Thursday, 16 October 2014

Billy's Thirty-Third Law Transition Three: Finance goes from Internal to External and From Income Statement focused to Balance Sheet focused

When my accountant reviews my year end statements with me, all I see are dancing cows!

Finance for most entrepreneurs is difficult.  Most entrepreneurs' strengths are in the areas of Marketing or Operations and they have to pick up Finance as they go.  There are two transitions in growing businesses of which owners must be aware.  They are internal to external and income statement to balance sheet.

Internal to External

When you start a business, the financial focus is on the internal needs of the financial statements.  Most people simply want to know if the business is profitable.  Sometimes, it is helpful to have an idea of who owes you money, however; it is amazing how many business owners know exactly who owes them how much at any given time. 

That is the first challenge as a business grows.  The entrepreneur who kept track of things in his or her head is now in a situation where he or she cannot possibly keep track of these vast amounts of information.  Keeping track of five customers is one thing...keeping track of twenty is quite another. 

Financial systems develop to keep track of the internal needs of the business.  They usually begin for tax and compliance reasons, and morph to management information reasons.  (OK Sometimes they don't...Some owners only do bookkeeping for tax reasons, but I again digress.)

As a business grows, it often needs outside financing.  This is usually from banks, however; it can also come from investors.  Now the financial systems must serve the needs of the outside user. This often means that the bookkeeper must now take on more complex financial tasks.  Secondly, businesses may consider financial forecasting as a part of controlling their business during growing times.  Forecasting, both cash flow and revenue & expense forecasts, are an important tool for any business, but are essential for a growing business.  The forecasts are required for business loans and for potential investors.  Checking your plan vs. actual is an essential part of financial managements, yet few smaller businesses have formal forecasting or budgeting sessions.  Get into the habit of forecasting annually and monitoring monthly!

Income Statement to Balance Sheet

The second transition is managing the balance sheet.  Most people intuitively understand the income statement...the revenue less expenses for the business for a period such as a month, quarter or year.  The balance sheet has two critical pieces of information.  Assets, the things the business owns, Liabilities, debts a business owes, and Equity, the owners stake in the company.  Simply put Assets are the 'tools' and Liabilities & Equity represent how the business financed those assets.  That is why Assets = Liabilities + Equity...also known as the balance sheet equation.

Now this has important implications for a growing business.  If the business is growing (revenue growth) then the business needs additional tools.  It may have higher accounts receivable, as more money is outstanding due to increased sales. You may need more inventory to support the growing sales.  You may need to purchase new equipment or add additional outlets.  All of these represent increases in your assets. 

We know that all assets are financed.  The question is, "What is the source of the additional funding?"  This can only come from two sources, debt (borrowing) or equity (usually retained earnings.)

If your change in asset growth is greater than your change in profit / retained earnings growth, then you are going to finance a disproportionate aspect of your business with debt.  This is unsustainable in the end, and your business may well hit a ceiling preventing your business from growth or causing a severe cash flow problem. 

This is complex, so I developed a tool to help.  It allows you to calculate the change in working capital required for every dollar in sales growth.  If you would like a copy of this spread sheet, which I have bundled in a work book called 'Dr. Profit's Took Kit just send me a comment and an email address and I will send you a copy.  Don't worry, it is free and there are no strings attached. 

Finance is hard.  If you don't get it, or don't want to get it, please seek advice.  Your accountant is a good starting point.  Take courses from your local business development centre or your local colleges' Continuing Education department.  Your investment in finance is valuable, especially as you grow and develop your business 

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