We are often asked – “what key financial measures should I constantly monitor to run a stable business and avoid unexpected losses?” In this article, we will be briefly discussing the answer to this question.
What is the required minimum information to control the financial aspects of a business?
Often company’s owners and managers, who have no financial background, make a mistake by assuming that it is sufficient to monitor cash balance at the end of each business day. They assume that if their company has cash available on its bank account, this means that all is good. Often, this is a huge mistake. In our practice, we often encounter companies that ran into financial problems or even went bankrupt.
In order to avoid financial problems, company’s manager needs to monitor at least the following three fundamental factors:
Monitoring company’s profitability
Company’s manager needs to review and analyze monthly income statement. The statement shows manager the financial result and answers the fundamental question – did the company have a profit or loss in a given month? Let’s assume that the company had a loss of 1,000 GEL. This means that compared to previous month, either company’s liabilities increased by 1,000 GEL or company’s assets decreased by 1,000 GEL (or some combination of the two), which caused the company’s equity (assets minus liabilities) to decrease by 1,000 GEL. If a company has a loss over the period of consecutive months, this means that it accumulates liabilities, depletes assets or both. If this situation persists, equity will continue to constantly decrease, and the company will eventually go bankrupt.
Often company’s owners of managers make mistake by assuming that cash inflow is similar to profitability. Let us give you an example from our own experience: one of the companies operated on a loss over the extended period of consecutive months. However, due to specific nature of its business, the company collected advances from clients on not yet fulfilled orders. Such advances grew significantly along with the growth in the number of orders, leading to accumulation of cash on the company’s bank account. Cash balance of the company grew by approximately 20,000 GEL on a monthly basis and the accumulated cash
balance was quite significant. The company’s owner assumed that the business was profitable. He was not monitoring the income statement. However, until the orders are not fulfilled, advances received from clients do not represent revenues and do not participate in the calculation of company’s profitability. Ultimately, when company got to fulfill the orders, it turned out that material expenses and salary costs needed to fulfill those orders far exceeded the accumulated cash balances. The company’s owners had to inject additional cash in the company to discharge the liabilities. In around one year, the company went bankrupt.
Monitoring debtors and creditors
Manager should constantly monitor company’s assets and liabilities in order to analyze the amounts receivable and payable. If the amounts receivable are much smaller than amounts payable and the difference gets larger over the extended period of time, ceteris paribus, this means that company’s cash balance grows not as a result of profitability, but as a result of liability accumulation. As described in the above example, accumulation of cash balance is not a guarantee of company’s profitability. In our example, if the company had monitored debtors and creditors, it would see that despite the fast cash accumulation, liability was accumulating even faster and discharging those liabilities would have led to significant financial difficulties.
Monitoring cash flows
There is another extreme – when manager only monitors income statement and does not monitor cash flows. It should be noted that in Georgia’s reality this case is less prevalent. Nevertheless, ignoring the cash flows and respective forecasts may lead to company’s bankruptcy. For example, if a company has a contract that brings significant revenues, however the company is unable to collect cash from client/debtor, the revenues represent “paper” income and do not convert to cash. This situation may lead to company’s bankruptcy because it must pay salaries and other expenses, while, on the other hand, client has significant overdues or even does not pay at all. It is important to forecast cash flows, at a minimum, several months ahead. Namely, company’s managers shall plan expenses that a company will have to pay in the coming months and then shall plan cash inflows from clients. After this, manager shall match cash inflows and outflows and determine whether inflows are sufficient. This process can give company an opportunity to forecast any financial difficulties several months ahead and take actions to avoid them.
Based on our experience, if a company at a minimum monitors profitability, cash flows, debtors and creditors, it has strong grounds to avoid financial difficulties or at least foresee and prepare for them.