Financial Management: Five Key Questions

In today's challenging economic environment, it's more important than ever for entrepreneurs and small business owners to have a firm grasp on financial management.

When all is said and done, there are a handful of financial management questions that every owner should always know the answers to after the business financials have been put in the drawer for the month. Here is my list of the five most important small business financial management questions. Notice that I ask the questions but I don't provide the answers, because none of these are "one answer fits all" questions.

1. How much profit do you really make on each of your 10 largest customers? Why is this question so important? Because the profit you make on those big customers determines in large measure the profitability of your business.

Consider how often they buy, how large their orders are and how quickly they pay. Those are the obvious things, but also consider the special price concessions you might give them in appreciation for their business. Do you extend special services to them in delivery, warranty support or other customer service? Do you extend payment terms or wait longer before you call their Accounts Payable? Do you process special turnaround orders or accept smaller orders than you really want to?

Each of these extras cost your company money or time-both real costs of servicing that account. This is not to say you shouldn't do it, but you should know how profitable that account is in order to make the best decisions for your company. My point: Your largest customer isn't always your most profitable customer.

Are you giving these concessions because you're building a relationship that you hope will pay off "later"? If so, ask these customers if they will be willing to pay you more money tomorrow for something they're paying less money for today. Want to guess their answer to this question?

2. How much does each product you sell really cost you? The fact is, if you lose money on every item you sell, it's really hard to make it up on volume. I am amazed at how many companies figure their all-important Gross Profit on a product by deducting from the selling price only the direct costs of manufacture or purchase. Often this is calculated for an entire department, or even entire factories, rather than for the individual product itself.

Unfortunately, this is rarely the true cost of a product you sell. Consider the costs to receive, package, warehouse and deliver the product. How about servicing the warranty on its performance, or the development cost if it's your proprietary product?

And then there's the overhead cost of running your plant or warehouse. The costs related to having the facility ready and manned for operations range from the lights and extra insurance to the stock pickers' wages, the janitorial service and maintenance contracts on your equipment. If one of your products requires a disproportionate amount of overhead costs, an average overhead calculation for your company as a whole will never give you the right answer. Your most popular item could be a loss leader without your even knowing it.

3. How quickly does your inventory revolve, or turn over, during a year? Funny things happen to inventory that doesn't move out of your warehouse pretty quickly. It disappears, breaks or becomes old, obsolete or generally unusable. Or it just gets misplaced or lost, to be found soon after you've bought more. Or the market price comes down and you have to mark it down to sell it. All of these results take money out of your pocket without giving you any benefit in return.

The first step in preventing all these things from hitting your bottom line is to know how quickly your inventory turns and to note any changes in that rate. This is step number one in preventing inventory losses, to be followed closely by step number two: refining the overall turnover rate to an item-specific turnover rate, at least for high-cost items. Why the detail? Because expensive items that don't move may be hidden by fast moving commodity items on your floor that have much lower margins.

4. How quickly do your receivables get collected? This sounds like a no-brainer to most business owners, but ask yourself this: What is the aver¬age days' sales in your current accounts receivable balance (often called DSO)? Need to look it up? Too often we believe the concept but don't follow the practice. Collections get out of hand without our realizing it, because we're busy selling more and "managing the growth."

Think of it this way: Decide how much interest-free money you are willing to lend to your customers as a percentage of sales, and stick to it. Follow the trend of your DSO and take action when it starts moving in the wrong direction. If strong margin gains are available in return for extending terms, that's OK, but do this deliberately, not accidentally. As a follow-up, watch your accounts receivable aging trends as well, because old balances look the same as new balances in a DSO calculation-and it's statistically proven that the older those balances, the less of them will be collected.

5. If your business does what you expect it to, when will your cash reach its highest and lowest points of the year, and roughly how much cash will that be? Everyone seems to agree they'd like to know these answers in order to better plan for short-term borrowing needs or explore investment opportunities in advance. And yet few small business people believe they can get the answer in any way that's reasonably reliable or cost-effective.

Many CEOs track cash flow by following net income and the bank balance, neither of which is going to be very useful in predicting future cash needs for most businesses. Capital asset purchases; growth in inventory, receivables and payables; debt service; capacity expansion-these can all have a profound influence on future cash balances. The good news is that all can be reasonably predictable with a little work.