Proper financial management of business leads to success trajectory

Before you look at the different categories of proper financial management for a growing company, remember there is no one right way or easy method

By: Phoenix Lee/

You first have to accept that you operate in a world of uncertainty, in which decisions often are made without complete knowledge of all the consequences.

This approach can make proper financial management for growing a business both challenging and rewarding. When financing a growth cycle, seek assistance from professionals who know the process. Assistance is available through consultants, accountants and lawyers and through services provided by the government.

Proper financial management is important before you decide to actively pursue growth

A primary reason for pursuing growth is to increase profit. There are two components that can be increased – the absolute dollar amounts of sales or the profit as a percentage of sales. If these two can be achieved simultaneously, the resulting growth will be very rewarding. A more careful decision process must be completed in situations where there is a trade-off, such as between decreasing the percentage of profit to sales (through reducing prices) or increasing the dollar volume of sales (through increasing prices).

Reducing prices to achieve growth is a strategy you might not initially plan but must do to sustain growth after commitments have been made. By charging lower prices to increase sales, you usually decrease the gross profit margin. However, lower prices may result in significant increases in the purchase quantity, which then enables the business to earn a profit. The same concept, only reversed, can apply to costs. For example, if you increase costs in order to increase dollar sales volume, you still decrease your profit margin. This latter approach is feasible if you plan to increase marketing expenditures to gain additional business.

Costs also can be increased from an accounts receivable standpoint. A new business activity might increase sales by adding customers with poor credit ratings, thus resulting in a higher accounts receivable cost. Many managers of unprofitable businesses believe the solution to their problem is to grow in order to spread fixed costs over a larger number of units, thereby improving the gross  margin of the business.

Proper financial management would require your understanding of financial statements

The balance sheet, income projection statement and the monthly cash flow projection of funds are the statements used to manage and report a business’s financial operation. The balance sheet and income statement will be explained in this section. The cash statement is not always completed as the checking account register provides the same information except that it isn’t summarized by categories.

The balance sheet and income statement contain meaningful information about the business. The balance sheet indicates the value of the business at a given point in time and is usually prepared for the end of a typical reporting (or accounting) period. The income statement covers a period of time (month, quarter, year) and indicates the level of profit or loss based on sales less expenses.

Developing projections are crucial for proper financial management

The first step in undertaking growth is to develop projected income statements, cash flow statements and balance sheets. All potential lenders require these projections before approving loans. These estimates also can be used to help you decide whether to seek outside funding, even though this decision may seem obvious based on your current market activities.

These projection statements, sometimes called pro forma statements, should be developed for at least one year and perhaps two to five years into the future. You may wonder: How can I know what will happen? To answer this question, divide the projections into steps. The most critical step is balancing costs to sales in order to determine a profit margin.

Profit margins for income projections should always be reasonable, especially if outside financing is used. If the first years of the projections show a loss, it will be difficult to convince potential investors to invest in your business. If, however, the projections show excessive profits, potential investors may feel the project is unrealistic. This means that your figures must be fairly conservative.

What is a reasonable profit margin? It is a profit margin that is in line with the profit margins of the industry. For example, $80,000 on a projected income statement is a reasonable before-tax profit margin in the following case. First, all income tax is subtracted at an estimated rate of 25 percent, leaving $60,000. You quit a job that paid $40,000 to start this business; therefore, you maintain this salary as being consistent with your personal living expenses. This leaves $20,000 of profit.

The next step is to compare the remaining profit to the amount of equity invested or the amount of your equity on the current balance sheet. For this example, we will assume the equity level is $200,000. The profit of $20,000 is divided by the equity of $200,000, which results in a 10 percent rate of return. This rate of return is reasonable for a growing business; however, the rate of return could increase in the future because of the growth process.

Phenomenal rates of return, such as 100 to 1,000 percent or higher, are possible in smaller businesses. Even though this is possible, the rate of return should be conservative on a projection. Deciding the rate at which your company should grow is challenging and demands flexibility.

Flexibility can be difficult if you already have a preconceived idea of the growth level you want. Your idea may exceed the capacity of the business’s management and equity positions. It is helpful to develop several projections because different levels of growth will have different investment requirements and profit results.