In This Chapter

This chapter provides you with the information you need to master the sometimes foreign-sounding language of finance and take control of the finances of your business.

Relax. It’s easier than you think.

Budgeting is the core financial best practice for small businesses.

Budgets are essential for any business but are especially important for smaller businesses. Of necessity, you’ll be running a tighter ship than larger companies because you’ll have less access to money. That’s why it is essential that you learn how to manage the money you do have with maximum efficiency.

There are, of course, various best practices that support the budgeting process. To plan effectively, you’ll need to develop the following financial documents for your business:

Being able to understand and use all of these documents will enable you to monitor and run your business. Understanding all four is essential if you hope to master budgeting.

Let’s look briefly at the first three documents just mentioned before moving on to budgets.

Balance sheets summarize the assets, liabilities, and equity of your business for a particular period of time using the following formula:

Your assets include cash you receive from your customers, outstanding accounts receivable, inventory (products yet to be sold), and capital assets (such as manufacturing equipment you own). Your liabilities include both short- and long-term liabilities.

Short-term liabilities may include lines of credit you are paying off and money you owe to suppliers (accounts payable); long-term liabilities include loans you have on equipment or machinery, leases on capital equipment or office space, and mortgages on your office building or your manufacturing facility.

Your equity includes any past profits that you have put back into the business and have not spent (such as monies held for future research and development efforts) as well as capital that you or other business owners have invested into the business.

Thus your balance sheet shows what your business owns (assets) and what is owed by your business (liabilities).

Income statements show the revenue you have received and the expenses you have for a given period of time, based on this formula:

Your income statement for a month period may look like this:

Cash flow statements are meant to show you where your money is going and how fast it’s going there. Information from balance sheets and income statements help you to determine your cash flow statement.

Cash flows from three main sources:

Managing cash flow is a big challenge for many small businesses. This is a challenge you must meet. After all, you don’t know how well your business is doing unless you know your cash flow!

When creating a budget, be sure that you cover what is necessary for salaries and investment back in your business. It’s always good to have something tucked away for emergencies or unexpected opportunities that are too good to pass up.

Budgeting enables you to see and respond to important trends in your business. Consider this example: you sell consulting services. You notice your expenses are increasing each month. When you review the budget you created earlier in the year, you notice that your revenue has not changed significantly month after month but that the expenses associated with that revenue—such as the cost of contract consultants and marketing—has increased. In further analysis, you make the following observations:

You need to answer an important question: what is going on with your expenses?

You do some investigating, and here is what you find (actual amounts shown only for illustrative purposes):

This partial table shows you that marketing costs began to increase in June and have held at the higher amount since that time and professional fees (contract consultants) began to increase in July and are holding at the higher amount. Your budgeted amounts look like this:

You are seeing an increase in costs from June to September as follows:

Why have marketing costs changed from what was budgeted in the beginning of the year? Are you doing more marketing than you planned (even though you don’t see an increase in the number of new customers and revenue)? Or has the cost of marketing—such as spending on direct mail campaigns—increased? Has postage increased? Are you mailing to more customers than you assumed in the budget?

Why are your contract consultants charging you more money per day for their time? Was it part of a contract increase that you neglected to include in your budget, or have they increased their rates without telling you?

You’ll need to make some adjustments to your budget for the balance of the year based on your findings and the solutions you develop. Without a budget, you might not even have realized that your expenses were increasing, or, if you did, you might have had a more difficult time determining where the increases were coming from.

A lot of small business owners think of budgeting as a stressful process. Actually, poor budgeting is a stressful process, and not having any budget is perhaps the most stressful financial situation of all.

For example, consider a small convenience store that does not use any budgeting system. Its owners rely on a point of sale (POS) system to keep track of inventory needs, but have no real understanding of cash flow needs or budgeting for certain “busy” times of the year or for future investment. While this may seem to work in a very small business, ultimately it is not sustainable and could actually cause the demise of the business due to poor budgeting and forecasting.

A business that sells training courses could use budgeting techniques to get a better understanding of the cost associated with delivery of each individual training course the business offers and could establish exactly how many seats must be sold to ensure a profit. Without using a budget, this business would be unable to track the success of any training product or shift its strategy to ensure the profitability of a particular program. Such businesses often find out they are in deep trouble, and barely profitable, only when it is too late to fix the problem.

By effectively using money management tools, such as a cash flow statement, income statement, and balance sheet, and monitoring your monthly budget to see trends in your business, you can reduce stress and fatigue—and be in a better position to control your business’s future.

When you understand how cash comes into your business, you are better able to manage your cash flow. For example, if you know that a customer takes, on average, 45 days to pay his invoice, you know you need to have cash available to cover expenses until that payment is made.

Similarly, if you know that you are busiest during certain times of the year, you’ll want to manage your expenses and outlay of money to ensure that you can still meet your commitments during the nonbusy months. Review your cash flow on a regular basis to stay ahead of the game. Remember cash is king, especially in a tight economy.

In Chapter 4, we discussed getting started in your business by creating a budget to cover the first couple of years. As your business gets underway, you have a much firmer grasp on that budget, plus years of historical data. This enables you to develop a trends analysis, which makes the development of the budget easier to manage and more accurate.

When setting revenue goals, the most critical best practice is to be realistic. If you have never brought in $1 million in revenue in previous years, don’t assume you can do so this year! If you want to see an increase in your revenue goals from last year, you need a plan to get there. For example, you can’t assume you will increase your revenue by an additional $100,000 in a new year without increasing expenses such as marketing, sales costs, and development of new product or service offerings that will help you gain that extra revenue.

When setting revenue goals, consider the following:

Conducting a break-even analysis assists you in determining how many sales you need to break even (no net loss or gain) and to begin to make a profit for your business.

By using a simple spreadsheet, you can determine how many sales you need to make of each product and service to offset your variable and fixed costs. This is your break-even point. Once you understand how many sales you need to make to cover all of your expenses, you can then determine how many additional sales are required to begin to make the desired profit for the business.

Let’s look at an example. Assume your break-even analysis shows that for you to cover your expenses you need to sell 25 widgets in a month. If you sell more, you begin to make a profit. You would like a profit of at least $5,000 each month to invest in research and development. To gain this much profit, you will need to sell 100 additional widgets each month. If you do not believe you will be able to sell 125 widgets in a month, you need to find other ways to make your profit of $5,000. This might include reducing your costs of producing widgets by negotiating with suppliers of your material or increasing the price of your widgets in the marketplace.

Determining your profitability requires you to have an understanding of two types of costs for your business: fixed costs (costs that remain the same no matter how much of a product you sell, such as costs for rent for your storefront—these costs must be covered even if you don’t sell anything) and variable costs (costs that change depending on the number of products you sell, such as material costs or sales commissions).

Use this formula for your break-even analysis:

Let’s look at an example using this formula to determine how many units of a product you must sell to cover your fixed costs.

Your business makes handmade photo frames. Your fixed costs are $20,000 a year. Your variable costs total $10 per photo frame. You are considering selling the handmade photo frames for $25 each. Simply plug the numbers into the formula:

Now you know that 1,333 frames must be sold each year before a profit is made.

When setting up an accounting system for your business—regardless of whether it is an off-the-shelf small business accounting software system, a simple spreadsheet, or even a simple ledger book—it is important to ensure it is set up accurately right from the start. For storefronts, a POS system integrated with accounting software is readily available at a reasonable price to help you better track inventory and finances.

Just hiring an accountant is not enough. One of our accountants noted sadly that she has many small business clients who walk in to meet with her around tax time with a shoebox full of receipts, invoices, and cancelled checks, imagining that this is the information needed to complete the taxes for their business for that year.

Her questions to such clients include: Where’s the audit trail? How will you know where your business stands from a cash-flow perspective? You are doing such a poor job of tracking the finances for your business—are you even sure you have been paid for all your work, or all your orders?

Consider purchasing a system that will grow with your business. Don’t start out with a simple spreadsheet now if you know you’ll need a more advanced system in a few years. Starting with the advanced system now provides you growth expansion and continuity in your business. Most systems have modules (additional functionality) you can purchase as needed.

There are two basic ways to track your business’s finances: the cash basis accounting method and accrual basis accounting method.

With cash basis accounting, income and the expenses are recorded when the income is received and the expenses are paid out. With accrual basis accounting, income is reported in the fiscal period in which it was earned regardless of when it is received, and expenses are recorded in the fiscal period in which they occur, whether they are paid at that time or not. The simpler of the two is the cash basis accounting method.

Cash basis accounting is frequently used by smaller firms or by cash-only businesses. For instance, a convenience store owner would likely use cash basis accounting as they mainly deal with cash or credit cards and receive immediate payment.

On the other hand, if you are a project consulting business, you may have longer-term projects for customers, contracts associated with those projects, and invoice payment terms of 30 days. Your costs may be incurred in one fiscal year and not paid until the following fiscal year. In this case, the accrual basis method might give you a more accurate picture of your finances.

There are a variety of reports that help you to manage your business. These include the following:

These reports provide insight into how your business is performing and provides historical data to track progress. Smart business owners regularly review reports on how their business is performing to enable quick course corrections when necessary to get back on track.

Frequent reports on your business’s health may be required by bankers (if you have outstanding loans), investors, and your accountant. Select those reports you need to best manage your particular businesses and the challenges you face.

Dashboards are visual representations of where you are at a particular point in time. They are designed to be easy to read and give you all the information you need to run your business. Components of a dashboard may include the following:

You may have multiple dashboards covering key performance indicators (KPIs) for the different areas of your business such as marketing, sales, finance, and production. Alternatively, you may have one dashboard that displays all of this information.

If dashboards are connected to an enterprise resource planning (ERP) system, you can have access to real-time metrics. You can define KPIs that are pulled from your ERP system to display on the dashboard. For example, you might pull revenue, expense, cash flow, and any other data you want to see to regularly monitor your business. Dashboards are useful for keeping your finger on the pulse of your business.

The term “dashboard” describes any reporting mechanism that presents you with a concise visual summary of your finances or other relevant business information. You might have multiple dashboards for each department in your business, or one dashboard for the overall business. Dashboards can be based on a spreadsheet or accessed as part of an ERP system.

Certainly a key component of your business is receiving money for your products and services in time to make payments to your creditors and suppliers. Delays in getting money in from your customers can cause a cash flow crunch and delay payments, which may cost you more in interest payments and other fees.

It is becoming increasingly common for larger organizations to increase the amount of time before they pay on invoices. Where 30 days may have been the norm at one point, you now see larger organizations pushing that to 45 or even 60 days. This becomes a real problem for smaller businesses that rely on this money to keep cash flow positive.

When setting up accounts with your suppliers and vendors, you want to establish terms of payment that benefit both of you. While you may be tempted to pay suppliers and vendors when you get paid by the customer, it’s unlikely you’ll be able to make this arrangement.

Follow these best practices to ensure an accounts payable system that works for your business:

By keeping this simple system in place, you can track materials received against what was ordered and avoid overpaying your suppliers. Additionally, you’ll easily see those suppliers and vendors with whom you purchase the most and might be able to use this information to negotiate more favorable terms or better pricing when the contract comes up for renewal.

If a supplier provides for a discount for early payment, consider taking advantage of those discounts to save costs if your cash flow allows.

There are many things you can do to help speed the collection process. Having an agreement in place for all of your customers will certainly help; however, you may find that some customers simply will not abide by any agreement.

Consider these best practices:

Have milestone payments. Where appropriate, especially for longer-term consulting engagements, invoice the client in thirds—one third up front, one third in the middle, and the final third due upon completion—or when specific milestones are met on a project. Specify such payment terms in your contracts with customers.

Follow up with customers. If customers are late on a payment, follow up with them immediately about that overdue amount via telephone; don’t let it wait.

Invoice immediately. Invoice customers as quickly as possible. Delaying invoicing only delays payments to you. As a best practice, try to get invoices out to customers within 5 to 10 days of project completion.

Offer early payment discounts. Offer a discount of 2.5 percent to 5 percent for early payment to some or all of your customers. For example, if a customer will pay an invoice within 10 days, give them a 5 percent discount; in 20 days, give them a 2.5 percent discount.

Set up late payment fees. Even though you will be unlikely to get additional money when a customer pays you late, it makes sense to include late payment fee terms should you ever have to go to collections on an account.

Make sure your customer information is accurate. Don’t discount the importance of ensuring that the information on the invoice is accurate. If you need to reference purchase order numbers, make sure the number is correct and reflected on the invoice, and that the “bill to” information is accurate. Too often late payments are the result of inaccurate invoices.

Should you decide to extend credit to your customers, do your homework first. Only extend credit to long-term, good customers of your business. Be sure to check their credit history and ask for references from their other suppliers of credit. Use Dun & Bradstreet (www.dbn.com), Experian (www.Experian.com), or a similar service to check on your customers’ credit history and financial standing.

As part of cost management best practices, businesses should review and manage their costs on a regular basis. Certainly in difficult economic times, cost-cutting measures may become necessary to keep your business moving forward.

Consider these steps to regularly monitor and control your costs:

Review your budget. Compare your actual expenses against your budgeted expenses on at least a monthly basis.

Have processes in place for purchases outside of budgeted items. Go through a formal process before making large purchases that were not previously budgeted for; if there isn’t an ROI tied to the purchase, don’t make the purchase.

Look for efficiencies. There may be efficiencies you can take advantage of that will save costs over the long run for your business.

Ask employees for help. Ask your employees to help keep an eye on expenses along with you. They are on the front line and may see ways to save costs that you haven’t yet seen.

Keep your cash flow statement updated. Keep your cash flow statement updated, and keep an eye on it.

Do the basics. Do the simple stuff—turn off lights that aren’t needed, reduce the air-conditioning setting, turn off computers and other electronics that don’t need to be left on. Small things add up!

Internal cost-cutting options are focused within your business. Here are some suggestions for cutting costs internally:

Manufacturing and production: For manufacturing businesses, consider leasing rather than purchasing equipment, or look into the feasibility of purchasing major pieces of equipment from the used market to save money. Additionally, review your manufacturing processes to look for ways to increase their efficiencies.

Overall process and procedure review: Fine-tuning processes and procedures enables for efficiencies in productivity that save costs. As you make adjustments, you may find that you can get products out the door faster, find ways to customize services for your customer for less cost, and close the deal more quickly with new accounts.

Sales and marketing: By utilizing technologies such as WebEx, Skype, and other web-conferencing software, you may be able to reduce travel costs for your sales team. Consider restructuring sales commissions to reward salespeople more for bringing in new customers or for closing deals over a certain amount of revenue. For marketing, rather than mailing out postcards or brochures to your customers, consider e-mail marketing that routes potential customers to your website, where they can download brochures.

Human resources: As you begin to experience growth, don’t immediately jump to hiring full-time employees. Consider hiring part-time or temporary staff or contractors as a stopgap measure while you determine the need for additional full-time resources. Rather than using a recruiting firm to source new hires, ask your employees for referrals. They know your business better anyway, and you might offer them a referral fee—it will be less costly than hiring a recruiting firm! Consider savings in benefits offered to your employees by reducing the amount you contribute and increasing the contributions from the employees toward health-care costs, or reduce contributions to 401(k) accounts until things improve in your business. You might also ask your employees to take a temporary cut in pay while the business gets back on its feet.

Office supplies: Buy less costly pens and pads of paper, use recycled toner cartridges, and make cuts in your office supplies. While this may seem minimal, it all adds up in the long run.

Electronic banking: Consider using online banking services to make payments to suppliers and send invoices and receive payments from customers. You’ll save on mailing costs.

External cost-cutting measures are focused outside of your business, and there are a variety of options for you to consider here.

Suppliers and vendors: Consider renegotiating with your suppliers and vendors for better terms and lower costs. Consider also sourcing other vendors—a little competition goes a long way toward getting you some concessions from your suppliers.

Shipping: Negotiate for better shipping rates for your products. You may find that by putting all your business with one shipping company you are able to secure better rates. Alternatively, you may choose to pass some of these costs on to your customer.

Health care: Look into alternatives for health-care coverage for your employees. By changing providers or the type of coverage you offer (PPO or HMO), you may find that you are able to provide the same level of service and coverage to your employees but at reduced rates. Look at all your options and consider talking with your local Chamber of Commerce, business associations, or industry groups for lower-cost options.

Internet/telecommunications provider: Consider alternatives to sources for your Internet and phone services. Depending on your need and criticality for “up time” and bandwidth requirements, prices can vary dramatically from one vendor to another. Similarly, check in with your cellular phone service provider to see if they have any lower-cost plans that will work for you.

Printers: Look at your options for printing marketing and sales collateral and business cards. Consider printing your own business cards and brochures.

Leases/rent: Try to renegotiate rental costs, especially during a depressed real estate market. If there are lots of options in your area for space, your landlord may be willing to negotiate with you to reduce your costs.