parties and institutions and the
amount of money (loans or credit) you are willing to extend (lend)
to your customers when they make a purchase.
Cash Flow Cycle. Every business has a cash flow cycle.
This is the period of time and the steps involved in taking cash,
investing it in the business to buy inventory (goods), machinery
and equipment, pay your employees, etc. and then sell your goods
and services to your customers and then collect cash from them,
and so on.
In general, the longer it takes you to collect cash,
the more financial investment you will have to make in your business.
And, to the extent you can collect cash from your customers before
you perform the work or make the good collect deposits or progress
billing/payments the less financial investment you will need to
make in your venture.
Product EFG (an example). Cash management in
some ways becomes a risk management task and risk transference mechanism
between you and your customers. For example, suppose your best customer
Mr. Y asks you to build a special Product EFG. While you routinely
make the generic product E in your day-to-day business operations,
EFG is a unique combination of ingredients and features that make
it useful only to Mr. Y. To manufacture Product EFG requires you
to purchase and design a number of unusual and expensive items.
The nature of these special inputs is that they are only saleable
to Mr. Y (this is called special use property). But the sales price
and profit margin are relatively high so you could significantly
grow your business.
The first thought that probably comes to your mind
is whether you can successfully deliver the product to Mr. Y’s
satisfaction because if you are successful, then you will earn a
significant profit. The next thought that comes to mind may be whether
you can ask Mr. Y to make a down payment to cover the purchase price
(cost) of the unique materials and inputs. Well you decide to ask
Mr. Y, but he gets insulted and he says, “I am your best customer
and I was your first customer when you opened your business. It
was my business that helped you get started and stay in business.
So it is unfair of you to ask me to make a down payment on this
project. I asked you to make Product EFG and of course I will purchase
the product if you build it in accordance with the plans and specifications
(specs) we agree on.
Now, you can step back and decide whether you want
to finance the cost of this product or not. In this example (and
many other real-life situations), you will continually face such
requests and challenges from your customers. And you will have to
assess whether Mr. Y will in fact pay you if you deliver Product
EFG. You might require Mr. Y to give you an authorized, bona fide
purchase order for Product EFG. And you could draft a purchase contract
that obligates Mr. Y to purchase EFG. If Mr. Y signed such an agreement
you might gain comfort that you would collect your money upon delivery
or some period thereafter. Alternatively or in addition to the above,
you could raise your sales price to enable you to earn a return
(interest income or financing cost) on the incremental money you
invested to produce Product EFG.
But, let’s consider one other comment that Mr.
Y made: Product EFG has to meet certain specifications. Specifications
and performance standards typically mean whether a unit of equipment
or a product and perform up to or at certain levels or meets certain
requirements. This may mean a certain yield or efficiency. For example,
suppose you own a machines that produces Chemical Z and that production
requires two inputs: water and raw material H. The yield would be
the amount of Chemical Z produced (the output) for every unit of
H and water you input. The yield the percentage of output might
be 97%, 90%, etc. Then the buyer and seller would test the product
to determine whether the product met the agreed upon yield. Then
the buyer would be obligated to make the agreed upon payment.
This situation is somewhat complex and involved and
yet occurs with many of the customers we work with in helping them
to build their businesses. There is no right answer on whether to
accept the terms of Mr. Y’s request or not. On the one hand,
by delivering Product EFG, you could significantly expand your business,
increase your profits and perhaps learn new avenues and ways to
grow your venture. On the other hand, if you fail or if Mr. Y does
not pay your invoice, then you risk losing a significant amount
of money and timeætime that you could have used to pursue
other projects and new business.
Sources of Money. Every business needs money
to operate, and there are a number of sources where you can obtain
money. These sources include:
- Your savings.
- Credit cards (often a relatively expensive way
to borrow money).
- Secured loans (against property you own such as
securities (stocks, bonds, etc.), your house, car, etc.).
- Loans from friends and relatives (often complex
for other reasons; for example can strain your relationship, or
they may want to govern your business).
- Loans from financial institutions.
- Investments from third party investors
Often, the most practical and reasonable way to get
your business started is to use your own funds. Many entrepreneurs
work with us to obtain loans from the US Small Business Administration
and the Small Business Development Corporation, but there are certain
requirements to obtain such loan funds. One of these requirements
is that the business owner(s) make a significant investment in the
business. And this essentially means that you have to use your own
funds or your friends’ and relatives’ funds to get started.
Credit. Many businesses involve the extension
of credit. In effect, when you grant a customer credit, you lend
them money. Credit means that a customer buys products and services
and agrees to pay you later, perhaps in 30, 60 or 90 days after
the date of purchase. Credit varies by company and industry. It
is important for you to set a sound and specific credit policy.
This should include those types of customers (criteria) to whom
you will extend credit and on what terms. Terms typically include
payment (due) dates, interest rate, penalties for late or non-payment,
and security.
Accounts Receivable and Collection Activities.
Accounts receivable are amounts your customers owe you. These amounts
relate to purchases on credit.
For example, suppose Mr. Y purchases Product EFG and
agrees to pay you in full within 30 days after he purchases EFG.
You have an account receivable from Mr. Y for the purchase price
of EFG. When you extend credit, you will have to make sure you send
out bills (invoices) and perhaps statements on a regular basis.
It is crucial to the survival, let alone the success, of your business
that you carefully monitor your accounts receivable on a daily basis.
And you may have to undertake and pursue collection activities.
These may include calling your customers to request payment, sending
them letters and sending them “past due” notices. Generally,
the longer an accounts receivable is outstanding, the more likely
it is that you will not collect those funds; typical days outstanding
will vary across industries. For most industries, an invoice that
is younger than 30 days from date of purchase is considered to be
“current” but in certain industries where the goods are
perishable (food), the invoice may be due within 7 or 10 days. In
other words, an invoice that is 60 or 90 days old may be considered
current in some industries.
At the beginning of your business life, you may want
to perform all the functions of the business, including finance,
yourself. But if you lack the specific financial expertise it can
be worthwhile to hire a part-time finance person, accountant or
services provider. Small Business Advisors has helped many businesspeople
handle these functions. Personal Budget Planner
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