Most of us have heard how important it is for young people to gain a measure of financial literacy as they approach their adult lives. Many online and classroom resources are dedicated to making this type of education available.
But what about financial literacy for prospective small business owners? What should entrepreneurs be aware of before they decide to devote a considerable amount of time, effort and resources to a small business startup? Since April is National Financial Literacy Month, here are 10 financial literacy issues for new entrepreneurs and prospective small business owners to consider:
- Know your (and your family’s) tolerance for financial risk: Experienced business owners know that during the startup phase and beyond, the owner is the last one to be paid. While the rewards of business ownership are numerous, so are the risks. Fluctuating economic trends, changing consumer tastes, supply chain disruptions and many other factors can make business success a less-than-guaranteed proposition. Make sure everyone involved has the emotional and financial capacity for a high level of uncertainty. Using all of savings or a retirement account is a serious decision to carefully consider if there’s a potential for losses.
- Learn how a legal business structure affects future tax liability: There are different tax advantages associated with formal corporate structures that accrue to both the company and owners, but tax law changes nearly every year. Given the possibility of higher business taxes and fees going forward to erase the federal budget deficit, discussing the business structure options with a qualified accounting or legal professional can help determine the best course of action.
- Understand how much money it REALLY takes to start a business: Unbridled enthusiasm for a new company’s prospects shouldn’t overshadow the realities of startup costs. Most startup projections for revenue growth are too optimistic, expenses are underestimated and anticipated break-even time frames are too short. Take your projections and double the cost to get to break-even and triple the time frame. Preparing for a possible worst-case scenario offers good insurance against running out of money and time on the cusp of success.
- Understand what startup expenses are crucial versus questionable: Plans for revenue growth and quick break-even can fool an entrepreneur into believing all startup costs can be quickly recouped, but such is rarely the case. Focusing on expenses directly related to generating revenue generation is one of the keys to financially managing a startup. Incurring large costs for new or fancy equipment, fixtures or facilities where used options at a fraction of the price will do can use up cash that could be used for marketing, promotion, inventory and other crucial business needs.
- Learn when it makes sense to use business credit. The wise use of business credit will help a company stabilize, grow and prosper. But business credit should be considered only when the money is used for either of two purposes: increase revenues or reduce costs. Business credit should not be considered if the goal is to maintain a lifestyle, pay the owner’s salary or use the money for anything that isn’t tied to bottom-line results.
- Understand the relationship between your credit history and business lending: Personal credit histories are one of the major tools lenders use to evaluate the business risk their institutions incur in making a startup business loan. Lenders are literally banking on the owner’s prospects for success. How an owner has managed their personal finances offers an important indicator. Even a compelling business plan might not be able to overcome an owner’s poor or marginal credit history. After a business has been in operation for a while, availability of a business loan is more likely to be based on the company’s credit and operational histories.
- Learn how to record and track business income and expenses: While entrepreneurs don’t need to be accountants, they do need to know how to accurately record revenues and expenses. Accountants can only work with what they see. If it’s not recorded, it didn’t happen. Accurate records enable an owner to gauge the financial health of the business through the use of ratios and other measurements. Having at least a basic computer-based financial system and keeping up with regular data input is a must for any business owner when financial indicators aren’t trending well.
- Learn how to read, interpret and use business financial statements: Three major financial statements comprise a financial “report card” — the income statement, balance sheet and cash flow statement. Each one tells a different part of the story about a company’s financial condition. Together, they can be used to find weaknesses and strengths. Ratios derived from financial statements provide clues to where an owner needs to implement corrective actions before a situation becomes serious.
- Understand how cash flow keeps a business alive: Cash is king. A business can be profitable on paper, yet fail from a lack of cash flow. Important aspects of cash flow include the timing of accounts payables and receivables, inventory turnover, fixed expense loads and other areas. Without a solid foundational knowledge of such areas and the effects they have on cash flows, a business owner is handicapped in managing cash.
- Understand the financial implications of a new hire: Making the decision to hire someone should go way beyond thinking only about if you can afford to pay the wages. How will a new hire increase revenues or enable the business to become more efficient or productive? Quantifying these areas will help determine if a new hire is really worth what you’ll pay in wages, benefits and training.
While this list is by no means comprehensive, these 10 areas have the potential to greatly affect the success of a new business venture. As the economy continues to recover, financial literacy is as crucial to the prospects of a business as it would be to any one of us in managing our personal financial affairs.
Daniel Hannaher, the U.S. Small Business Administration Region VIII administrator, works out of Denver. Reach him at (303) 844-0505 or Daniel.Hannaher@sba.gov.