Lesson 4: Fundamentals of Finance

Introduction

Entrepreneurs tend to be jacks of all trades responsible for all aspects of the business – including the finances. Many people don’t consider this their area of expertise, so they may attempt to avoid it. While you may be able to wing it with creative things like branding and marketing, it’s not wise to do the same with the trickier financial side of the business.

By tracking your spending, you will see exactly where your money is going and create financial awareness. If you don’t know where your money goes or how you spend it, you won’t know what habits you can change to make that money work for you. Even your small daily expenses can blow your budget. People who become millionaires are aware of the money they make and what they spend. True wealth is built when you spend less than you make – and to do that you need to know what you are spending. If you want to build wealth, you need to stop wasting money.

While we often see some incredible startups entering the entrepreneurial arena, many of them seem to have trouble with a key challenge:  financial management. Finances aren’t nearly as glamorous and exciting as developing an innovative marketing plan or new product, but they are essential! Failure to come to grips with even the most basic elements of financial management can negatively impact your long-term financial strategy as well as your ability to negotiate and set up basic cost structures within the company.

A sound financial management system means keeping a set of books for your business from day one. Regardless of whether you received funds from friends, family, or venture capitalists, you need to know how much of that cash has been used to set up the operations of the business. A rigorous financial management systems allow you to:

1.  Manage proactively rather than reactively

2. Plan ahead for financing needs

3. Provide financial planning information for potential investors or bank loans

4. Make your business processes more efficient and hopefully more profitable

5. Set growth-oriented sales goals

6. Perform tax planning

7. Pricing your services more effectively and thereby improving your gross profit margin

8. Perform sensitivity analysis with the different financial variables involved.

Know your terms

Bottom Line

Net earnings and net income both fall under the “bottom line” description. Any action that may increase or decrease a company’s net earnings or overall profit has an impact on the “bottom line”. It’s also in reference to the location of the number on a company’s income statement (below both revenues – top line – and expenses).  Net Income dictates the minimum amount a startup needs to raise to become profitable.

Gross Margin

Expressed as a percentage, gross margin refers to the total sales revenue that a company keeps after deducting the cost of producing its goods or services. The higher the percentage, the more the company keeps on each monetary value of sales. For example, if a company’s gross margins are 25%, for every Rand of revenue that is generated, the company will retain R0.25 before paying its overheads such as salaries, rent, etc.

Fixed versus Variable Costs

A fixed cost is a cost that does not change with increases or decreases in the volume of goods or services that are produced by your company. These are by far the easiest to predict and plan for and include rent, salaries and any other utilities.

Variable costs are the opposite and are dependent on the type of business you’re running. Variable costs are a lot more difficult to forecast. Unlike fixed costs, which remain constant regardless of output, variable costs are a direct function of production volume. These costs tend to rise when production expands and fall when production contracts. Raw materials, packing or labour directly involved in your business’ manufacturing process are examples of variable costs.

Equity versus Debt

Equity refers to money obtained from investors in exchange for ownership of a company. Debt comes in the form of loans from banks and needs to be repaid over time. Equity and debt are equally necessary for business growth – the only caveat is that investors are not always too keen to invest in a business with too much debt. Before starting out on your entrepreneurial venture, decide whether you’d be happy to enter into an equity or debt agreement – the future of your business might rest on this! Take time to draw up a list of pros and cons, and don’t rush into any decisions.

Leverage

From a financial standpoint, leverage denotes an amount of debt that can be used to finance a company’s assets. As an entrepreneur, you’ll want to strike a very clear balance between your debt and equity. For example, if you have more debt than equity, you’ll be viewed as “highly leveraged”, which is also known as “very risky” to potential investors.

Capital Expenditures (CapEx)

Capex refers to any items purchased by your business that create future benefits. If you purchased something beneficial for your business beyond the taxable year in which you bought it, you can capitalise the items as assets in your accounting. Some examples of these items might include computer equipment, property, or transportation.

Concentration

Concentration is usually defined as a percentage and measures how much business you’re going to do with a specific client or partner. If you rely on one or two clients and partners to do business with, you are demonstrating over-concentration. If something goes wrong with these limited relationships, your business could be in serious trouble.

Financial statements

In finances, you should always be proactive, which is why you need to generate financial statements on a monthly basis. These financial statements need to include:

  • An income statement
  • A balance sheet
  • A cash-flow statement

Let’s look at each of these in turn.

Income statement

An income statement, otherwise known as a P&L (profit and loss statement), shows the company’s revenues and expenses during a particular period and shows how the revenues are transformed into net income. The main components of the income statement are revenues, expenses, gains, and losses.

An  income statement provides critical information about the performance and future direction of your business.  Revenue reported on an income statement is revenue booked during the period the statement covers. In cash accounting, the revenue on the income statement includes all payments received from customers. Money that you earned but have not yet received does not appear on a cash-basis income statement.

Key elements for an income statement include:

  • Sales: The sales figure represents the amount of revenue generated by the business
  • Cost of Goods Sold
  • Gross Profit
  • Operating Expenses
  • Total Expenses
  • Net Income Before Taxes
  • Taxes
  • Net Income

Example of an income statement

Balance sheet

A balance sheet is a financial statement of company assets, liabilities, equity capital, total debt, etc. While a balance sheet can coincide with any date, it is usually prepared at the end of a reporting period (month, quarter or year-end). The balance sheet is organised into three parts:

1. Assets

2. Liabilities

3. Stockholders’/owner’s equity.

Cash flow statement

A cash flow statement refers to the net amount of cash and cash equivalents that are being transferred into and out of a business. A company’s ability to create value for shareholders is determined by its ability to generate positive cash flows.

Key elements for a cash flow statement include:

  • Identifies sources and uses of cash
  • Tracks cash in and out at a time of movement
  • Looks forward to what will happen
  • Ignores “non-cash” item

Example of a cash flow statement

Double-entry bookkeeping

At the centre of financial accounting is a system known as double-entry bookkeeping, or double-entry accounting. Every financial transaction a business makes is recorded using this system. Let’s take a closer look at what “double entry” means.

The term relates to every transaction having an impact on at least two accounts. For example, if your startup borrows R10 000 from a bank, the company’s cash account (any current assets which include currency, coins, checking accounts, and undeposited checks received from customer) increases (is credited), and the company’s notes payable (any amount of principal due on a formal written promise to pay- like a loan from a bank) increases (is debited). In any transaction made, the debit amount must equal the credit amount. The greatest advantage of double-entry accounting is that at any given time, the balance of a company’s asset accounts will equal the balance of its liability and owner’s/shareholder’s equity accounts.

Debiting an account means entering an amount on the left side of the account; crediting an account means entering an amount on the right side of the account.

The following types of accounts increase with a debit:

  • Dividends (Draws)
  • Expenses
  • Assets
  • Losses

Conversely, the following types of accounts are increased with a credit:

  • Gains
  • Revenues
  • Income
  • Liabilities
  • Stockholders’ (Owner’s) Equity

T-accounts are a useful visual aid for seeing the effect of the debit and credit on two (or more) accounts. Let’s take a look at the two T-accounts: Cash and Notes Payable.

Let’s look at an example of these T-accounts being used with two transactions:

On June 1, 2018, a company borrows R10,000 from its bank.

This causes the company’s asset Cash to increase by R10,000 and its liability Notes Payable to increase by the same amount.

To increase the asset Cash, the account needs to be debited. To increase the company’s liability Notes Payable, the account needs to be credited. After entering the debits and credits, the T-accounts look like this:

On June 2, 2018, the company repaid R2,000 of the bank loan. This causes the company’s asset Cash to decrease by R2,000 and its liability Notes Payable to also decrease by R2,000.

To reduce the asset Cash, the account will need to be credited with R2,000. To decrease the liability Notes Payable, that account will need to be debited. The T-accounts now look like this:

Financial modeling

A financial model is a tool built in Excel to forecast the future financial performance of a business. A financial forecast is typically based on the company’s historical performance and involves preparing a balance sheet, an income statement, a cash flow statement, and supporting schedules.

As a startup business, you’ll want to aim for developing something simple that helps you make the right business decisions. Don’t overdo it; the frame of a single spreadsheet should suffice. Straying from a single worksheet might mean you’ve made your model far more complicated than necessary. To get started, consider the four steps below.

Step 1

Start by creating a small section on the spreadsheet for market size. Remember that you can calculate market size in any number of ways, including:

  • How many customers exist
  • What percentage of those customers you are likely to acquire.

You can also work this out by taking an existing market and estimating your potential portion of that market.

Step 2

Next, we need to take a look at the unit economics. Having good unit economics will lay the foundation for a sustainable business.

What are unit economics? Let’s say, for example, that you’re selling jackets, and you have a manufacturer who makes the jackets. You buy the jackets for R100 each. That is your cost. You need to make sure you sell those jackets (the unit) for more than your direct costs.

The next step in your unit economics calculation involves allocating shared overhead costs among those product costs. For example:

  • How many jackets can you sell per employee?
  • How much does each employee cost to your company?
  • Does your business scale well?

You don’t have to go into too many details, but you do need to ensure that your unit economics look relatively healthy after your fixed overhead is applied.

Step 3

If your unit economics look sound, you’ll want to plan what your growth might look like for the next three years. If your business has been profitable (or is likely to be profitable) from day one, then you’re in luck. If not, you’ll need to add in your planned fundraising goals and cash burn to ensure you’re set up for future success.  

Cash burn is the rate at which a company uses up its cash reserves or cash balance.

Step 4

The final step in developing your financial model involves calculating your customer lifetime value (CLV). The calculations are quite simple and are useful for evaluating your business health and potential. CLV can be calculated as follows:

The total revenue you can expect to get from each customer is your average order value divided by one minus the repeat purchase rate.

For example: R50 / ( 1 – 0.1) = R55.56.

Subtract your customer acquisition costs from that, and you get a customer lifetime value of R40.56.

Check out this article on financial modelling.
 


Defining your financial goals

To stay focused, break up your big financial goal into smaller tasks, keep costs low, and keep things simple. How do you break up your big goal of making money? Let’s look at some tips.

1. Awareness

How do you spend your time and energy? What are your goals? Are these aligned? Look at the things you do on a daily basis, your common tasks versus your dreams or your goals. Does this everyday stuff support your big dream? Make sure you understand what your time is worth.

Did you know that about $80 trillion flows through the world every year? That’s approximately $220 billion a day. What are you doing to attract some of this?

If you want to be a millionaire, you need to understand your magic number. How much do you need to be earning per hour to have your dreams come true?

To be a millionaire, you need R521 an hour (R521/hour x 40 hours a week x 48 weeks/year = R1 000 320 a year)/

How do you do this? Dr Peter H Diamandis offers a hint with this quote: “if you want to be a billionaire, help a billion people.”

2. Cash flow

Cash flow should be the ultimate financial priority in your business. Managing your cash is vital to ensure that all your bills are paid on time. Just because your business is profitable doesn’t mean you’re in the clear. A good place to start is a cash flow forecast weekly, monthly and quarterly. You need to keep track of money coming in and money going out.

Dedicate at least one person to actively manage your cash flow, and think critically about your on-hand cash before making any major financial decisions. Put into practice routines that help you stay cash positive – for example, you can delay payments on bills to the last possible day and run credit checks on your customers to avoid non-payment issues.

Have a good budget that is adaptable but also sets limits on your spending. To make a profit, you need to have some understanding of your business finances so that you can:

  • Make predictions about the future
  • Attract customers and deliver goods and services on a larger scale
  • Measure your progress and change direction if necessary.

3. Pricing structure

Let’s look at the pricing of your product or service. Are you a volume-based business or a value-based business? Do you want 100 clients or just 10?

  • volume-based business has a lot more clients, so you will need a bigger staff to support these clients, more marketing, and a bigger infrastructure.
  • value-based business has fewer clients, higher fees, and fewer resources (i.e. staff and infrastructure), and your costs are lower.

The approach you take will determine how you structure your pricing.

Note the difference between the cost of your product, which is a science, and the price of your product, which is an art. Depending on what your product is, costing includes things like transport, storage, manufacturing, insurance, etc. Pricing is what you mark your product as – there isn’t one correct price.  

You often have to balance a delicate trade-off between selling at a high price to improve your margin and selling at a low price to improve your volume. Your competitive edge as a small business lies in your quality, service, and flexibility, so don’t compromise on these.

Take into account that the location of your business and the availability of your product are vitally important – people will pay more for convenience.

Pricing below your competition doesn’t automatically mean increased sales. You will have to negotiate well with your suppliers and have a good marketing strategy. Pricing above your competition generally indicates high-quality exclusivity that usually isn’t available at another location.

Psychological pricing is pricing that customers perceive to be fair. A common method is odd pricing, using amounts that end in 5 or 9. Many people believe that customers tend to round the price of R9.95 down to R9 rather than up to R10.

4. Save smartly

You should use a good savings vehicle such as a money market or unit trust account and invest with the minimum allowable amount. This money will take time to grow, but if you don’t touch it, you won’t have to get into debt in the time of crisis. If you save and invest your money with a monthly automatic transfer starting with a small percentage of your savings, you won’t have to rely on making choices over and over again. Once you’ve started this habit, the opportunity to watch your balance grow will become an addiction. This long-term investing will improve your quality of life experiences by reducing your debt.

Head down to your local bank and get set up with a bank account. This way, you’ll be able to keep all your business expenses separate from personal expenses.

Risk and reward are linked. The greater the risk you take, the higher the potential for return. Warren Buffet is an American Businessman, investor and philanthropist. He is considered by some to be one of the most successful investors in the world. In August 2017, he was recorded as being the second wealthiest person in the United States and the fourth wealthiest in the world, with a total net worth of $76.9 billion. He once said that he made his first investment at age 11, and he wondered why he waited so long.

If you know why money is important to you, you will be clear about what your financial planning decisions should be as you move forward in your business.

Keeping focus on your financial goals

5. Danger zone

The danger zone is when your resources are depleted and you have little backup. Here are a few tips on how to avoid this at all costs:

  • Don’t buy the most expensive car you can afford
  • Don’t apply for all the credit facilities offered to you – they could lead to overspending
  • Don’t go on a spending spree at the end of every month with your new financial freedom
  • Don’t put off starting to save and invest – this will create a bad habit, and breaking it becomes more and more difficult as time goes on
  • Make sound financial decisions about liabilities. Most people will have to buy their first vehicle or property with a loan from the bank
  • Don’t accept the first offer from financial service providers. Get expert advice to assist you with finding the best deal that suits your lifestyle and expectations.

6. Crisis management

What happens when all hell breaks loose? Managing a crisis situation will include effective communication and patience. All management should keep in touch with employees, external clients, and stakeholders. You need to train and involve several people on how you plan to handle each crisis situation and ensure that all information about your plan is accessible. Here are some scenarios that could potentially occur:

  • Your biggest client misses a payment or closes down. Your cash flow is shot. All your future forecasts are affected.
  • You experience technological failure like problems with the internet, corruption in software, or errors in passwords.
  • Employees do not agree with each other and fight amongst themselves. This could result in a strike.
  • Violence and theft in the workplace would result in an organizational crisis.
  • Illegal behaviors such as accepting bribes, frauds, data or information tampering could occur.
  • If you fail to pay creditors, you may have to declare yourself bankrupt.

Keep your team innovative by practicing different scenarios that could potentially occur in any one of these crisis situations. Test your plan. This will prove whether or not your recovery procedures are correct. It also familiarises people with the procedures, which helps them function effectively in a crisis.

7. Attitude of abundance

If your beliefs about money are not serving you well, change them. Create an attitude of abundance. The sayings you’ve grown up hearing, like “Money is the root of all evil” or “Money doesn’t grow on trees” are not true, and they can contribute to false beliefs about money. Many people feel they that they don’t deserve to be rich, and they associate money with greed and corruption. It’s okay to want to earn money!

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