Aspects of Financial Management:WINNING THE CASH FLOW WAR, The Realization Concept

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SME Management (MGT-601)

Lesson 24

All businesses need sound financial management and small firms are no exception to that rule. Proper

management of account s with Performa cash flows, profit and loss accounts and balance sheets are

essential if a firm is to survive and prosper, as is variance analysis comparing what was planned and

with what actually occurred.

Aspects of Financial Management

Winning the Cash Flow War.

Understanding the Nature of Profit.

Breaking Even.

Working Capital Management.

WINNING THE CASH FLOW WAR

Most of the business founders think their problems are over once customer starts to roll in. Unfortunately

they may have only just begun. One of the common characteristic that new and small businesses have in

common is a tendency to change their size and shape quickly. In early weeks and months customers are few

and each customer mean a large percentage increase in sales.

A large increase in sales in turn means an increase in raw material and perhaps more wages and other

expenses. Generally these expenses are to be met before your customer pays up. But until the money comes

in, the business has to find cash to meet its bills. If it cannot find the cash to meet these day to day bills the

business very often goes bankrupt. Bankers have a name for it. They call it over trading. It means taking on

more business than you have the cash to finance. Sales growth is a natural to successful new business as

physical growth is to baby. And just as baby runs out of clothes, new businesses run out of cash. The

following measure will help you to minimize the need for extra cash to finance the sales growth.

Send Bills Out Promptly.

Have a list of debtors, who owe money must be chased up for payment. It is good idea to list the debtors

by age of debt as this shows who owes how much and for how long. Take non-nonsense approach with

them and stop suppliers to people who take too long to pay or threaten to sue.

Check Credit Ratings.

Before taking on a new or big customer have them checked out. If they are blue-chip you may be able to

factor the debt and get up 80% of the cash owed immediately. Alternatively, offer discount for cash and

charge interest on over due amount.

Keep Stock Levels Down.

The chances are that the opening stock will be out of line with customer demand. After all, before the start

companies have to guess what will sell. Once a pattern develops to emerge, order accordingly. Too many

new ventures spend all their cash on opening stock.

Take Credit.

As rule of thumb successful business men and women try to take as much credit as they are giving. So

if their customers take a month to pay, they aim to take a month's credit from their suppliers.

Understanding the Nature of Profit

A significant number of small business firms operate largely on a cash basis. That is, most of their

transactions and income come in either as cheques or in folding notes. While it is certainly very pleasant to;

be able to conduct your business affairs in this way. Cash can often give rise to misleading signals. The

whole problem arises from the difference between accounting definition of Profit and common-sense

definition of cash. Cash and profits are not same thing, even in cash business, and a business need both

cash and profits to survive.

SME Management (MGT-601)

To make matters even more confusing, there are at least three sorts of profit to keep track of. The

fundamental difference between cash and profits can best be explained under the following heading.

a. The Realization Concept.

A particularly prudent sales manager once said that an order was not an order until the customer cheque

had been cleared, had consumed the product, had not died as a result and finally, had shown every

indication of wanting to buy again. In accounting, income is usually recognized as having been earned when

the goods (or services) are dispatched and the invoice sent out, not when an order is receive, or on

assumption of firm order, or expectation of prompt payment.

If it is possible that some of the products dispatched may be returned at some later date. This means that

income and consequently profit can be achieved in one period. And have to be removed later on.

Obviously, if return can be estimated accurately, then an adjustment can be made to income at the time.

b. Cost of Sale.

Obviously the goods which have not yet been dispatched must still be held in stock. A vital calculation is

that of how much stock has been used up over the period. This is calculated by adding the opening stock to

any purchase you have made and taking away the stock that is left to get it right.

Stock used over a period = Opening stock + purchases Ending Stock.

The materials used in business are usually a major element of expense and as such are separated from the

rest of expenses. For a manufacturing company materials are easy to define. For service business the sum is

less obvious, but still necessary.

c. Matching Expenses.

Expense is a general name given to the cost incurred in selling marketing, administrating, distributing and

advertising a company's products or services. Some of these expenses may be for items not yet paid for.

The profit and loss account sets out to "match" income and expenditure to the period in which they were

incurred.

Breaking Even

While a business has difficulty in raising start-up capital paradoxically one of the main reasons small

businesses fail in the early stages is that too much start-up capital used in buying fixed assets. While some

equipment is clearly essential at the start, other purchase can be postponed. This may mean "desirable" and

labour saving devices have to be borrowed or hired for specific period. This is not as nice as having them to

handle all the time. But if the photocopiers, minicomputers, typewriters and even delivery vans are

purchased into business they may become the part of fixed cost. The higher the fixed cost the longer it

usually takes to reach breakeven and then profitability. But small business has to become profitable

relatively quickly or it will simply run out of money and die. Difficulties usually begin when people become

confused by different characteristics of cost.

Fixed cost is a cost which remains fix in total but varies per unit of sales, e.g. rent of the shop or salaries of

employees.

Variable cost is a cost varies in total but remains fixed per unit of sales, e.g. direct material, direct labour.

Here is an example; if rent is $10,000.The angled line running from the top of the fixed costs line is the

variable cost. In this example we plan to buy at $3 per unit. so every unit we sell adds that much to our

assets. Only one element is needed to be calculated is breakeven point. We plan to sell it out at $5 per unit.

So this line is calculated by multiplying the units sold by that price.

The breakeven point is the stage when a business starts to make a profit, when sales revenue begins to

exceed both fixed and variable cost.

Breakeven Point formula

Fixed Costs=Selling PriceUnit Variable Cost

SME Management (MGT-601)

Breakeven Point = Fixed Costs

Selling Price Unit Variable Cost

10,000 = 5,000 units

5-3

Profitable Pricing

To complete the breakeven picture we need to add one further dimension-profit.

It is a mistake to think that profit is an accident of arithmetic calculated at the end of year. It is specific and

quantifiable target that you need at the outset.

Breakeven Profit Point Formula = Fixed Costs + Profit Objective

Selling Price Unit Variable Cost

Let's go back to our previous example. If you expect a return of say $4,000 then

Breakeven Profit Point Formula = 10,000+ 4000 = 7,000units

53

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