Know Your Financials

Entrepreneurship entails some element of creativity and vision. But in order for you to move within this vision, you have to deal with the exact science of managing your financials. In order for you to grow or expand, you need to invest at something. In order for you to invest, you need to have cash. In order to have cash you have to check your sources: If your business is currently earning already, then you manage your costs and save your cash for your future investments. If you are only starting a business yet, you have two sources: (1) From your own cash savings either from employment or practice of a profession and; (2) From borrowing.

It is not wrong to borrow and actually advantageous if you know the mechanics of borrowing. What is that mechanics? That you have to pay an annual cost and you have to return the money lent to you at some point in your business. Knowing these simple mechanics help you plan well in allocating a portion of your cash to pay off these loans. Going back on the concept of borrowing or leverage and how it helps a company. Imagine putting up a business with resource requirements of 100 pesos. This resources can generate revenues of 150 pesos and income of 10 pesos. The return 10/100 on your investment is 10% way better than how the market is performing today which is at (6-8%) and way way better than putting it in a savings account which only give you .5%-1.5% interest income. Now imagine if your 70 pesos (not 100) can achieve a business which generate revenues of 150 pesos and income of 10 pesos. The return on your investment is a whopping 14%. Now you’ll wonder how your 70 pesos can afford to have a business that can generate 150 pesos of revenue requiring 100 pesos of resources? The answer is the borrowing of 30 pesos (100-70). Here now you see that by using other people’s money, you can optimize the return on your investment. But this borrowing also comes with a risk if you cannot pay it. The lesson then is that before you borrow, you should ensure that your business model can generate enough cash flows to service this debt throughout this life.

Another point in leveraging is its cost lower than the cost if you invest using your funds. We know most things comes with a cost and it only makes sense if you prefer to go with an option with the least cost. Cost of debt is cheaper than cost of equity, you know why. Current corporate debt right now in the market ranges from 6% to 8% and your equity? How do you get the cost of your equity, it is very subjective. Imagine yourself having money, if instead of outing it in your business you decide to put it in the market which currently or forecasted in the near term to earn 7.5%, this means it is only logical for you to at least demand a return of 7.5%. But wait aside from inputting these alternative investment opportunity in the calculation of the cost of your equity had you decide to put your money in the business, you should also think of other compensation for the risk of tying your money with the business. Risk of business not going well, Risk of not having the opportunity to put your money in other business that would boom, etc. etc. Thus it only makes sense that your cost of equity could be around 9-17% by factoring other risk factors. Thus comparing cost of debt of 8% with cost of equity of lets say 14%. Cost of debt is cheaper.

In summary in running a business, you need to source funds, put it in resources that would generate revenues that could give you returns above the cost of sourcing that funds in the first place and the cycle continues. First determine your leverage (this is also managing the cost of your funds), then when you have resources in place with the funds you have, implement your business model to generate revenues above the amount of resources you invested. In order to produce income you have to manage the costs that will eat up these revenues. Only then you achieve a satisfactory return. Thus the key is 3 activities: (1)Manage cost of funds (2) Manage asset utilization (3) Manage cost of operations.