There is no one blueprint of coming up with a triumphant business. If you are lucky enough, you might me born of parents who are already thriving in business that you take over. If not don’t hesitate to read up on Sydney Sheldon’s novels and learn about how a young and impecunious girl working at a boarding house ends up owning half of New York’s buildings, but none of this is that important. What I am focusing on is how one successfully runs an already established business?
Entrepreneurs who are devoted look for means and ways of maximizing the already maximized profits. Cost minimization and revenue maximization will take heat. Staff will end up with low remuneration and cheaply produced products with poor eminence that will be fed into the market at high prices. Loss of sales and de-motivated staff are typical in such a business entity. Super business units have come crashing down overnight, so this can’t work.
Others would use force to succeed in business. They would threaten their clientele even with death if they fail to pay up their debts and use guns to force defaulting debtors to sign up to their last asset as repayment for their debts. This works superbly well in movies and novels. I don’t have any idea if it can work in reality.
Others might use their political influence to secure plum deals and even obtain cheap loans. We have seen this working especially in developing nations with young democracies. Developed countries are not left out either, but what of when there is a political change? I have seen cases where banks that were influenced to give loans to ‘politically correct’ people giving them overnight notices to pay up all their dues. The outcomes have always been disastrous.
Perhaps the most efficient way of managing your business is proper management of working capital over and above that one of long-term assets, liabilities and equity. This is because working capital is the lifeblood of any business organization. Like blood circulating in the human body, working capital is the amount of capital that a business has available to meet its day-to-day operational requirements. This way, it circulates in the business.
Working capital management involves the management of debtors, cash, creditors and stock.
Credit is an unavoidable tool in modern business. This means that if you offer no credit you might end up having no sales. Offering lenient credit terms may add up to high sales and the sales may turn up to be bad debts. So how do you manage your debtors to avoid such a situation?
Debtors constitute a substantial portion of current assets in many business entities and hence investment in them should be kept at an optimum level. Investment in debtors depends on the volume of credit sales and the period taken to collect the debts. These can be influenced through a change in credit policy.
Credit policy is the contribution of three decision variables. They are the entity’s credit standards, credit terms and collection efforts. A credit standard is the criterion used by an entity to decide on the type of customers to whom goods could be sold out on credit. When these standards are too strict, the entity has little uncollectible debts but low sales too. On the other hand, when they are too lenient, the uncollectible debts will be as high as the sales. The standards should be moderate and proper assessment of customers must be done.
When assessing a customer to whom you intend to give credit the most important things to take note of are the length of time that the customer has been in business, qualifications and experience of key personnel and rate of growth of the customer’s business. It is also necessary that you see a record of the customer’s adherence to credit terms, as offered by other suppliers and financial institutions, and of course the financial statements of the customer’s business showing good performance. The customer’s character in terms of honesty, integrity and capacity to settle debts should be assessed. If possible, collateral should be pledged.
Credit terms refer to the period allowed to customers for making payments. One significant cost of investing in debtors is the investment return foregone. This is the return that would have been earned if the resources were invested in other forms, e.g. assets that earn the entity interest and dividends. The cost increases in direct proportion to the increase in the credit period. This period can be reduced by giving incentives that encourage prompt payment of any amounts due. This is done by giving cash discounts.
Collection efforts are the measures taken by the firm against customers who do not pay on the due dates. This may involve reminding the customers to settle their debts, starting legal proceedings or writing of the debts.
To avoid unnecessary collision with debtors a business can factor its receivables. This involves selling the debtors to a financial institution known as a factor. This entails an agreement on the basic credit terms of each customer. The customer sends payment directly to the factor that bears the risk of non-paying customers. The costs that will be incurred by the entity are factoring commission and interest on the advance granted. This means that the debts will be sold at a lower value than they are worth to cover for the risks that the factor will have. Other than costs, an entity will benefit from specialized services in credit management offered by the factor. This enables the entity’s management to concentrate more on manufacturing and marketing.
At the end of the day, sales will have increased due to attractive credit terms offered. Costs of credit management and bad debts will be significantly reduced.
A brilliant business tactic is ensuring that your debtors pay you as fast as possible as you delay payments to your creditors for as long as you can. This guarantees maximum use of the cheapest source of finance-credit. Precaution should be taken since harassing your debtors might scare off prospective customers and unnecessary delays of creditor’s money might earn you unlimited space in your creditor’s bad books.
Much care and skills must be taken in inventories. Unlike other classes of working capital, this class is exposed to more risk. Dishonest employees may decide to help themselves to the stock. Thieves may go over an electric fence, past the security guards and the surveillance cameras skip recording any movements. Due to the risks that stocks are exposed to, costs of holding stock have become a significant item in the profit and loss account of many business entities. The more stock you keep, the more storage space you will need and this will be more costly. Stock handling will require more people; this in turn inflates the wages expense. Insurance firms will want more premiums to cover the increased stock. To the unlucky few, fall in prices means capital loss. Worse still, one might end up not recovering the investment incurred. Consumers might change their tastes and preferences rendering your stock obsolete. The more stock you keep, the more the investment return you forego, is the solution keeping the stocks at the lowest levels possible?
Low stocks have their evils too. Incase of a break in supply of raw materials, production stops. Finished goods stock might run out forcing the customers to lose their confidence in you and take business elsewhere. Low stocks also mean frequent ordering. Costs of transporting ordered goods, insurance in transit and other significant clerical costs related to ordering will sharply rise. Business entities are faced with the problem of meeting two conflicting needs. The stocks are to be maintained at a high level for efficient and smooth production and sales operations. They are also to be maintained at a lower level to maximize profitability.
The problem has to be solved mathematically. All stock related costs have been classified as either stock ordering costs or stock holding costs. Stock ordering costs decrease with increase in inventory maintained while stock holding costs increase with increase in inventory maintained. When curves of the above functions are drawn on costs vs. inventory size axis, they intersect at a point where both costs are equal. This is the economic inventory quantity and if stock is maintained at this level, costs will be at their lowest.
Proper receivables management increases sales, creditor’s management increases financing and stock management reduces costs. Cash will start streaming in and with it comes another challenge-how do you manage your cash?
Pilling it in a bank account wont work. Sometimes the ledger fees and transaction costs exceed the interest that they offer for the money banked and who gains at the end? It’s the bank. Do you get some light to the source of their billions profit every year?
Entities that avoid dealing with liquid cash could be working it the right way but they are exposed to massive banking frauds and unnecessary costs associated to bouncing cheques. Many entities have therefore opted to deal with liquid cash despite the risks that they face. Robbers have reigned everywhere and if not, dishonest staff has taken their part. This has forced the entities to take fidelity covers for their cash at an extra cost.
For entities that deal with cash, they have to keep it to meet their transaction needs, take advantage of investment opportunities that come their way and meet any emergencies or unusual demand for cash. Like stock, keeping cash in large amounts has its costs. Its purchasing power might be lowered due to inflation and there is the investment return that has been foregone by holding the cash in its liquid form.
Insufficient cash leads to increased transaction costs incurred each time cash is raised. Cash discounts may also be lost over and above the loss of good credit rating. An entity may also fail to honour its obligations in time due to insufficient cash and this may attract penalty interest. So there comes the challenge of meeting two conflicting needs. Cash has to be kept in large amount for smooth running of business and in small amounts to avoid risks and maximize profits.
Mathematically, cash costs have been classified into cash holding costs which increase with increase in cash balance maintained and transaction costs which decrease with increase in cash balance maintained. On an axis of cash costs vs. cash balance maintained, the curves of the costs functions will intersect at a point which the costs are equal and the total costs lowest.
In the end, prices will remain the same, sales increase and costs reduce. Running a business is quite simple and you really don’t have to be avarice. Do you?
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