Assessing Your Needs
Cash Flow Issues
Using Financial Ratios
The Product Life Cycle
Preparing a Strategy
Assessing Your Options
Borrowing from Financial Institutions
Other Sources of Funding
Glossary of Terms
Useful Contacts
Comprehensive financial analysis of your business will enable you to determine what it needs for survival and growth - whether extra funds, new management strategies or both.
Undertaken on a regular basis, comprehensive financial analysis can help you optimise the overall development of your business. It enables you to recognise opportunities, head off problems and gain feedback about the effectiveness of your management decisions.
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A business can develop cash flow problems for various reasons, including:
It is important to identify the reason for your cash flow problem and seek an appropriate solution, rather than just putting more money into your business.
What is the break-even point of your business?
When the sales revenue of your business equals the value of its obligations (both fixed and variable) it is at break-even point. Below that point it is operating at a loss; above, it is making a profit.
Look at your break-even analysis to see if you are trading profitably. Even if your business is operating above break-even, it can experience cash flow problems if a time gap arises between its outgoings and its income. You may have to pay your creditors more quickly than you can collect sales; or money may be locked up in raw materials or unsold goods. As a result, you may need to supplement the working capital of your business.
You can take preventative action to avoid cash flow problems if you use basic financial ratios to monitor your business, understand its cost structure and create cash flow budgets/forecasts.
Temporary cash flow problems can be managed by arranging appropriate short-term finance, eg:
Working capital and the cash cycle
A business earns money from the products and services it sells. It then spends these earnings on acquiring the inputs to create further products and services. The flow of cash varies at different points in the cycle. First a business needs to invest cash to acquire inputs; then it needs to sell its products and services to realise enough cash to cover the investment and make a return to the owners of the business.
Financial ratios are valuable tools for understanding and monitoring the performance of your business. They can help you manage more effectively by encouraging you to focus on operational aspects that are impacting financial performance. Different financial ratios are used for different management purposes. Some of the most common are shown here.
Profit margin: a measure of the effectiveness of your marketing; the ability of your business to earn a profit on every sale.
Asset turnover: a measure of the operational effectiveness of your business; how well assets are deployed to achieve sales. Assets include plant, machinery, stock, raw materials and accounts receivable.
Financial leverage: a measure of how effectively your business uses debt to boost return on equity or net assets.
Always interpret financial ratios in context - eg by comparing with historical records, business goals and strategies, industry norms and economic conditions:
Regular analysis of financial ratios can reveal trends that indicate the need for management action:
Understanding the four stages of the product life cycle can help you interpret changes in the financial ratios of your business.
Your business is likely to have an evolving portfolio of products, each at a different stage of the cycle. Nonetheless this concept offers some useful guidance.
Stage
Typical effect on financial ratios
Start-up
Growth
Maturity
Decline
If after careful analysis you have decided to seek extra finance for your business, you need to:
Pro forma cash flow budget/forecast
To prove that your business represents a worthwhile investment, you will need to present your situation and strategic response as clearly and convincingly as possible.
Setting out the facts in this way will give you added confidence in your actions and decisions. It also prepares you to identify and successfully target a potential investor. Investors need to know how you will use the money that they are being asked to put into your business.
Typically, growth will require an increase in working capital and investment in fixed assets. Working capital needs are usually met by an increase in short-term debt (eg an overdraft), while needs for investment in fixed assets are met by long-term debt and/or equity.
Short-term trading difficulties arising from changed economic conditions or from losing ground to competitors should be met by an appropriate strategic response - for example, by cutting costs, developing products or undertaking business development activities. Funds can be sought specifically to carry out such strategic actions.
Financing Strategies
There are two basic types of finance: debt and equity. There are also a number of strategies to raise finance that go beyond these approaches, including:
Debt or Equity Funding?
Debt and equity funding are each appropriate to different business needs and have very different implications.
Debt funding
Debt financing is appropriate when funds are required to finance a specific asset and you are confident that the cash flow in the business will allow you to service the loan. Debt is useful to leverage returns from your business and helps multiply the return on your equity investment in the business. Generally, you should match the term of a debt to the expected life of the asset being financed. Working capital should be financed by overdrafts or other short-term debt, while the purchase of fixed assets should be financed by appropriate term loans.
Before agreeing to lend money to your business, an investor or institution needs to be convinced that the business will be able to make interest payments on time and repay the capital on maturity.
Debt agreements cover such issues as the interest rate; how interest is to be calculated; the frequency of repayments; and the term of the loan. Other conditions in a debt agreement may include limitations on dividend payout ratio and the maintenance of current and other financial ratios. If the agreement is breached the loan and interest may become payable in full immediately.