Much too often business owners fail the financial IQ test by tying their fortune completely to that of their Company and fail to sufficiently secure their personal long-term financial needs. With more than 50% of small businesses failing after four years and the added challenge of today’s hyper-competition, the focus is often placed exclusively on survival in the short-term.
While this kind of attention is necessary, it can often be excessive and near-sighted. Sudden success can lead to a false feeling of invulnerability. It is important to separate the interests of the business from the individual managing it. While they are inter-dependent, owners must also keep in mind their personal best interests. To reach a stable balance there are certain actions that can be taken:
Separate the facility from operations – It is one of the most useful financial IQ measures that can be taken by the owner. Placing the building in a holding company protects against double-jeopardy in case of business failure. The liabilities of the operating part of the business are contained within a separate firewall, which is protected from lawsuits by suppliers and unsecured lenders. Banks like to bind the two together to increase the value of the collateral, but this should be resisted. Better to use accounts-receivable, equipment, and other assets for collateral.
Remove personal guarantees – No bank will offer a loan to a new business without some kind of personal guarantee. Owners must be cognizant of the fact that financial institutions will do everything in their power to recover their loan. Keeping track of the liquidity ratio (current assets divided by current liabilities), and maintaining this at the 1.5 to 2.0 range, is a good way to safeguard yourself from over-borrowing. As soon as the business starts to generate cash and receivables that are sufficient to cover the bank debt, work on removing the personal guarantee.
Spousal Sharing – It is often useful to allocate company assets to the spouse as a protective measure, and tax strategy. It can be a positive financial IQ. However, the statistics on divorce clearly indicate that caution should trump emotions. Nuptial agreements and other legal measures should be considered before agreeing to place significant assets in the hands of someone, who may not always have the owner’s best interest in mind.
Reward yourself slowly – There is a penchant for small business owners to overestimate their early success and start taking out large sums of money and benefits too early in the business cycle. The statistics on failure imply that this is a hazardous practice. Wise owners reinvest a much higher percentage of their profits back into the business than they take out. In particular, they avoid posturing through luxury acquisitions.
Take money out in a timely manner – The business should eventually become a source of personal wealth to the shareholders. After it has reached stability, a percentage of the profits should be directed to the investors in the form of dividends, bonuses, and additional salaries. Before embarking on this course, personal tax implications should be discussed with tax experts. However, the financial needs of the company should always take priority.
Valuate your company – In general, business owners tend to overestimate the value of their business. At times, they use the stock market as a reference and apply price-to-earning multiples that are totally inappropriate for their type and size of business. It pays to use business valuation tools available on the internet or use professional evaluators. It is a proper use of financial IQ to perform this kind of valuation periodically because it provides a reality check.
Keep track of financial ratios – These are early harbingers of success or failure and should be part of a company’s quarterly analysis. Ratios provide a sober assessment of the company’s ability to maintain a good balance between debts, assets, and return on equity. Ensure that the accountant provides both a breakdown and analysis of key ratios and compares this to the industry average.
Focus on profits – Don’t be fooled by the high-tech companies that burn an enormous amount of cash and show substantial losses year-after-year while managing to maintain a high stock market value. Some of this value is projected well into the future, as in the case of a company like Amazon. Most small business owners must focus on profitability. Concentrating on sales volume exclusively, can quickly undermine cash flow and place the company in an unsustainable position.
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