Originally Posted 6/2/2010
This is a leap forward along the Business Analysis storyline, but I recently wrote about it elsewhere and I realized that this simple model can be of great help for startups. I'm going to talk about your company balances, but not in the terms you're thinking.
Have you ever thought about what can kill your business? I'm sure you did many times. Actually there are 3 easy concepts that can help you assuring the long term wealth of your company. These are 3, rather simple, checks you can do to verify the chances your business have to grow and prosper.
A business is financially balanced (in financial equilibrium) if it can pay all the bills when they are due. You should be able to pay for whatever you need to keep the company up and running (including debt) with your ordinary activities revenues. Any imbalance means that money must be harvested, from banks, investors etc, to keep the company running. Protracted imbalances may lead to a cash crisis that can actually kill the company. To be sure not to incur into financial imbalances, you have to forecast and constantly update your cash flow statement for the months to come. How to build a cash flow is beyond the scope of this article.
A business is economically balanced (economic equilibrium) if there's a margin after every cost has been accounted for. This is not the same as before because you buy raw materials today, use them after one month, sell after two and cash in after three; this is often referred as the monetary cycle. All these activities, albeit distributed in time, are all related to a single unit of activity. In other words, disregarding the actual payments, we can make an estimate if every company activity is profitable or not, if it produces a positive margin or not. Your company as a whole, for each month of activity, must produce a positive margin. If your margin is red, cash flowing in from previous periods can temporarily compensate, but you risk to fall back on the case above. Note that you can have a continuous row of positive margins but hit a cash crisis, because an unforeseen expense has lowered your cash or an important customer has delayed its payments. You can do everything well and still have cash problems. This is why the financial balance is more important than the economic balance and must be carefully safeguarded.
The third and final balance is the equity balance. A company has been founded upon an amount of money. In the medium/long term, the company must repay this equity in terms of dividends. The overall interest rate on the equity should also be higher than other investments to remain a viable option for the investors. This measures if the company can be profitable in the medium/long term. If every income cent is invested back in the company to make it grow or for R&D, nothing is left to pay the investors which, in turn, invested in a view to gain money. For a small, family owned, company, keeping it running is enough to make a living but, for larger companies, this may be a crucial, long term parameter.
So, when reviewing figures, start thinking in terms of the three balances, and let me know if you discover something new.