2 Golden Rules of Good Financial Management

A recent survey found that most businesses close down because of bad financial management or financial mismanagement. 

An organization closing down because of an inferior product or service or technological disruption is expected. But a business failing due to poor financial management can be avoided. This is a serious problem, as good management is completely in the control of the business owners. Also, when a business fails, there are a lot of jobs lost, everyone loses money, including vendors and shareholders. This is a terrible outcome, and can be avoided with some basics of Good Financial Management.

Here are 2 very basic rules. If followed sensibly, it can lead to business success.

However, if any of the 2 rules are violated, businesses will most certainly pay the price.

Rule No 1: Profitability (Return on Capital Invested > Cost of Capital)

Imagine you are borrowing at an interest rate of 10%. Would you lend that money to someone at 8%?

No, right?  But you will be amazed at how many big businesses are guilty of investing in opportunities which do not even provide returns which are equal to the cost of capital.

And the frightening part is some business owners don't even know or realize this fact.

Let’s learn more about this by understanding how the Cost of Capital (COC) and Return on Capital Invested (ROIC) are calculated. 

1.      Understanding the Cost of Capital

The cost of capital refers to the expected return on the total capital employed by stakeholders in the business. It is the weighted average cost (WACC) of Debt (Kd) and Equity (Ke).

a.      Cost of Debt (Kd)

When companies borrow funds from outside lenders, the interest paid on these funds is called the cost of debt. The cost of debt is very easy to calculate. If you take a loan at, say, 10% interest rate, the Cost of Debt is the Rate of Interest adjusted for savings on tax.

Kd = Interest Rate of Debt X (1- tax rate)

b.      Cost of Equity (Ke)

Computing the cost of equity is not very straightforward compared to calculating the cost of  debt. Cost of equity is the return required by the equity investors. In simple terms, it is the return the equity investors expect to earn on taking the risk of doing business over and above the risk-free rate of return.

Ke = Risk free rate of return + Premium expected for risk

c.      Weighted Average Cost of Capital (WACC)

WACC is the minimum expected average return for all stakeholders in a corporation. Once we know the costs of debt and equity, we can take a weighted average of the two.

WACC = (Proportion of Debt X Kd) + (Proportion of Equity X Ke)

2.      Understanding Return on Capital Invested (ROIC)

Return on Capital invested (ROIC) measures the potential of a company’s ability to generate profits compared to the capital invested by the shareholders and debt holders.

ROIC = Net Operating Profit after Tax (NOPAT) / Average WACC

A business should never invest its funds without ensuring that what it can earn through the deployment of those funds (Return on Investment or ROI) is either equal to or greater than the cost of acquiring those funds (Cost of Capital or COC).

Rule No 2: Cash Flow Management 

Imagine you are borrowing money at an interest rate of 10% for 1 year. Would you lend that money to someone at 12% for 2 years?

Again, common sense would suggest not right? Even if you are earning a rate of return higher than the cost of capital, you won’t have the money back in time to repay the loan.

Similarly, business organizations should invest their funds in such a way that assets bring back the money invested before the liabilities ask for it. Assets must bring cash inflows before the liabilities demand back cash outflows. 

Cash is the lifeblood of any business and cashflow management is a very important aspect.

Cash is the lifeblood of any business and cashflow management is a very important aspect. It is making sure that your business is able to cover all the bills. It can impact the company's cash position, which can affect the company's ability to pay employees, provide benefits, make interest payments, repay debt commitments and meet other obligations. It can also affect the company's ability to raise capital in the future.

Importance of a Cash Flow Forecast

It is important to have a good cash flow forecast. A cash flow forecast is an estimate of future cashflows that a business will experience in different scenarios. Forecasts are used for the purpose of budgeting, planning, or forecasting needs for operational financing. A cashflow forecast can help a business plan for their expenses and their income, as well as predict the risks they might face. This can help avoid many common and potential pitfalls. It also helps predict the future, which can make it easier to take corrective actions in time. 

A cash flow forecast is an estimate of future cash flows that a business will experience under different scenarios.

So, let’s quickly recap the 2 golden rules of good financial management.

Rule No 1 Profitability: 

A business should never invest its funds without ensuring that the return on capital that it can earn out of those funds is either equal to or greater than the cost of acquiring those funds.

Rule No 2 Cashflow Management:

Business organizations should invest their funds in such a way that assets bring back the money invested before the liabilities ask for it and assets must bring cash inflows before the liabilities demand back cash outflows.

If the above 2 rules are followed judiciously, it will lead to business success. However, if any of the above 2 rules are violated, businesses will most certainly pay the price.

Reference: Romancing the Balance Sheet by Dr Anil Lamba.