Financial failure in the company – how to avoid it

introduction

Business is the foundation of the world economy. Unfortunately, many businesses fail due to financial reasons. In entrepreneurial ventures, the failure rate is extremely high – especially in the early years. This article highlights some of the key factors that need to be addressed in order to minimize the likelihood of financial failure in the business. The discussion takes place under the following headings:

  • financial planning;
  • financial management.

financial planning

Financial planning should be carried out continuously in every company. It should begin with the conception of a new company and continue until the company is closed or merged with another company. However, planning is meaningless if the leadership of a company does not have the necessary business and financial acumen. Management needs to understand the basics – even if the actual financial planning is outsourced. This includes an understanding of financial statements, cash flows and financial ratios. They should know whether the company is making enough profit, whether there is sufficient liquidity and solvency, where potential problems lie and how they can solve them.

Financial planning should include the following activities:

  • sales planning. Without enough sales, no company can survive in the long run. Break-even sales should be known. Sales targets should be realistic and sustain the required growth and profits.
  • credit policy. Credit is usually provided to generate the necessary sales. However, this is done at risk (non-paying debtors) and costs money. It is therefore extremely important to have a proper credit policy that is strictly adhered to. The policy must include what type of person or institution will receive credit, under what circumstances, how much they are entitled to, guarantees that must be in place, the terms of credit, and how payment (and lack thereof) will be handled.
  • pricing. Pricing is a science in itself. Prices that are too high discourage customers, and prices that are too low reduce the profitability of the company. The prices should therefore be competitive. A company’s gross margins are the direct result of pricing. Gross profits are necessary to cover a company’s financial obligations and enable growth. The profitability of different products and services must be analyzed and they should only remain part of the offer if they offer sufficient margins or are of strategic importance.
  • cash flow projections. Several aspects of a business affect its cash flow. Many seemingly healthy companies go bankrupt because of liquidity problems. It is of paramount importance for a company to plan sales and expenses, especially their timing. Money that should be received within 90 days cannot cover current expenses.

financial management

Company finances should be continuously monitored and managed. Problems must be identified and rectified as quickly as possible. Being proactive now can make a big difference later.

Financial aspects of a business that need to be managed include the following:

  • financing. Investments and working capital must be financed. Planning a business and its cash flows should emphasize the need and timing of funding. Financing can be provided by the current shareholders, by selling new shares or by external financing. External financing is expensive and risky for the company. It can lead to a company’s financial downfall if commitments are not met. On the other hand, it can allow for much faster growth. Funding should be part of a company’s broader strategy and appropriate to the company’s risk profile.
  • stock holding. The stock should be at an optimal level. Too little inventory (with regular stock outages) can negatively impact customer relationships and lead to lost sales. Overstocking is expensive and risky (because of obsolescence and theft). Stock levels should be professionally determined and managed (using inventory optimization models that take into account a product’s importance, stock turnover time, and lead times when ordering a product).
  • accounts obtainable. In general, lending is important in today’s economy. However, the difference between debtors paying on average in 30 days versus 60 days can make the difference between success and failure (this is clearly reflected in cash flow projections). Debtors should be analyzed according to their aging and debtors who do not meet their credit terms should be carefully followed up and their credit grants revoked where appropriate.
  • business growth. A company can only grow as fast as it can generate enough money (through profits, investments, or financing) to fund its working capital. Any growth that goes beyond this is not sustainable and will lead to the financial failure of a company in the long term. A company’s sustainable growth rate is determined by a combination of its profitability, efficient use of its assets, financial leverage (ratio of debt to equity) and the earnings retained in the company. This rate should be closely monitored and its various determinants managed effectively.
  • Expenditure. Expenditure items should be budgeted. Significant deviations between actual and planned figures must be explained and their effects filtered into new budgets, cash flows and other financial forecasts. In practice, periods of rapid growth and good economic conditions are dangerous in that there is a tendency to increase spending too much during this period. It can then be difficult to contain spending (particularly salary and wage related) in times of economic downturn.
  • financial circumstances. Proper use of metrics can help management identify problems and take corrective action. It is important to know the profitability, liquidity and solvency of the company, where potential problems lie and how to fix them. The key figure analysis should be carried out monthly (if applicable) and should be compared with other companies in the industry and in particular with planned and historical figures (previous period and previous year’s period).
  • cash flows. Everything that makes a company successful or fails tends to impact cash flow. Cash flows should be checked for potential problems and adjusted monthly. Ignoring cash flows for a few months can easily turn a small problem into something out of control.

summary

This article highlights just a few, but very important issues that need to be planned and managed within an organization to reduce the risk of financial failure. In general, a company’s cash flow is the most important issue to manage. All income and expenses and their actual dates are reflected in a cash flow statement. There is a two-way causal relationship between all aspects (mentioned in this article) and a company’s cash flow.

Copyright © 2008 – Wim Venter