MGT601 - SME Management - Lecture Handout 24

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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.

  1. 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.
  2. 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.
  3. 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.
  4. 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. 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.

  1. 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.
  2. 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.
  3. 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 Price–Unit Variable Cost
Breakeven Point = Fixed Costs / (Selling Price–Unit Variable Cost)
Breakeven Point = 10,000 / (5-3)
= 5,000 units

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 Objectives

Cost Variable Unit Price Sellin

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

Breakeven Profit Point Formula =



Breakeven Profit Point Formula = 7,000units

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