Thursday, October 28, 2010

3 Hidden Costs Destroying You

In the last article we wrapped up our series on developing and using performance measures (aka metrics) to create a world class sales force.  Properly applied, metrics enable you to identify future top performers and nurture and improve your top talent. Even a novice manager can achieve superb results by measuring results and tweaking processes.

Today we turn our attention to cash management.  The reason most often cited for business failure is under-capitalization.  The root cause is often financial ignorance leading to mismanagement of cash.

In the next series I'll explore three areas where you’re bleeding cash without even realizing it.  Unless you set up the right policies financial ignorance can damage and even destroy you.

In each of the next articles I’ll explore one of these hidden cash drains and how you can combat it. Knowing this might just save your company.

Companies must borrow money to finance their operations.  They pay interest on that money.  How you borrow those funds and how to avoid borrowing those funds when you don’t need to are critical components in effective cash management.

Would you believe you might easily be throwing away half your profit or even all of it in some cases? In an earlier post I discussed how I showed that one local merchant almost made a disastrous mistake.  In this series I’d like educate you and help you guard against making these mistakes.

First let’s define some terms:

Net Terms
This is the number of days you allow your customers to pay.  It’s typically expressed as Net X where X is the number of days you allow the customer to pay you back.  The most common is net 30 although net 10 and net 15 are common.

Cash Conversion Cycle
You pay a carrying charge on what you sell.  This is your CCC times your highest credit line.  To calculate the number of days, subtract the date
a client receipt is available to you from the date money is removed from your bank account.  This can be deceptively longer than one believes.

Cash vs. Accrual
Whether you operate a cash or accrual business determines your CCC.  A cash business pays its supplier
at the same time or after the customer pays for goods.  If your customers pay you for every sale and you then arrange to pay for these goods, you operate a cash business and your CCC is zero or negative.  An accrual business pays for goods before receiving payments and its CCC is a positive number.

Hidden Cost #1: Extending Credit

If you buy merchandise to sell later, you extend credit, possibly without even realizing it.  That means you operate an accrual business.  An accrual business finances its operations by borrowing.  A cash business doesn’t.

Most small business owners don’t realize it but even service businesses operate on accrual.  Sole proprietors often finance their operations with a personal credit card.  And accrual businesses pay interest.  Holding inventory, allowing your customers to pay on time, invoicing for services rendered, paying your creditors before receiving merchandise, buying goods to include in assembly...  All of these practices increase your Cash Conversion Cycle and make it longer for you to get paid.

These hidden expenses eat up profits and drive you crazy.  To understand the underlying reasons requires a shift in perspective.  Once you do, you can tweak your policies to fix it.

With a little work, you can set up your policies so your profit increases, not decreases.

The Risks of Extending Credit

Often it seems harmless to extend credit.  But you accept these risks each time:

  • The payer can pay late
  • The payer might default
  • Your potential profit is eroded by financing costs
Also, borrowing affects your own finances.  You can overextend or alter your own credit profile which might impact your ability to borrow or dramatically increase your costs in doing so.

In the next article we’ll explore how much extending credit is actually costing you and we’ll discuss a way to combat this expense.  Then I’ll share why two other hidden costs are killing you.  In future columns, we’ll explore additional ways to combat these hidden costs.  It’s all coming up starting next week, so keep your eyes peeled.  Until then,

profitable business All!

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