Ask SCORE: The Three Most Important Things Good Finance Can Provid
The Three Most Important Things Good Finance Can Provide
The Basic, Intermediate and Advanced Tools for Success
By Richard Walton, Assistant district Director for SCORE
What are the three most important things that an understanding of organizational finance can provide? The answers do not include providing more money or enabling higher salaries, although these results may occur as a result of successfully managing the 'big three'.
Here they are, in order from the most basic through the intermediate, and finally to the most advanced.
First, Breakeven Analysis. This is the calculation of the point where revenues equal costs and is calculated with three variables. They are fixed costs (rent, salaries, insurance, etc.), variable costs (materials for production, labor, etc.) and product prices, (making the assumption that the firm sells more than one product). The breakeven point is calculated by first deducting variable costs from selling prices to yield the contribution margin (also known as gross profit in accounting speak). The resulting margin (calculated as a profit margin per dollar of sales) is then divided into the fixed costs to yield the amount of revenue needed to break even. Example: Variable costs are .75 Cents of the sales dollar. Fixed costs at $15,000 per month. $15,000 divided by .75 is $20,000. Revenues equal costs when sales are at least $20,000 monthly. Anything above that figure is a profit, anything below it, is a loss, assuming of course that costs remain the same.
This calculation enables the firm to plan to make a profit and thereby stay in business. They either increase revenues or reduce costs, if they are below the breakeven point.
Second, Ratio Budgeting. This is the process by which each cost element is measured against revenue and its percentage of revenue is determined. This is done after the breakeven point is calculated. When revenues decline, management must maintain the ratio through cost reduction is each cost category in order to avoid losing money. Similarly, when revenues rise, the percentages must be maintained in order to produce a profit, since any revenues above breakeven will yield a profit, but only if costs remain in the same percentage relationship with revenues. Rather than look at individual dollar costs when cuts need to be made (as in the case of declining revenues) the real task is to maintain the percentage relationship or ratio of costs to sales in order to avoid losing money. This has been a major concern of financial managers in the recession.
Finally, Goal Directed Cash Flow Management. Cash flow management is normally considered to be attempting to match available income to necessary costs. But in a declining business, this is nearly impossible, and in a business where revenues are rising having extra cash usually means increasing salaries. But Cash Flow Management has to take into account the non operational activities of the firm which include financing and investing. Financing is the management of debt, where investing is the management of assets to produce revenue, such as machinery. Goal Directed Cash Flow Management takes each of these requirements into account in order for the business to successfully manage both its debts and its investments. Each period must include a requirement to set aside revenues for debt reduction if the firm has borrowed money. It is not a sustainable practice to merely account for operating expenses. Finally, investment activities need to be part of cash flow calculations as a means of business growth in the future. Making funds available to replace assets that are wearing out, or to obtain new capital equipment to expand the productive capacity of the firm are essential ingredients of long term sustainability and growth. Without them, the business cannot grow.
The three tools we have presented here, Breakeven Analysis, Ratio Budgeting, and Goal Directed Cash Flow Management are the key financial tools to help businesses grow and prosper, and along the way as an added bonus, these tools will enable a more proactive stance toward borrowing money in that they will show a lender that you can manage your profitability even in a down turn, and also provide the means of paying back a loan.
Mr. Walton teaches Entrepreneurship and Quality Management at Frostburg State University. He is also Assistant District Director for SCORE, Western Maryland, and the President of ERMACORP, a Hagerstown based Management Consulting Firm. He may be reached at 301-462-9850, or by email to Richard@ermacorp.com.