Three aspects of financial management all entrepreneurs should know

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Date: 16 May 2022

Money going into a piggy bank with stacks of coins next to it

Entrepreneurs generally start their small businesses because they are passionate about an idea, yet at the early stages, it's common for them to not understand the financial realities of the path they've chosen. It's not their fault, either, as CFO skills are usually not taught in schools, aside from specialized programs.

When you're first getting your new venture up and running, it's easy to feel lost and for everything to take longer than you might expect, and this is certainly true when it comes to managing the business's money.

According to a recent financial literacy survey by vcita, 78% of small business owners manage their own finances alone, even though many lack previous experience. Despite, or perhaps because of, this reality, some 59% of these entrepreneurs believe they need a financial advisor. While some may think the best solution is to simply hire someone external to look after the books, the truth is this is a luxury some small businesses can't afford.

These owners might find themselves trapped in a vicious cycle where they lack the information to effectively manage their finances, which then prevents them from having enough cash flow to hire an advisor. Unfortunately, some businesses will shut down because of financial mismanagement before ever reaching the tipping point of solvency.

To help bridge the gap in the meantime, here are three financial concepts that all small business entrepreneurs should be familiar with.

1. Cash flow

Interestingly, vcita's survey showed that 39% of small business owners say they don't understand their cash flow situations, despite it being a fundamental part of keeping a business alive.

At a high level, cash flow is the net amount of cash and cash equivalents being transferred in and out of a company. In order for the owners to pay themselves, their staff and their other bills, they need good cash flow. It's possible for a business to be profitable on paper but to go bankrupt simply because expenses go out faster than billings are paid by clients. In this sense, it's critical to make sure the business has healthy cash flows so that unexpected expenses don't bring it to ruin.

Cash flow can be broken down into three main areas: operating activities, investing activities and financing activities.

  • Operating activities are intuitively the easiest to understand. The inflow is from selling goods and services, while outflow is from salaries, cost of goods sold, rent and so on. Essentially, if the salaries of your staff are greater than the cash you earn from your products then you're in a bad position. Note that monthly revenue is different from monthly operating cash inflows as it depends on when the money is received, not when the order was closed.
  • Investing activities are related to how much was made or lost on activities such as asset purchases or sales, R&D, stocks and share purchases or sales. For instance, businesses that generate a lot of cash might choose to invest in speculative stocks where they could gain or lose money. For most small businesses, this is a risky use of cash, and they could collapse because of a bad investment even if their operating activities are positive.
  • Financing activities are about debt, equity and dividends. If you have a large bank loan out to support your business, you might find that the repayments end up offsetting a prohibitively significant amount of your overall cash inflows each month. This can cause instability in the business, and you might need to try to negotiate better terms.

2. Business credit score

Many people know about their personal credit scores, as they know it will be checked when it comes to taking out a mortgage or applying for a credit card.

Yet according to vcita's survey, 53% of business owners don't know their credit scores. A business credit score is highly important to the survival of a business, as it determines the terms of any credit they are given.

Every business should be aware of their credit score whether times are good or bad. Even a business that seems to be financially healthy can suddenly fall on hard times and need a bank loan. This is especially true in small businesses where the success can fluctuate so easily. A key staff member could leave the business, or a competitor could open up nearby, for instance.

In the worst case scenario, you will be unable to get a loan at all if you haven't been taking care of your credit score. You might be forced to sell part of your business for it to survive. Generally, the interest on debt is cheaper than issuing equity, and you won't have to give up any control of your business, so it's better to not close your business off to credit.

Sound financial principles can help you to maintain a strong credit score. Here are four tips to get you started:

  • Pay your bills promptly.
  • Always have money in your account.
  • Update details with officials as soon as possible.
  • Don't enquire too often about loans.

3. Business taxes

Although most small businesses try to handle their financial books alone, it makes most sense to hire an advisor specifically for taxes, at the very least to get you set up with the right systems. It can be a nightmare to unravel accounts that are in a mess when it comes time for tax returns and other reports. The need for assistance is compounded by vcita's survey showing only 64% of businesses understand their tax return.

Laws can vary heavily between countries, states and even cities within the same state. It's best to understand the specifics of your particular jurisdiction in full. Failure to pay taxes properly can bring your company down because of the huge potential fines. There are 150 kinds of civil penalties in the US Internal Revenue Code alone, so it's not worth playing a guessing game if you want your business to survive.

There are some basics that apply to almost all businesses when it comes to tax books, though. If you follow these tips, then you'll be much less likely to fail:

  • Don't mix personal and business finances. It can be difficult to prove to the tax authorities later on that business expenses are legitimate.
  • Keep track of your receipts throughout the year. If you are ever investigated, this makes the process less painful and builds trust with the authorities.
  • Don't underreport your income. Getting caught isn't worth the risk.
  • Don't underpay estimated taxes on a quarterly basis. The penalties are heavy, so it's better to overestimate a little and for the tax authorities to owe you instead.

Don't forget

Financial literacy is a crucial skill for business owners if they want their businesses to thrive in the long run. The accounting systems are often complex and it's understandable for owners to want to focus on running their business rather than being lost in spreadsheets. Yet at the very least, they should understand these three concepts:

  • Cash flow - Ensure there is always positive cash flow so everyone is paid when expected.
  • Business credit score - Ensure sound financial practices so if needed banks will lend on favourable terms.
  • Business taxes - Keep accurate logs of all financial transactions and don't try to game the system. 

Copyright 2022. Featured post made possible by Jeff Broth.

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