Financial management: The essential third component
Every business needs to make and market a product, or provide and sell a service. One overlooked but necessary discipline in any type of venture is financial management.
Financial management enables business to reach their goals by allowing them to make good decisions about their pricing and how to use their assets. Knowing how to reach profitability will allow for reasonably certain forecasting of growth. Additionally, financial planning enhances new product line development, diversification and how to pay for reaching new markets. Bankers also appreciate reason-based financial forecasting when approached by potential borrowers. One of the necessary financial statements supporting loan requests is the balance sheet.
The balance sheet is a reflection of the assets, liabilities and equity a firm has at a certain point in time. Assets include both current and long-term resources. Current assets are generally those that are either cash or will be converted to cash at some time during the next year, such as product inventory. Along with cash, inventory and accounts receivable (payments from sales) make up the bulk of current assets. Fixed assets are long-term investments and include equipment, real estate and investments. While a piece of equipment may be converted to cash in the next year, it is more likely that a replacement will be needed to allow the business to continue operations and will never actually be an asset that will be cashed in.
Liabilities are also categorized as current and long-term liabilities. Current liabilities are 1) the money you owe to suppliers that are to be paid in a month, called account payables and 2) trade payables which are the payments you make in one year for a longer loan from a supplier. Long-term debt would include real estate mortgages and loans on fixed equipment.
The equity portion of the balance sheet reflects both the initial and additional investments made by the owners that are not attached to any loan, as well as the retained profits held by the company.
Measuring the strength of the business can be determined by calculating financial ratios. Ratios are the relationship between certain values contained on the balance sheet. The term ratio began in the early 1600s and allowed traders to set relative values among and between goods and currency. Bankers also use ratios to compare a firm with others in a similar industry and to look for trends. This trend and comparative analysis is used to indicate an improvement the business has made, a needed adjustment the business needs to make, and the ability of the company to repay loans.
The debt-to-worth ratio gives a straightforward answer of “who is financing the business?” It is determined by dividing the total liabilities by the total equity. A ratio of greater than 1 indicates that lenders are supplying a greater amount of financing than the owners are. This creates caution by potential financiers for future lending. Correspondingly, debt-to-worth ratios of less than 1 means that total assets are more than twice the total debt.
This debt-to-worth ratio is convenient for long-term lenders but two more indicators are needed to give both owners and lenders the real picture of how the business is doing. These ratios are the current and quick ratio.
The current ratio compares the current assets to the current liabilities. Does the firm have assets that can or will be converted to cash in the next year to cover the current liabilities? A ratio greater than 1 in this case is desired. This shows liquidity and that the firm is not using current obligations to finance long term assets. Another term associated with the relationship between current assets and current liabilities is working capital. If the subtraction of the liabilities from the assets gives a positive number this is a positive indicator.
A stricter liquidity indicator is the quick ratio. While similar to the current ratio, inventory is removed from the current assets before the division by the current liabilities is performed. Some call this the close-it-up-tomorrow indicator. Just how liquid is the operation? While a value of 1 could be desired, it is seldom prevalent. The assumption that the company is in business to sell inventory should be a vindication of a low ratio.
The relationships among the various components of the balance sheet do need to be in balance. Financing of long term assets by long term financing (long-term debt and owner equity) reflects well thought out and implemented strategy. Michigan State University Extension educators working with the MSU Product Center assist aspiring and current entrepreneurs understand how the balance sheet reflects business capabilities and weaknesses.