Starting a business can be an exciting time. For many of us, that first taste of entrepreneurial spirit can manifest in something as small as a lemonade stall or a lolly drive, the exchange of coins, that rush of being able to serve a customer, then wondering what to spend the profits on. More lollies.
For many adults, starting a business represents an opportunity to escape the daily grind of working for someone else. All of a sudden, the power’s in your hands to create your vision, your idea. No matter whether you choose to sell socks or chilli sauce, however, it’s important to understand the basics of business finance and what you’ll need as a business to keep operating.
While qualifications such as a Graduate Certificate in Finance are helpful, it’s also useful to understand the fundamentals, regardless of your skill level. Understanding how key areas, such as cash flow, working capital, and liquidity, affect your business can help entrepreneurs avoid common operational pitfalls. It may just be the difference between a business that lasts a day and one that operates for many years.
The Grim Reality of Business Failure
Here’s a grim statistic – while it’s easy to start a business, lots of folks suck at it.
While small businesses are a major employer, employing millions of Aussies, they’re also remarkably volatile. Some estimates suggest that as many as one in five businesses fail within twelve months of opening, and more than half fail within three years. Australia is one of the wealthiest nations on the planet, and it seems unfathomable to think that businesses could fail.
We live in volatile times, with supply chain issues, extreme weather, and inflationary pressures each presenting a range of challenges for businesses. These factors can all have an impact, but ultimately, they often mask a core issue – a lack of financial management skills, which can be a business killer.
Fundamentals: Cashflow
Starting a business is excellent, but where’s the money going? Understanding cash flow is essentially understanding the movement of money through a company. It seems relatively straightforward, but businesses often have multiple points where cash is flowing, making it challenging to track.
Consider a small store selling shoes and footwear. At any point in time, there may be cash inflows, such as money received for shoes that have been sold. They may also be cash outflows, such as the cost of paying rent, wages, or other operational expenses.
In an ideal world, it’d be great to have constant positive cash flow — having more money coming in than going out — allowing a business to reinvest profits into itself or distribute them among shareholders. In reality, however, business operators must negotiate periods of positive cash flow against expected periods of negative cash flow, for example, when sales are down or a business closes for the holidays.
Fundamentals: Liquidity
Liquidity sounds like an energy drink, but in fact, it’s a key concept of business finance. While cash flow only considers the cash that’s on hand, liquidity extends beyond that, considering a company’s ability to pay its creditors on time.
Cash on hand is just one component of this; after all, you may have outstanding invoices or other pending sources of funding that you can use to make payments. If a business experiences a liquidity problem, owners may consider options such as selling products at a loss to cover a shortfall or converting physical assets into cash.
Liquidity problems can occur for several reasons, such as a debtor being late with payments for a product or purchasing excess stock, which hinders a business’s ability to cover ongoing operating costs. A lack of liquidity can also harm operating profits. For example, online retailer Kogan experienced a decline in profit growth during the COVID-19 pandemic, which was attributed in part to reduced customer demand, leading to higher costs for storing unsold stock.
Fundamentals: Working Capital
Working capital has a close relationship with cash flow and liquidity. Where liquidity refers to a business’s ability to make payments on time, working capital considers the difference between a business’s short-term assets and short-term liabilities.
Simply put, considering all of the current assets of a business (stock-on-hand, cash-on-hand, etc), is there enough there to cover the short-term liabilities of a business (for example, wages, tax costs, debt-servicing costs) over the next twelve months?
Curiously enough, a business can be profitable yet still experience periods of negative working capital or cash outflows. Fortunately, with a bit of planning, business owners can identify and address these challenges, hopefully before they affect their business.
The Importance of the Fundamentals
Understanding the fundamentals of business finance is critical to operational success. Running a business requires a significant amount of effort, and understanding its financial aspects is a crucial part of operating successfully.
Liquidity, cash flow, and working capital each play a vital role in the effective financial management of a business, and if managed poorly, can have significant consequences. In tandem, this trio of elements provides critical insights into business operations, including the ability to pay employees, cover operating costs, and respond to adverse financial events.
All it takes is one bad decision to tarnish a business’s reputation. Perhaps it’s a cash flow failure, where there are insufficient funds to pay employees, or maybe it’s a poor stock purchase that impacts working capital. Ultimately, businesses need to be prepared for adversity; in today’s world, navigating volatility has never been more important.
With a bit of patience and practice, even the most inexperienced business owner can become a master of their financial destiny. From free tools such as the Australian Government’s Business Finance Basics Kit, to further education and business qualifications, there are plenty of ways to get to work on your business’s finances – and it may just mean a brief idea and a long-running business.
Photo by Kelly Sikkema; Unsplash
A seasoned technology executive with a proven record of developing and executing innovative strategies to scale high-growth SaaS platforms and enterprise solutions. As a hands-on CTO and systems architect, he combines technical excellence with visionary leadership to drive organizational success.
