Financial failure in business: how to avoid it

Introduction

Business is the foundation of the world economy. Unfortunately, many businesses fail due to financial reasons. In entrepreneurial ventures, the failure rate is extremely high, especially in the early years. This article highlights some of the key factors that need to be addressed to minimize the likelihood of financial failure in business. The discussion takes place under the following headings:

  • Financial planning;
  • Financial management.

Financial planning

Financial planning must be done continuously in any business. It should start with the conception of a new company and continue until the business is closed or merged with another business. However, planning is meaningless if the management of a company does not have the necessary business and financial acumen. Management needs to understand the basics, even if the actual financial planning is outsourced. This includes an understanding of financial statements, cash flows, and financial ratios. They need to know if the company is making enough profits, if there is enough liquidity and solvency, where the potential problems are and how they can solve them.

Financial planning should include the following activities:

  • Sales planning. Without sufficient turnover, no business can survive in the long term. Breakeven sales must be known. Sales goals must be realistic and support the required growth and profits.
  • CREDIT Policy. Credit is generally provided to achieve required sales. However, this is done at risk (of non-paying debtors) and costs money. Therefore, it is extremely important to have a proper credit policy that is strictly adhered to. The policy should include what types of people or institutions will obtain credit, under what circumstances, how much they will qualify for, the collateral that must be in place, the terms of the credit, and how repayment (and lack thereof) will be handled.
  • Prices. Pricing is a science in its own right. Prices that are too high deter customers and prices that are too low reduce the profitability of the business. Therefore, prices must be competitive. The gross margins of a business are a direct result of pricing. Gross profits are necessary to cover a company’s financial obligations and allow for growth. Different products and services need to be analyzed for profitability and should only be kept as part of the offering if they provide sufficient margins or are of strategic importance.
  • Cash flow projections. Various aspects of a business impact your cash flow. Many seemingly healthy businesses go bankrupt due to cash flow problems. It is of the utmost importance for a company to plan sales and expenses and, especially, their timing. The money that must be received in 90 days cannot pay the current expenses.

Financial management

Business finances must be continuously monitored and managed. Problems should be identified and corrected as soon as possible. Being proactive now can make a big difference later.

The financial aspects of a business, which needs to be managed, include the following:

  • Money. It is necessary to finance capital expenditures and working capital. Planning for a business and its cash flows should highlight the need and timing of financing. Financing can be done through current shareholders, through the sale of new shares or through external financing. External financing is expensive and risky for the business. It can cause a company’s financial downfall when commitments are not met. On the other hand, it can allow for much faster growth. Financing should be part of a company’s broader strategy and in line with the business’s risk profile.
  • Holding of shares. Inventory must be at optimal levels. Carrying too little stock (with regular outages) can have negative effects on customer relationships and slow down turnover. Too much stock ownership is costly and risky (due to obsolescence and theft). Inventory levels should be professionally determined and managed (using inventory optimization models that take into account the importance of a product, stock turnaround time, and lead times when ordering a product).
  • Accounts receivable. In general, it is important to provide credit in today’s economy. The difference in debtors paying on average after 30 or 60 days can, however, make the difference between success and failure (this is clearly reflected in the cash flow projections). Debtors must be analyzed according to their age and debtors who do not meet their credit terms must be diligently followed up and, where appropriate, their credit provisions revoked.
  • Business growth. A business can only grow as fast as it can generate enough money (through profits, investments, or financing) to finance its working capital. Growth above this is not sustainable and, in the long run, will lead to the financial failure of a company. A company’s sustainable growth rate is determined by a combination of its profitability, efficient utilization of its assets, financial leverage (debt-to-equity ratio), and retained earnings remaining in the business. This rate needs to be closely monitored and its various determinants need to be managed effectively.
  • bills Expense items must be budgeted. Substantial deviations from the real vs. budgeted figures need to be explained and their effects filtered into new budgets, cash flows and other financial projections. In practice, times of rapid growth and good economic conditions are dangerous in the sense that there is a tendency to increase spending too much during this time. So it can be difficult to control expenses (especially those related to wages and salaries) in times of economic downturn.
  • Financial coefficients. Proper use of ratios can help management identify problems and take corrective action. It is important to know the profitability, liquidity and solvency of the company, to know where the possible problems are and then how to correct them. Ratio analysis should be done monthly (if applicable) and should be compared to other companies in the industry and especially to specific and past figures (previous period and same period last year).
  • Cash flow. Everything in the success or failure of a business has a tendency to impact cash flow. Cash flows should be examined for potential problems and should be adjusted monthly. By ignoring cash flows for a few months, a small problem can easily spiral out of control.

Resume

This article highlights just a few, but very important, issues that need to be planned for and managed within a business to lower the risk of financial failure. In general, the most important issue to manage is the cash flow of a company. All income and expenses and their actual times are reflected in a statement of cash flows. There is a causal relationship in both directions between all the aspects (which are mentioned in this article) and the cash flow of a company.

Copyright© 2008 – Wim Venter

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