Most business owners don’t do this but I suggest you should
Do you agree that having a financial plan with a forecast is a good thing for a small business? If you do, do you have one? My guess is that not many small business owners devote their busy schedule to work on a financial plan. One of the reasons for not having a financial plan is about the perception that it’s time-consuming and it’s too difficult. Additionally, many small business owners might not know how to do it. In this article, I would like to offer a simple explanation and an easy way to do a financial plan.
Why is it important for small businesses to have a financial plan? Put simply, a good financial plan can tell you your current financial status and your future business trend. A plan doesn’t have to be complicated. It only requires that you spend a few minutes to read and understand this article and you develop some sort of discipline to track your revenue and your expenses. There are two simple concepts that you need to know for your financial plan — one is business cash flow, and the other is a concept of time value of money.
Let dive into these 2 concepts.
Business Cash Flow
Let start with the cash flow. Your cash flow is simply the movement of cash of your business. The major goal of the cash flow management is you need to ensure that you have enough cash to pay all of the obligations that keep your business running. You also have to understand that being profitable is not the same thing as having good cash flow management. This is because even though you are profitable, you may not have enough cash in a particular month to pay suppliers if you don’t plan well.
What you should be doing is to create a discipline of recording or tracking your revenue and expenses. The first step is to record all “current” in and out of your cash. It will help you understand your financial status. Then, you have to do a “forecast” of your cash flow. It’s the same practice of having a budget for big corporations. You can use this template to record your cash flow.
I don’t have to explain why knowing your cash flow situation — the past, the present, and the future — is very important to your business. You certainly need to know what you spent and whether those expenses were absolutely necessary. You also need to ensure that you have enough cash to fulfil your current and incoming commitments. And, most importantly, having an idea of your future cash flow helps you do business more effectively.
The next concept that you should know is “time value of money”.
Time Value of Money
What is the time value of money (let call it TVOM)? It doesn’t sound like fun but it’s a good concept for you to know. Why? The concept of TVOM tells you that the same amount of money your receive today is worth more than the same amount in the future. This is because the amount in hand today can be invested to turn into more money in the future. The key difference between today’s and the future’s money is “interest or rate of return”.
Suppose that a customer offers to pay you $1,000 today or $1,050 one year from today. This promise comes from the customer that you trust very much, and thus you do not believe there is any risk that you will not be paid. Which option would you choose?
It all depends on the return you can earn on this amount. If you can earn 6% on your money, for instance, then you should accept the $1,000 today. If invested for one year, it would grow to $1,060, beating the option of receiving $1,050 one year from now. However, if you can only earn a 4% return on your money, you should accept the offer of $1,050 paid one year from now. If you accept the $1,000 and invest it at a 4% return, it will only grow to $1,040 in one year, compared to receiving $1,050 after one year from this customer. I cannot talk about the TVOM concept without showing you the formula (sorry).
The basic formula for the time value of money is as follows:
PV = FV ÷ (1+I)^N
where:
PV is the present value
FV is the future value
I is the required return
N is the number of time periods before receiving the money
The good news is you don’t have to do the calculation yourself. When I was studying, I had to do a manual calculation and it wasn’t fun. There are a number of websites that offer a TVOM calculator. I suggest this one because it’s simple and straight forward.
I can’t stress enough why being on top of your business’ financial is super important. If you feel like this is not your forte, you can always seek help. However, I would encourage you to at least start small with a good record-keeping for your revenue and expenses. Once you have a very good tracking system, the rest is super easy.
