Sunday, January 2, 2011
Beginner's Guide to Saving Money
The ROI
The ROI can also have a negative value if the investments suffer losses and the total return from an investment is less than the total expenditure behind the investment. A negative ROI value is an investor nightmare.
As is evident, the ROI formula is a simple formula that can give the investor a fair estimation of the profits (or losses) of an investment decision. However, it must be remembered that the simplicity of the formula makes it vulnerable to manipulations. What that means is that if the hidden values of an investment are not included in the return on investment formula then the formula will not be a fair estimation of the investments. Therefore, there is a high risk of being misled by the return on investment formula.
Whenever an investor is presented with a return on investment formula statistics, the investor should make sure that he or she properly verifies the sources of the different parameters of the formula. The total return on investment should include the most current statistics as investments never cease to function. A calculation of returns also requires an updated knowledge of the stock market conditions. The investments expenditure section is also a critical parameter of the ROI formula. Since an investment expenditure is made in different forms, so it must be made sure that all the different forms of investments are taken into account when calculating the ROI percentile. This is especially true when the investor is examining the ROI values of a corporate concern, because a corporate concern, by default engages in different methods of investment all of which are not disclosed for public scrutiny.
The use of the return on investment formula, if properly used, can be to have a fair estimate and comparisons of different investments decisions. In fact, the simplicity of the ROI formula enables homeowners and small enterprises to use the formula along with the corporate big names. The return on investment formula is especially a very efficient tool of a personal budget worksheet as the general investor can clearly make a decision about what to do and what not to do. The ROI formula can also be used to have a fair comparison of different investment strategies and to calculate the percentage of increment (or decrement) on an investment.
Finally, an important factor to be kept in consideration in the ROI calculations is that the time factor is not included in the formula. The time factor should be kept in mind while you are evaluating the return on investment formula percentages presented to you.
This is something you should be using before making ANY investment decisions.
Improving Financial Performance through Clear Objectives
While almost every business pays attention to financial performance, studies show that small and medium sized businesses in particular frequently do not engage in thorough financial planning – if at all.
This article covers an important aspect of using planning and the continually improving process approach to enhance performance – setting and reviewing objectives, then taking appropriate action.
Reviewing the Importance of Balance
If you read our email articles regularly, you may recall that I occasionally refer to Kaplan and Norton’s concept of a Balanced Scorecard. Interestingly, I recently heard someone discount the Balanced Scorecard during a business improvement presentation with the claim that there is no real balance in business; there has to be clear priorities.
Kaplan and Norton probably didn’t mean balance in an exact and literal way – that there has to be perfect balance in all areas of business. I believe their point is that to be successful a business needs to pay attention to, and work to
improve, all key business areas. They present a basic set of four segments: Customer, Learning & Growth, Internal Processes, and Financial.
According to Kaplan and Norton, many companies pay too much attention to, and guide their business disproportionately by, the financial aspects of their business. Too frequently, they also gauge success only by short term financial factors. Of course financial factors are important. Without financial success virtually no business will be around for long. On the other hand, financial success, no matter how great, will be short lived if a business is not paying attention to satisfying customers or its internal processes.
Financial Objectives Drive Financial Performance
As noted above, all companies pay attention to financial performance, sometimes too much so. But monitoring financial performance is a lagging indicator; it looks at results that tell you how you have done in the previous period. Obviously at that point it is too late to do anything to alter or improve the financial
Setting objectives that can be measured on weekly and monthly basis means you are measuring leading indicators of financial performance; numbers that indicate or predict what the end of period numbers will be. Leading indicators provide valuable information about financial performance, and they provide the opportunity to take corrective or improvement action instead of passively waiting to learn results when the period is over.
An Objective Example
For example, if your company has significant cash reserves in investment accounts, setting objectives followed with action plans can improve financial performance in this area. It allows you to actively affect performance instead of just accepting whatever return results happen to occur that year.
Let’s say you set an aggressive but realistic objective of a 5% annual return on account balances. The plan should call for a monthly review of account statements and of how well current account types and providers are helping you reach your objective. If current accounts are not meeting the objective, then the action plan would call for searching out and reviewing other account options in order to find accounts that would meet, or at least come closer to meeting, return objectives. If these accounts meet other criteria (such as insurance and convenience), then funds would be shifted to the higher return accounts.
As this example illustrates, using objectives, leading indicators, and action plans provide the kind of proactive approach that doesn’t leave results to chance. Plus, the same philosophy can be applied to all areas of finance such as cost of capital, days sales outstanding, and inventory turns.
Keep in mind, however, as the Balanced Scorecard approach emphasizes, financial numbers are not the only factor employed in driving a business. Numbers themselves do not mean everything. Consider our above example. If you have a great relationship with a bank and conduct most of you business there, it may not be worth moving a large money market account over one-tenth of one percent. (You may, however, want to mention to the account manager that a competitor is beating their rate.) If there is a more considerable difference that could lead to significantly missing an objective, then it calls for action.
Working Capital: Putting Your Financial Resources to Work
In the past few weeks we have been covering important elements of finance processes, including internal control systems as prescribed by Sarbanes-Oxley, and the importance of capital planning to ensure key high level financial facets such cost of capital and return on assets
have established goals and are being measured.
Our final topic on finance processes is about working
capital. Working
onthly basis. It is the money used to pay your suppliers for
materials and the money needed to pay for the goods and services (i.e. inventory and payroll) you have used while you wait for your customers to pay you.
There are three important areas that companies should actively manage
in order to get the most from their working capital. Here’s how they
are related:
working capital = accounts receivable + inventory – accounts payable
Accounts Payable
Accounts payable is perhaps the easiest process to control because i
t simply involves paying the bills. But paying bills shouldn’t just be left to chance; there should be clear policies and goals that direct these activities. But generally, when it comes to paying bills, The Golden Rule should apply. Treat others’ invoices as you wish others would treat your invoice. Basically, that means pay it on time according to the terms. There may be no advantage in paying early, but purposely paying late as a working capital management tool is unprofessional and can negatively impact your business.
You may think you are getting away with paying your bills late
ou’re paying late has their act together, then your delayed payment may eventually result in increased prices or reduced service levels. While you may be the customer, do you really want to run you business in a way
that elicits frowns and curses when your name is mentioned? Building such a negative reputation can have long term detrimental repercussions.
Ensure you policy states that payment will be made according to terms, with a goal of mailing payment five business days prior to the due date or having funds transferred on the due date for electronic payments (and a supporting measurement that clearly indicates performance in relationship to th
e goal). The accounts payable policy should also clearly state when invoices should be paid early.
Effective Annual Rate of Return
Is a 2% reduction in the invoice amount enough of an incentive to pay within 10 days? Typically it is, as paying early for a 2% reduction can result in a 37% return. The important issue is that accounts payable policies are well thought-out (in terms of overarching working capital goals) and followed through with objectives and measurements.
Accounts Receivable
The cash flowing into your business as a result of customers paying invoices is crucial in managing your business’ working capital. Your organization s
the period for which you are calculating DSO; for
example 30 if you cal
culate it monthly and 90 if you calculate it quarterly.
One key to managing Account Receivable is to remove delay in invoicing customers after shipment of an order or delivery of a service. These delays consume cash available as working capital. Set a goal to invoice custo
mers immediately after fulfillment. If it currently takes 10 days to invo
ice a customer, then the goal should be to do it in 5. If it currently takes 5 then the goal should be 2 days. Finding ways to reduce the DSO frees cash formally tied up in receivables so it can be used in ways that provides return and fuels growth.
Prompt invoicing is the most important method to reduce DSO. It is something you have direct control over, plus, why should customers be conscientious about paying your invoice in a timely way if your make little effort to send invoices promptly?
Inventory Management
Including inventory as a finance function sometimes causes confusion and skepticism. There is no doubt, however, that inventory consumes financial resources; whether in the form of purchased materials/parts, work-in-process, or finished goods. Those responsible for managing the company’s financial resources and performance should also have the ability to oversee and monitor all three types of inventory.
The purchasing representative might believe they are getting a good deal by buying one years worth of parts, and perhaps they are. But making such decisions impacts the overall financial resources consumed by inventory, especially when you include the cost of ownership.
The responsible financial authority should stay informed of inventory performance, and in response set clear policies and goals for reducing and managing inventory levels through metrics such as Inventory Turns (the number of times that a company’s inventory cycles or turns over per year), Days Inventory (the average number of days of inventory on hand per accounting period), Average Inventory (the starting inventory number at the start of a period minus the ending period inventory number divided by 2), and Cost of Ownership (the total cost of maintaining inventory such as warehouse space including utilities and maintenance, finance costs, personnel, equipment, shrinkage, obsolescence, and insurance).
The overarching goal should be to find ways to reduce all types of inventory while ensuring operational needs are being met. This, as with accounts receivable, releases cash tied up in non-productive means so it can be used to gain return or grow the business.
Managing the working capital processes is just as vital to business success as producing products and services that customers want and that fulfills their expectations. Businesses not actively managing their working capital may find an exorbitant amount of financial resources being consumed in unproductive ways such as growing accounts receivable amounts and hefty inventories.
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Keys to Improving Business Success
Question: Why is due diligence and transparency important?
Due diligence means you are collecting the proper information and ensuring you are aware of all the relevant facts. As the term transparency implies, it means there is a degree of openness and honesty. The recurring theme of October’s articles illustrate how important due diligence and transparency can be to business success.
Manage Your Business Banking Relationship
Part of financial due diligence in operating a business is having a financial representative (i.e. Owner, CFO, Controller, Business Manager) meet regularly with a bank representative. Prior to the meeting, create a
- Future financial needs for expansions or acquisitions, like lines of credit or loans
- Best use of cash accounts like sweep accounts to maximize return and minimize expense
- Short and long term investment options for a practical liquidity tree
- Use of merchant accounts
Plus, in these times it may not be a bad idea to discuss the bank’s liquidity and financial stability, esp
ecially if you have money in non-insured accounts. Be prepared to ask questions that require details, not unresponsive platitudes. The bank sure doesn’t hesitate to grill you about your business when the money flows the other way.
Is Sarbanes-Oxley Improving Corporate Governance?
Again we find ourselves in middle of economic turbulence due in a large part to a lack of business ethics and sound business practices. Without the necessary transparency and due diligence, lies and deception can go unchallenged, particularly when people are being dishonest with themselves.
But wait a minute! Wasn’t Sarbanes-Oxley supposed to put an end to all that? Aren’t public com
unrealistic, overly optimistic projections and reporting? Obviously, though well-intentioned, SOX has not been as effective as it should be in preventing fraud, abuse, and intentional ignorance. Also, it apparently has not been successful at encouraging organizations to implement effective financial internal control systems and improve corporate governance.
Managing Financial Strategy Means Business Success
A clear strategy and plan not only incorporates goals and the activities needed to reach these goals, but it also addresses risks. Obviously, the risk of handing out loans for hundreds of thousands of dollars without t
he proper due diligence and transparency was not accounted for in managing the financial strategies of those lending/financial organizations now failing or on the brink of failure.
On That Note;
Answer to the question: Due diligence and transparency are important because being aware of the facts and avoiding deception (including deceiving yourself) can mean the difference between success and failure; between staying in business and going out of business. The current state of financial crises may have been avoided if those in charge of banks, lending institutions, regulatory offices, and even elected officials would have exercised appropriate due diligence and transparency.
Effective Policies and Procedures: The Complete Cash to Cash Cycle
Final in Cash to Cash Cycle Series
In the last four posts, we’ve brought to light four key areas in which you can save $250,000 each — for a total of $1,000,000. Point by point, we’ve shown you just how cash flows through these areas, making up the Cash to Cash Cycle.
And as we’ve seen, the cash cycle is undoubtedly the single most important process to optimize for any business – from when you spend money to when you get money.
So now let’s put it all together.
Cash to Cash Cycle Definition
By definition, the cash to cash cycle is a financial ratio that shows the length time for which a company must finance its owninventory. It measures the number of days between the initial cash outflow (when the company pays its suppliers) to the subsequent cash inflow (Accounts Receivable).
Cash Conversion Cycle and Cash Flows
One way to express this is the length of time between the purchase of Inventory (raw materials, etc) and the collection of accounts Receivable created from the sale of your product — also called the cash conversion cycle.
Why is this most important? Because this is your cash flow and because;
Operations Assessment and Working Capital
Businesses live and die by the cash generated from operations. If your operations don’t create cash, then they consume it. A cash-consuming operation means that you have negative cash flow and you are living on financing (debt or equity). But the Cash to Cash Cycle also shows you the amount of working capital you have committed to your organization.
Just add the number of days of inventory to the number of days of receivables outstanding, and then subtract the number of days of payables outstanding. The result is the number of days of working capital your organization has tied up in managing your supply chain. This can be quite a significant number – one not to overlook.
This can also be expressed by the formula: stock days plus debtor days minus creditor days equals the cash-to-cash cycle.
So, for example, a company that keeps its stock for on average 30 days, gets paid by its debtors on average within 30 days and pays its creditors on average within 30 days will have a cash-to-cash cycle of 30 days.
Companies that receive cash from their customers at the point of sale and that have their inventory under good control will have a short cash-to-cash cycle. A company could even have either a negative cycle or a cycle time of zero. For example, if a business’ receivables and payables are held in check at 30 days while inventory runs at Just-In-Time (JIT) levels, then the cash cycle is zero – meaning that this company is in good shape with no working capital needs. And, of course, when receivable days are less than payables with JIT inventory, then the company will enjoy a positive cash-to-cash cycle – creating more cash on hand.
On the other hand, however, if a company puts payables down to 15 days and allows receivables to grow to 45 days, while inventory remains at steady levels, the cash cycle will be high. And. here, working capital will be constrained to compensate for inefficiencies.
Processes and Procedures Investments
Did you realize that working capital is the investment you are making in the inefficiencies of your processes and procedures plus your investment in your suppliers’ and your customers’ inefficiencies too? In other words, if you do not monitor inventory, accounts receivable, sales and marketing and accounts payable to ensure a healthy cash-to-cash cycle, then your working capital needs will not maintain a strong cash flow. The process will be out of control, and will not be optimized to create the greatest amount of financial effectiveness for the company.
Policies and Procedures Savings
So now you can see the relationship between your cash flow, your working capital and your cash to cash cycle. In order to increase your cash flow, you need to increase the velocity of your cash to cash cycle by reducing the inefficiencies found in your processes, your suppliers’ processes and your customers’ processes. The result is a decrease in your working capital and an increase in your cash. And, as we’ve seen, this can be a significant number – again, one that you shouldn’t overlook.
Strategies for Writing Accounts Payable Procedures
The “finish line” — the $1,000,000 “prize”, cash savings for your business – is within sight. In our articles on Inventory andAccounts Receivable, we found $250,000 worth of savings in each functional area. We found another $250K could be saved in Sales and Marketing. Accounts Payable is
the final process in the Cash-to-Cash Cycle — the source of thefinal $250K.
The cash cycle – from when you spend money to when you getmoney – is undoubtedly the single most important process any business can optimize.
Completing the Cash-to-Cash Cycle
So, let’s tie this to accounts payable – the event that pays for the liability incurred by purchasing, which is for inventory required by manufacturing to meet demand. Sales generate this demand that creates the accounts receivables, which is turned into cash, and we have come full circle and completed the discussion on the cash to cash cycle.
Increasing the Velocity of Accounts Payable Processes
Your accounts payable is a bit different than the other processes we have examined so far. The first three processes we looked at represented processes where the focus was on reducing the size of assets (inventory or accounts receivable) or expenses (marketing) and increasing the velocity or cycle time. In accounts payable our focus is on increasing the size of assets while maintaining a solid credit rating and increasing the process velocity.
Now, let’s look at how to find $250,000 in accounts payable savings. If your organization has $500,000 in accounts payable each month…STOP! We can find $250,000 in savings right here! ”Where?”, you ask. Increasing payables by 25% will produce $125,000 in cash plus $125,000 from automating tasks, taking more discounts, and managing the processbetter.
Service Business Procedures Case Study
An organization with $600,000 in monthly payables needed assistance. We examined their payables process to understand and quantify workflow, paper processing, and credit issues, then designed and implemented a process to increase their use of payables and discounts, improve their payables cycle efficiency, and tie it to their purchasing and receivable cycles. We then reinvested $50,000 back into an Enterprise Resource Planning (ERP) program to automate some of the processes that weren’t automated already.
The metrics we developed reduced their purchasing and payables expenses by 25% and increased their efficiency from 50% to 75% within 2 months of implementing the new procedures. With these new processes and reports, the company now tracks payables cycle efficiency and average days payables, rather than just bills paid on time or outstanding balance as the measure of their payables effectiveness. The result: an extra $300,000 in cash, plus a 50% increase in process capability (capacity).
But…how?!
Methods to Help You Design Your Accounts Payable and Accounting Procedures
- Eliminate Paper. The single biggest cost for any purchasing and payables department is paper, including: purchase orders, purchase order follow-up, small-dollar purchases, delivery tracking & receipts, and vendor payments. Utilizing paperless invoices, Web-based supplier self-servicing, centralized vendor files, automated workflows for electronic or imaged invoices (see ERP below), and payment methods, such as business credit cards, Electronic Data Interchange (EDI) and Electronic Funds Transfer (EFT), can reduce paper handling costs by as much as 90%.
- Integrate ERP Systems. Enterprise Resource Planning (ERP) automates the purchasing and payables functions, which allows a company to get more work done with fewer personnel. Also, electronic invoice matching applications save time in retrieving paperwork. It is estimated that an ERP system can annually save an organization $300 per million in sales.
- Increase Payment Terms. Negotiate payment terms based on receipt of goods or the invoice. This can add one week or more to your terms, which can be 25% of 30 day terms. Use EFT for just-in-time payments to maximize your payables terms and minimizing the impact to your credit.
- Take Payment Discounts. If you are getting 2%/10 net 30 terms, then consider taking it. This means you are offered a 2% discount if you pay within 10 days, instead of the normal 30 day terms. This translates into an 18% return on your capital, and for many organizations this is a good return on your investment.
- Review Purchases. Purchasing is a continuous process that requires continuous review. Consider: transportation charges, expedited fees, odd lot penalties, new pricing, new products, consolidating vendors, new vendors or buying groups, payment terms, and more. Communicate with your suppliers to improve the process. And review and monitor everything to account for changes in your environment.
- Communicate with Suppliers. Communicate with your suppliers to improve the process. Ask suppliers to submit their invoices electronically. This will save you time, resources and losses due to waste.
- Eliminate Disputes. Disputes with your suppliers are typically the result of a problem with your purchasing/receiving process. When disputes occur, review your purchasing procedures to ensure that they are producing the correct metrics and that you are not forced to pay for your mistakes.
- Reduce Errors. Overpayments, payments made to the wrong vendors, fake invoices, or even late payments represent a common problem for payables. Increasing your focus on error control, along with written procedures and audits, can reduce these errors considerably.
- Train Personnel. Provide your accounts payable staff with regular formal training. This will arm them with better knowledge of frauds, negotiating skills, and an understanding of the economics of payables, which will result in improved effectiveness.
Accounting Policies and Procedures for Cash in the Bank
In the preceding articles in this series, we showed you three parts of your financial statements that will each contribute $250,000 in cash savings. The last hurdle was Accounts Payable, and we sailed through it. And now we have crossed the finish line and achieved our goal: $1,000,000!
Time was – is – the key. All you have to do is own it.
In the next post we’ll put together the four parts of the cash-to-cash cycle and look at how they affect the working capital of your business.