Feature Story

Five Keys To Effective Financial Management

by Bryan E. Milling

Effective financial management remains essential for the success of a business enterprise. Yet many managers ignore the need for that effort until a financial problem arises. Financial management then draws their attention only long enough to solve the problem. Any interest in financial management fades with the problem.

A current income statement remains essential for effective expense control and profit management. In the absence of an income statement, a firm's expenses can creep out of control and erode a firm's earnings without management's knowledge. Managers become aware of the higher expenses and lower earnings belatedly. The damage may not prove financially fatal. But the business operating without current financial statements earns less than it should.

In any event, current financial statements only provide the starting point for an effective financial control system in a business. Those accounting documents then provide the basis for preparing a company's financial forecasts and cash flow budgets. These complementary projections provide the foundation for effective financial planning.

A financial forecast helps anticipate a firm's need for funds that inevitably accompany growth. After all, an increase in receivables, inventory and other assets result naturally from a higher sales volume. The typical business must finance some of the asset expansion with borrowed funds. A financial forecast helps anticipate that need.

The most prominent management concern should center on the cash flow. After all, a business can sustain periodic losses if offset by periodic profits. But the company without the cash to meet its obligations confronts financial failure. Unpaid suppliers become reluctant to ship new orders. And employees unpaid on Friday seldom return to work on Monday.

To help preclude such problems, prudent managers use budgets that project the cash flow into and out of a business. Those budgets help managers anticipate potential gaps in cash flow. That foresight helps provide the time to take the actions necessary to fill those gaps.

Many managers view cash flow budgets with disdain. Projecting cash flows in an uncertain future presumably becomes a futile effort.

But evidence proves that experience provides a rational basis for predicting future cash flow. Past customer purchase habits usually continue. A firm's own payment obligations typically are even more predictable. So, a cash flow budget typically becomes more reliable than many managers admit.

From another perspective, a cash flow budget that includes a margin of error still can be beneficial for a manager. The budgeting process encourages a manager to focus on the factors influencing the cash flow. The manager gains a better view of customer purchase patterns, develops better insight into payment obligations and should improve the understanding of the interrelationship between the cash flow into and out of his business.

The knowledge that develops from the budgeting process also provides the premise for management action to improve cash flow. That can influence the timing of special product promotions. Well-timed promotions can offset an expected temporary drop in sales. And those benefits result even though the projections inevitably remain uncertain.

Anticipating the financing necessary to support growth becomes the second key for effective financial management. Although interrelated with the cash flow budgeting process, the perspective here centers on the borrowed funds needed to support the asset expansion that inevitably accompanies growth.

To illustrate, assume a business expects a 50% increase in sales. To generate that increase, the business typically will require at least a 50% increase in inventory, operating cash and other assets. In some instances, asset growth may out-pace the sales increase.
In any instance, the increase in equity from operating profit provides some of the financial support for the asset increase. But the equity that develops from even a very profitable enterprise usually falls far below the financing necessary to support the asset growth from the higher sales. Managers who ignore that fact often confront problems when they ignore the need for that financing. And the lack of financial foresight makes it more difficult to borrow funds when the need does develop.

So, prudent managers make the best possible forecast of expected sales. That projection then becomes the basis for forecasting increases in assets. Recognizing that anticipated profits provide some support for the asset expansions, any short fall identifies financing needs. Anticipating those needs helps make a favorable decision by lenders more likely.

Controlling inventory levels stands as the third financial consideration critical for a firm's success. From a conceptual perspective, determining the appropriate level of inventory remains a simple task. A business should carry enough inventory to meet its sales requirements, but not too much.

That simplistic perspective obscures the common inventory management practice that creates financial problems. Indeed, business managers suffer from excessive fear of losing sales when a firm lacks the items in stock that a customer wants. So, they carry an over-investment in inventory that can create a financial strain on the business.

Achieving a properly balanced inventory stands as a complicated management task that exceeds the province of the discussion here. But recognizing a few basic principles can help orient that task. Those principles center on dividing the inventory needs into three segments.

The stock necessary to meet normal, expected day-to-day sales requirements makes up the core of its inventory. Of course, customer demand fluctuates over any short term period. Sales of any particular item can exceed normal requirements. So, a business' inventory should include some safety stock.

Safety stock describes that part of inventory that satisfies a modest, unanticipated increase in customer demand. It provides a measure of protection against stock-out costs.

In the absence of an expanding sales volume, inventory that exceeds that necessary to meet normal sales requirements plus some safety stock becomes an excess investment in inventory. That drains funds a business may use more profitably elsewhere. So, in any circumstance, managers should combat the intuitive urge suggesting that a higher level of inventory is always more desirable.
The fifth critical key for effective financial management centers on the need to earn a profit. Specifying that need will appear ludicrous to some managers. Few businesses can survive long without producing profits.

But some managers focus on targets that make profits a secondary consideration. One may press constantly for higher sales, erroneously presuming that higher sales automatically lead to higher profits. Another may make market share the most prominent consideration. Still another may focus efforts on charitable service presuming that profits will become the natural reward for contributing to the community.

In some instances, such objectives fit into a firm's overall strategy for success. But they must remain secondary to the need to produce a profit. The business that operates profitably enjoys the opportunity to achieve secondary objectives important to particular managers. That opportunity evaporates when a business continues to sustain operating losses. eb

Bryan E. Milling is a banker and an instructor in financial subjects at a Midwestern college. He has written extensively for trade and professional magazines.