Financial Management Basics

#1 Financial Management

The Issues:

Why is 80% of the wealth typically held by only 20% of the people, and why is this imbalance steadily increasing. Why do some people have to line up for food parcels at Christmas while others spend freely on lavish dinners at top class hotels?  And what do people mean when they describe someone as being ‘good with money’? And anyway, how did they get it in the first place?

Maybe they won lotto, or inherited it, or married it, or stole it!  No, mostly it was none of those.  A good friend of mine who had become significantly wealthy, when dealing with comments from others about his good luck, reflected that it was interesting in retrospect that the harder he had worked, the ‘luckier’ he had become.  ‘Yes’ you might say, ‘but I’ve worked really hard most of my life, and I’m not part of the 20% holding onto most of the wealth!’.  So just hard work is not the full answer.

In other cases people have become wealthy through owning a successful small business that became a successful larger business.  However, business ownership and management are separate and large subjects deserving of a book of their own.  The focus here is restricted to successful management of the finances.

The explanation for good finance outcomes is more straightforward than you may think.  Firstly, income and wealth are measured in well-defined frameworks, and you need to know which numbers in the framework are critical and how you can get them working together to generate the best results from your life’s endeavours.

Secondly, if you get the first part working well then what you do with your money and how you protect it, is even more important in explaining how some people become ‘good with money’ and get to hold on to it, while others don’t.

One other important point to make is ‘the world is not short of money and is in fact awash with it’.  So a starting question relates to the money environment you choose to be in, and the access points to the existing flows of money.  These factors will influence your control of events and therefore have more to do with where you position yourself and your decisions of ‘what countries, what industries, and what businesses’, are in the big money flows.  Think in terms of scarce resources (e.g. start with water, energy, food).

However, let’s get back to the basics.  Measurement frameworks and the key numbers in them.  Financial managers of businesses have lived and breathed these structures and numbers since the merchants of Venice created them in the 14th century, so I guess its ok for us to borrow them now for our purposes of understanding how money gets made in a business, and how wealth is created.

A picture is worth a thousand words is the old saying so we are going to use the picture in Figure 1.below to tell our story.

For any business owner to construct an income statement for a year, they first have to list the money they receive from various sources of income. This will usually be from sales, or commissions, but they may also receive rent from owning property, interest from savings, government benefits and dividends or capital gains from financial investments. All of these when added together will be the starting income (Sales) on the Income Statement below.

Next, the owner has to make a list of all expenses and decide if any of them are directly related to any of the income streams.(e.g.for a manufacturer, if the cost is for materials then the costs will be directly related to product manufacturing costs). Costs of this kind are called Direct Costs as shown in the Income Statement below and separated from all the other non-direct costs or Indirect Costs. This is because Direct Costs rise and fall directly in tandem with changes in the income stream, whereas Indirect Costs are fixed at a constant level, and do not change because of changes in income.  After the Direct Costs have been deducted from the Sales Income we are left with Gross Profit the measure of operational profit. This is a critical number in any business because this is where the money is made to pay the Indirect Costs and Returns to the owner on their investmwent. Deduction of the Indirect Expenses from the gross profit leaves us with the Net Profit.

With both the income and expense sections done, the business owner can complete the income statement, by deducting costs from the income to see the before-tax result.  After paying the tax things now get much more interesting.  What is done with the surplus has a major influence on the ability to generate wealth.

At this stage it is time to introduce the concept of making your money work for you.  If the business owner invests the after-tax surplus in optimal places they can maximise the return on that investment and start growing the wealth using the power of compounding interest rates.

Figure 1. The Basic Financial Structure and 4 Key Points to Improve Performance.


The Financial Position (Balance Sheet) is shown above in Figure 1.  You can see that the report is divided into two sides – Assets that the business owns on one side, and where the Funding for the assets has come from on the other side.  If we put dollar values on each box in the Financial Position model above, we would find that the total value of all the assets would exactly equal the total value of all the funding. (i.e. the Financial Position will always show a perfect balance between total assets and total funding).  This is because the ownership (shown as Equity on the funding side) is part of the funding, and adjusts up or down to keep the two sides always balanced.

Just a quick note on the dotted line that cuts through the Financial Position chart between the current and non-current assets.  Above the dotted line values are constantly changing – current assets and current liabilities are very fluid and highly variable in real time.  That means the amount of equity money needed to fund the short-term assets is also highly variable.  In contrast, the area beneath the dotted line is much more stable and does not change substantially over time.  It follows that the equity money funding long-lived assets, stays tied up over longer times.  The astute financial thinker is always concerned with the return on the equity that is invested in their assets.  Put another way returns up and unproductive assets down is a good formula to pursue.  There is irony in that despite the attraction of having plenty of cash, having surplus cash sitting in the bank creates an unproductive asset and is a waste!

So the Key Point is that retained earnings from the Income Statement should be used (a) to pay down high interest debt first (credit cards, hire purchase and property mortgages), and (b) to invest in a balanced mix of high return assets that represent acceptable risk and the optimal rate of return (bank term deposits, government and bank bonds, shares and property funds).

That’s it – get out of high compound-interest debt, get into high compound-interest bearing investments – then sit back and watch your wealth growth from the passive income streams.

Well – there are a few more tips.  Firstly, to get the best out of your Income and financial Position frameworks here are the eight action steps.  Doing them in concert is better than doing them in isolation, and revisiting them for continuous review and improvement is recommended.

Step 1. Your Value

What you can charge for your efforts needs to reflect value, so focus on changing the market’s perception of your value and work at premium-pricing your service or products to lift sales and profits.  Think creatively and innovate around both the product and the customer experience to maximise your value.

Step 2. Increase Volume

Create innovations in your channels into the market using social media and viral marketing.  Double your market overnight by offering your service or products to new economies, new industries, new customer segments.  Which ones? – follow the money.  Where are the big-money flows? – and get into those. (Note: you might need to invest in education and qualifications to get access)

Step 3. Direct Costs

Reduce Direct Costs. Learn about ‘Lean’ methods and tools in business (see www.managementsupport.com). Redesign your activities and processes to take advantage of eCommerce and save time and cost in everything you do.  Eliminate non-value-adding steps in all your activities.

Step 4. Indirect Costs

Reduce Indirect Costs.  ‘Lean’ methods and tools can help here as well.  Eliminate wasted time and aggregate similar activities together.  Also, don’t forget to engage people in your networks to help you to keep indirect costs down.  (Internet methods for getting things done, have very low indirect costs)

Step 5. Short Term Credit to Customers (Trade Debtors)

Always know who owes you money by producing regular lists – and then contact them frequently to get the cash coming in.

Step 6. Short Term Investments

If you have the ability to make investments in financial assets, Balance Risk against Return in your selection of investments and think carefully about investing in ‘managed funds’ that have the profile that suits your tolerance for risk.  (see ‘Key Point’ above). Short term money is similar to cash because it can be converted back into cash fairly quickly if you need it.  However short-term investments carry lower rates of return so keep them at an appropriate level in your investment mix.  Keep feeding the short-term investments with new free cash from income, but as older investments mature, transfer the gains into longer term investments with better rates of return.

Step 7. Long Lived Assets

For your assets (of land and buildings, vehicles, other machinery and equipment), measure your asset utilisation rates.  Divest non-core assets that are not always necessary to your business, and rent or hire ones that you don’t use often.

Despite the perceived attraction of available capital gains from owning your real estate “It aint necessarily so” to quote the Gershwin classic song.  If the property is carrying a significant mortgage interest cost it will not compare favourably with other kinds of investments – you may be better to sell, rent premises and put the surplus into a higher-end productive assets  Although its mot clear, the point is – avoid making assumptions about potential capital gains, know the full cost of ownership and taxation scenarios.  However, mortgage repayments are a great form of forced saving, and with population growth and increasing demand for property there can be an expectation of rising values that add to your personal wealth from real estate ownership.

For long-term financial investments, feed a constant amount of money in to these regularly from savings or from maturing short-term investments.  Do this regardless of market movements and then leave the money there.  It’s the long-term game that wins, so don’t try to out-guess the market by buying and selling in speculative trading.

 

Step 8. Liabilities

Large unproductive tangible assets funded with high interest debt are the culprits here.  They lock up large amounts of your capital as well as saddling you with the full evil of compounding interest over sometimes a very long term.  They may satisfy your psychological needs for status and style, but think carefully about the wisdom of investing in assets that are not productive, don’t produce a regular return, and that suck up all your available free cash that otherwise could be generating wealth from intangible investments (customer relationships, analysis and elimination of non-value adding activities, total quality management systems, management education of key people in the business)

For a property mortgage the trick is to reduce the total interest cost by setting up the bank accounts so that there is flexibility in the repayment structure.  The first step is to break the mortgage account into two parts – one part on a fixed interest rate and the other part on a floating rate with freedom the repay any amounts at any time.  The terminology may change but common account types offered by banks, embodying flexibility are Offset accounts, Re-drawable accounts, and Revolving Credit accounts.  All of these allow you to reduce the level of money owed on your mortgage and therefore the amount of interest you are paying.  Not all banks offer the same terms and conditions so shop around for the best deal.

 

To conclude, the messages are clear:

Plan for strong income by exploiting your abilities and opportunities to increase the perceived value of what you offer.
Know your business numbers and use them to ‘steer the ship’.
Maximise your savings and invest them where you can get the best return relative to risk.
Pay off high interest debt first before investing in other areas.
For financial assets Invest in a balance of short-term and long-term assets.
Always balance risk and return.  Diversify your investments across low-risk, medium-risk and high-risk funds to get the optimal return on the package of risk-balanced funds.
For all long term financial assets commit the money and leave it there. Then rely on professionally managed funds more than speculative short -term trading on your part.
Negotiate flexibility on your land and building mortgage accounts to allow you to pay off blocks of debt or off-set debt when you have available free cash in other accounts.
Some Blogs Coming in Future Posts

Financial Ratios – The Du Pont Ratio Chart

Internal Monthly Ratio Reports

Improving the 8 key Financial Factors with the Power of 1% Improvements

ABC Analysis on Gross Profit of Each Activity in the Business

Approaches for Managing Uncertainty

Looking After your Health