Create an Effective Business Website

build effective websiteA strong web presence can give your company a competitive advantage. An effective website is a key ingredient in building the powerful web presence you want.

What constitutes an effective business website depends to a considerable extent on your audience. We can however, outline some general principles that apply to most sites.

Set Your Website Goals

Decide beforehand what you want your website to accomplish. Will it be used to sell products online, inform visitors, or generate leads? Make sure your website fits into your business and marketing goals so that you can maximize the effect of the resources you put into your website.

Try to think about what you’d like your website to accomplish in the longer term as well. This will help you decide on the technologies to use that best fit with your website objectives. For example, you’d like non-technical staff to be able to update the site, you would probably need to use a CMS (content management system).

Know Your Audience & Keep it Relevant

Remember, people will visit your website because they want something. Visitors ask themselves “what’s in it for me?” before clicking links, and only visit pages they think will be worthwhile to them. Time is precious and there are many websites out there competing for your audience’s time. Keep in mind what your visitors want, it will go a long way to help you create relevant content for your website.

For example, if you have an interesting company history, don’t hesitate to include it. However, make sure you put it in a section users expect, like an “about us” page. Don’t give into the temptation to add cool information about your company on pages where visitors are looking for other content.

Make Navigation Easy

Have navigation menus laid out in a logical way. Ideally, a visitor should be able to go to any page on your site from any other page. Make sure you have a “home” link so that users can get back to your main page if they get “lost”.

Having a site map is a good idea. It gives your visitors a page where they can access all of the other pages that make up your site. Another benefit is that search engines love them because it helps them index your site.

Use Visual Cues

Humans are visual creatures, use visual icons and images to guide users around your site. Avoid long blocks of text that are hard to read, break them up with headings and interesting images. Text only links are fine in navigation menus but images are better on pages where you want to grab your visitor’s attention. Just make sure you don’t over do it. Too many images will clutter up a webpage.

Make it Easy to Contact You

Don’t make people search for a way to get in touch with you. Make it easy. If you’re selling goods online, you should let your visitors know how to reach you on every page. For example, include your phone number on your page header and/or footer.

No Bugs & No “Under Construction”

Make sure there are no broken links and that there is no buggy behavior on your website. Users do not visit your site in hopes of testing it. Make sure they have a smooth ride.

If you have an area that is under construction, avoid linking to it and then having an empty page with an “under construction” notice. It’s a waste of user time. If linking to a section being built is unavoidable, at least, put some kind of description of what is to come.

Make the Visit Enjoyable

Consider including things like free information or videos that are of benefit to your visitors. People like to laugh, so why not use humour where appropriate? Interesting, useful and amusing content will encourage repeat visits and help differentiate you from your competitors.

Web Design Mistakes to Avoid

Not respecting accepted usability practices

Designers often want to use their skills to produce websites that are veritable works of art. Unfortunately, that well-intentioned exuberance often comes at the expense of functionality which is not a good thing for most business sites. This doesn’t mean your site has to lack creativity or be boring. Nevertheless, there are certain features that visitors expect when they arrive at your website. You could say these features have become a kind of “website standard”:

  • Clickable logo on the top-left of the page that links to the website’s home page
  • Horizontal navigation bar near the top of home page
  • Dark text on a light background for your content, especially if you expect your users to read for any significant length of time. Have you ever seen a news site with a black background and red text? Of course not, and for good reason!
  • Vertical scrolling so that users scroll pages up and down, not side to side

E-Commerce Overview

E-commerce is a truly revolutionary innovation. But what is it exactly, and what are its benefits? This article answers these questions and will give you an idea about how you can use this vital tool to help your business and customers.

What is E-commerce?

E-commerce describes using computer networks (often the Internet) to buy and sell products and services. Basically it means transacting online. Some people find this definition narrow and prefer the term e-business instead. We’ll use the term “e-commerce” to mean a broader definition which includes servicing customers, collaborating with business partners as well as transacting within the organization.

Some organizations can be called pure e-commerce organizations, in that all processes are digital. The products are digital (such as e-books), product delivery is digital, and the selling process is digital. At the other end of the spectrum, purely physical organizations use no digital dimensions and are called brick-and-mortar organizations. Many organizations fit somewhere in between and can be called partial e-comerce organizations. Amazon.com is a good example of a partial e-commerce organization. It sells physical goods but uses digital means for activities like customer service and order processing.

You might also hear the term click-and-mortar (or click-and-brick) organization. This refers to companies like Walmart, whose primary business is done in the physical world, but gradually expand their e-commerce activities.

Types of E-Commerce Transactions

E-commerce transactions can happen between various parties, not just between a business and its retail customers. The most common terms you’ll come across that describe the types of e-commerce transactions include:

  1. Business-to-business (B2B): Both the seller and the buyer is a business. Most e-commerce volume is B2B.
  2. Business-to-Consumer (B2C): The sellers are organizations and the buyers are individuals.
  3. Consumer-to-Consumer (C2C): Both the seller and buyer is an individual.

What’s the whole point of E-Commerce?

Most companies provide products and/or services to customers. To do so, the company has to buy inputs like parts or materials and/or services from suppliers, process the inputs, and then sell the final products to customers.

The main idea of e-commerce is to automate as many business processes as possible. By “processes” we mean things like order initiation, order fulfillment, buying, product delivery and customer support. The aim is to benefit both the seller and customer.

Benefits and Limitations of E-Commerce

As far as recent human innovations go, the benefits of e-commerce on businesses, individuals and society is no doubt towards the top of the list. On the other hand, e-commerce does have its limitations. As time passes, we expect these limitations to decrease, or to be overcome. We’ll quickly outline some of the main benefits and limitations of e-commerce on businesses and individuals.

Benefits of E-commerce

To Companies:

  • Expands an organization’s potential customer base by reaching customers in new markets in a cost-effective way.
  • Allows companies to buy materials and services from other organizations at less cost and more quickly.
  • Helps shorten or eliminate distribution channels allowing for lower prices and higher vendor profits.
  • The cost of creating and selling products that can be digitized (such as music and software) can be reduced by up to 90%.
  • Allows for lower costs in areas like telecommunication and inventory.
  • Helps smaller companies to compete with the big guys.

To Consumers:

  • Often provides less expensive products and services by allowing consumers to compare product prices more easily.
  • Gives consumers more product choice.
  • Enables convenient 24/7 shopping without the need to travel outside the home.
  • Customers can quickly retrieve detailed product information.
  • Enables customers to get customized products quickly and at competitive prices (computers, cars, etc.).
  • Makes it possible to work and study at home.
  • Allows for individuals to more easily sell to other individuals using classified and auction websites.
  • Allows consumers to interact in online communities to exchange ideas and compare experiences.

E-Commerce Limitations

  • There is currently a lack of universally accepted standards for quality, security and reliability.
  • Costly or inconvenient Internet accessibility for some potential customers.
  • Lack of national and international government regulations and standards.
  • Difficult to find accurate methodologies for measuring the benefits of e-commerce and for justifying its costs..
  • Perception that e-commerce is expensive and not secure.

Conclusion

Entire books on e-commerce have been written with far too many concepts for us to include here. Nevertheless, with this brief introduction to e-commerce, we hope you’ve gained a better understanding of what it’s all about and how you might use it to help your business and customers.

Basic World Wide Web Concepts

If you’re reading this, then the World Wide Web has probably become a part of your daily life. The Web is an increasingly important tool companies use to reach customers and other stakeholders. This trend is sure to continue into the foreseeable future. To help with decision-making on Web related matters, it’s a good idea for managers and business owners to have, at least a basic understanding, of what the Web is and how it works.

What is the World Wide Web?

World Wide Web diagramEssentially, the World Wide Web (WWW) is made up of a lot of interconnected computers (via phone lines, cables, or satellites). Some of these computers are designed to serve out webpages. These computers are called web servers, which are usually running 24/7. Other computers, like the one you are using to read this text, are called clients. Client computers make requests to server computers, like asking for a web page and its associated graphics. The server computer responds by feeding (or serving) the web page data back to the client.

The Internet is often confused with the World Wide Web. The Internet consists of a wide range of technologies including email, file data transfer, protocols (communications infrastructure) as well as the Web. The World Wide Web is just one component of the Internet.

Web Browsers

Web browsers are computer programs that are installed on client computers to request web page files from server computers. It’s the program you’re using to access this website and read this text. Once a request is made via the browser (by clicking a link or entering a web address in the “address bar”), the web server sever sends the requested data back to the browser. The browser then interprets the data and displays it on the screen.

Popular web browsers include Firefox, Chrome, Opera, Safari, Edge. Each of these browsers differ somewhat in terms of features, but their purpose is the same. They’re all meant to request and present web pages to the user.

“Mobile browsers” are web browsers designed for use on a mobile devices like PDAs and cell phones.

Website

A website is made up of a collection of files sitting on a web server. These files usually include:

  • Image and/or video files
  • Text files that tell the web browser how to layout the page and what text to include
  • Script files (small programs) that add functionality or effects to the webpage

Website Hosting

The files that make up your website have to be put somewhere that people can access. This somewhere is a computer running web server software.  The server takes incoming user requests and returns your website files to their browser. Web hosts are companies that rent space on their servers for you to store your website files on. The web host takes care of the necessary computer hardware, software and connections.

Website Address

website address barLets say you have a website, how can people reach it? One answer is, by entering your website address (or “URL” in nerd-speak) into your browser’s address bar. A website has to have a unique address so that it can be found. Just as real world home addresses are unique to avoid confusion, website addresses have to be unique also.

How do you get a unique address? By registering a domain name. Examples of domain names are “ibm.com” and “wikipedia.org”. Our domain name is “helpsme.com”. The helpsme.com domain name is mapped to the server that stores the files that makes up this website.

An organization named ICANN coordinates these domain names across the world. This is necessary so that when you type an address into your browser, you reach the website you were looking for.

Conclusion

The main ideas to understand are that:

  • The World Wide Web is nothing more than a large number of interconnected client and server computers
  • Websites are accessed by client computers via the web browser
  • Each website has a unique addresse determined by its domain name
  • Website files are stored on server computers that wait for requests from client computers

We have deliberately not gone into great technical detail here. Nevertheless, this article should give you a basic understanding of how the World Wide Web works and what’s required to have a website.

Financing Expansion

Financing ExpansionIf your business is on solid ground and you’re looking to expand, you’ll need to finance that growth. Expansion can involve a lot more than growing your customer base. It can mean tackling new markets, buying more equipment, offering new products, hiring employees and more. All of this requires money. But where can you find the required financing?

Retained Earnings

Retained earnings are company profits you keep in the company instead of paying yourself and other shareholders. It is very common for businesses to expand via retained earnings. The advantage is you don’t need to look for outside sources for financing and possibly give up equity. The disadvantage is that the speed at which you can expand is limited to the amount of available company cash.

Equity Investment

Raising money through equity investment means exchanging partial ownership of your company for cash. There are various ways of accomplishing this:

Investment From Within

If you bring in people to run the business with you, you’ll probably have them buy either a partnership share (if your business is not incorporated) or shares in your company (if your business is incorporated). After all, you did all the hard work and took the risk getting the business off the ground, it’s only fair that a new partner buy in. This will bring in some cash you can use for your expansion plans.

Incorporated businesses can also sell shares to employees. This brings in capital and has the added benefit of giving employees more incentive to to work hard to increase profitability. A downside with giving up significant share is that even if you make sure to keep at least 51% of the shares, you may still end up in conflicts.

Newer startups are often cash strapped. It can be difficult for these companies to afford the needed expertise. If this is your case, you may choose to bring in partners with needed expertise and trade shares in the company in exchange for work done. Otherwise known as “sweat equity”. The benefit is that you don’t have to pay cash up front for work done and the new partner shares in the risk. The downside is that if your company takes off, the equity you gave up might be worth a lot more than what it would have cost you to pay in salaries.

Angel & Venture Capital

It’s often easier to get financing from angels and venture capital once your business is out of the startup phase and has steady earnings. These investors often prefer to help businesses increase production and/or market share because it’s perceived as less risky than funding an unproven startup.

What exactly are angel investors and what is venture capital? Take a look at our “Sources of Financing” article for details.

Go Public

Your country of operation might have laws that can limit the number of outside investors that are allowed to have shares of your company. In the U.S. The U.S. Securities Exchange Act of 1934 generally limits a privately held company to fewer than 500 shareholders. In Canada, securities laws let a maximum of 50 people who aren’t employees own shares in a private company.

If you want to raise more money beyond what the limited number of investors can provide, you’ll have to “go public” or make an “IPO” (initial public offering). This means shares in your company to the public. The shares can then be traded between investors on a public stock exchange like the NASDAQ, NYSE or TSE.

A word of warning, an IPO is expensive and complicated to set up. You’re not guaranteed to get any money out of it and you’ll have to comply with regulations that private companies can avoid. As such, many owners prefer to stay private, and expand in other ways.

Loans

As with securing venture capital, loans are often easier to obtain for a business that has been running for a while with a good financial history. Banks, loan, trust, insurance companies and credit unions will often lend money to businesses. Additionally, governments sometimes have programs to guarantee loans for small businesses.

Sale & Leaseback of Equipment

If you already own business equipment, you can free up cash by selling the equipment and leasing similar equipment. Leasing companies will buy your equipment and lease it back to you. Of course, If you don’t really need the equipment at the moment, you can just sell it off. Any of these options will provide some extra cash.

Further Reading

For more information, please refer to our article on sources of financing.

Cash Budgeting

Cash BudgetThe cash budget is an essential tool for short-term financial planning. It shows you how cash flows in and out of your business, so that you can figure out what your company’s short-term financing needs (and opportunities) are. With a cash budget, you can get a better idea about what your company might need to borrow in the short-term. Crucial, if you want to avoid cash-flow problems.

This article explains cash budgeting using an example. We’ll create a quarterly cash budget for a one year period. Although, in practice, you could create one for any reasonable time period (60 days, 90 days etc.).

Cash Budgeting Example

Let’s say your company is a toy distributor called Toy Inc., and you sell mainly to retail stores on credit, so that sales do not generate cash immediately.

Other assumptions:

  • Toys Inc.’s fiscal year starts on July 1st
  • Sales are seasonal. Peak sales are in the second quarter because of Christmas.
  • Toy Inc. Has a 90 day collection period, and 100% of sales are collected during the following quarter
  • Accounts receivable at the end of the fourth quarter of the previous fiscal year is $1 million
  • Collections (of accounts receivable) in the first quarter of the current fiscal year are $1 million

The first quarter sales of the current fiscal year of $10 million are added to the accounts receivable, but $10 million of collections are subtracted. This means that Toys Inc. Ended the first quarter with accounts receivable of $10 million.

The table below shows collections for Toys Inc. for the next four quarters. In our example, the only source of cash is the collection of accounts receivable. In reality, cash could come from other sources such as sales of assets, long-term financing, and investment income.

cash budget inflows

Cash Outflow

Once cash inflow dealt with, we look at cash outflow. Cash disbursements can be put into four basic categories:

  1. Payments of accounts payable. These are payments for products or services that Toy Inc. has bought on credit. Purchases will depend on the sales forecast. For toy Inc., let’s assume that:

    • Payments are equal to last quarter’s purchases
    • Purchases are equal to half of next quarter’s sales forecast
  2. Payments of wages, taxes and other expenses. This category includes all other normal costs of doing business for which payments are made. Depreciation is not included because it does not involve cash outflow.
  3. Capital expenditures. These are payments made for long-term assets like equipment and buildings. In this example, let’s say Toys Inc. Plans a major capital expenditure in the fourth quarter.
  4. Long-term financing. This includes interest and principal paid on long-term debt as well as dividend payments to shareholders.

To show cash outflows, we create a table shown below:

cash budget outflows

The Cash Balance

Finally, we put cash outflows and inflows together in another table. Below, we see that a large cash outflow is forecast in the second quarter. This isn’t because of an inability to earn profit, rather, it’s because of delayed collection on sales. This results in a cash shortfall of $3 million in the second quarter.

Let’s say Toys Inc. has established a minimum operating cash balance of $0.5 million to protect against the unexpected and to facilitate transactions. This means the shortfall in the second quarter is equal to $3.5 million.

cash budget

What-If Analysis

Once you have a best guess estimate for your cash budgets, you could take it further by tweaking conducting a “what-if analysis”, or “sensitivity analysis”. For example, you might substitute best-case and worst-case values for the sales forecast, and see how it affects your cash budget.

Capital Budgeting

Capital BudgetingIf you’re trying to decide whether or not to buy a long-term asset for your business (like a vehicle, machine or some expensive software), you want to be reasonably assured that it will be worth it. By “worth it”, we mean that the benefits outweigh the costs. Capital budgeting helps evaluate the whether a long-term asset will pay off. 

This article won’t make you an expert in capital budgeting. It should however, provide you with a good overall understanding of capital budgeting and some commonly used techniques. To get the most of this article, it’s best to have an understanding of the time value of money.

To help make that “to buy or not to buy” decision, we introduce four common approaches to capital budgeting:

  1. Payback Period
  2. Accounting rate of return
  3. Internal rate of return
  4. Net present value

Example Company – Frodo’s Bakery

The easiest way to understand the approaches to capital budgeting is take a look at them using an example company. We’ll use the example of a fictitious bakery called Frodo’s Bakery (let’s say Frodo found that the market for rings and other jewelry was saturated, so he opened a bakery instead).

Frodo’s Bakery is thinking about buying a new automatic bread cooker that would cost $70,000 and last 5 years. It would boost capacity and decrease operating costs, allowing Frodo to increase profits by $20,000 per year. Frodo’s cost of capital is 10% (or, Frodo’s interest rate is 10%). Frodo expects the cooker to have a $10,000 salvage value (in other words, Frodo expects to sell the cooker for $10,000 at the end of 5 years). Is the investment in the new cooker worthwhile?

Payback Period Method

The payback period calculates the number of periods needed to recover a project’s initial investment ($70,000 in this case). Since Frodo gains $20,000 per year from the investment, the payback period is 3.5 years (3.5 x $20,000 = $70,000).

Many people consider the payback period to be a measure of risk. The longer the payback period for the investment, the higher the risk.

There are two main problems with the payback period capital budgeting approach:

  1. The payback period method ignores the time value of money. We know that because of the time value of money, it is always better to receive money earlier than later. Cash received earlier should be weighted differently than cash received later.
  2. It ignores cash outflows that happen after the initial investment and the cash inflows that occur after the payback period. For example, say that Frodo could have bought a different bread cooker which provides the same cash flows as cooker 1 except that it has a disposal value of $20,000. Of course, it’s better for Frodo to buy the cooker he can sell after 5 years for $20,000 but the payback method would consider both choices to be equivalent because the their payback periods are the same at 3.5 years.

Despite these limitations, the payback period approach is one of the most widely used. Probably because of its simplicity.

Accounting Rate of Return Method

The accounting rate of return approximates the return on an investment. It’s calculated by dividing the average accounting income from the investment by the average level of investment.

Accounting Rate of Return = Average Income / Average Investment

Suppose Frodo decides to depreciate the cooker using the straight-line method (meaning that the value of the cooker decreases by the same amount each year). With a $10,000 salvage value, this means that the cooker will decrease in value by $12,000 per year for the 5 years.

Annual depreciation = (Historical Cost – Salvage Value) ÷ Asset Life = ($70,000 – $10,000) ÷ 5 = $12,000.

Therefore, the increased income Frodo will report thanks to the new cooker will be $8,000 ($20,000 – 12,000).

The average investment for the cooker will be $40,000 as shown below:

Average investment =  (Initial investment + Salvage Value) ÷ 2 = ( $70,000 + $10,000 ) ÷ 2 = $40,000

This means the accounting rate of return for the cooker will be:

Accounting Rate of Return = Average Income ÷ Average Investment = $8,000 ÷ $40,000 = 20%

If the 20% accounting rate of return is greater than the target rate of return, Frodo should by the cooker.

The accounting rate of return method is an improvement of the payback method because it considers cash flows in all periods. However like the payback method, this method has drawbacks because by averaging, the explicit timing of cash flows isn’t considered.

Net Present Value Method

The net present value (NPV) is the sum of all present values of all cash inflows and outflows associated with a project (or investment). This method incorporates the time value of money. To calculate an investment’s net present value, we can use the following six steps:

  1. Choose the appropriate length of time to evaluate the investment proposal. The most common period length used in practice is annual, although some analysts also use quarterly or semiannual period lengths. In the example case of Frodo’ bakery, use 1 year because all cash flows are stated annually.
  2. Identify the company’s cost of capital for the period length chosen in step 1. Frodo’s stated cost of capital is 10% per year. Since the period chosen in step 1 is annual, no adjustment to the 10% is necessary.
  3. Identify the incremental cash flow in each period of the project’s life. In Frodo’s case, there is an immediate $70,000 cash outflow to pay for the cooker and $20,000 cash inflow at the end of each year for 5 years. Finally, a $10,000 cash inflow (salvaged) at the end of 5 years. It’s best to organize the cash flows associated with a project on a time line like the one shown. This allows you to identify and consider all the project’s cash flows systematically.
  4. Calculate the present value of each period’s cash flow. In Frodo’s case, we have a five-year annuity of $20,000 at 10% and a $10,000 cash inflow in 5 years as the salvage value.

    We can use our financial calculator to show that the present value of the annuity is $75,816.
    Present Value of an Annuity

    The present value of the $10,000 salvage in 5 years when Frodo’s cost of capital is 10% is $6209.
    Present Value - Capital Budgeting
     

  5. Add up the present values of all the periodic cash inflows and outflows to determine the investment’s net present value. In the case of Frodo’s Bakery, the present value of cash inflows from the investment is $82,025 ($75,816 + $6209). Because the $70,000 investment happens at time zero (immediately), its net present value of that cash outflow is $70,000. This gives us a net present value for this investment of $12,025 ($82,025 – $70,000).
  6. If the project’s net present value (also called residual income) of a project is found to be positive, the project should be accepted from an economic perspective. In the case of Frodo’s Bakery, it would be worthwhile to buy the new cooker because the net present value is positive ($12,025).

Internal Rate of Return Method

The internal rate of return (or IRR) is the rate of return expected from a project or investment. It is the discount rate that makes the net present value of the project equal to zero. If an investment’s net present value is positive, it means that it’s IRR is greater than its cost of capital. In other words, the project’s rate of return exceeds the rate to fund the project.

We can use trial and error to find the IRR for Frodo’s cooker. We substitute various values for the rate of return in our net present value calculation. The value that yields a net present value of zero is 16.14%. Because the IRR for the investment is greater than the 10% cost of capital, the project is desirable.

A project’s net present value summarizes all of its financial elements. This means you don’t need to use the IRR method to prepare financial budgets. Moreover, the IRR method has disadvantages:

  • It assumes a company can reinvest a project’s intermediate cash flows at the project’s internal rate of return. This assumption is often invalid.
  • Using the IRR method to evaluate proposed investments can produce ambiguous results, especially when evaluating competing projects when the company doesn’t have enough cash available to invest in all positive net present value projects.

The net present value calculation is superior to the IRR method and only requires one extra piece of information for the calculation – the company’s cost of capital. Nevertheless, internal rate of return is pervasive in financial markets and is widely used in capital budgeting.

The Effect of Taxes

So far, we’ve ignored the effect of taxes in our capital budgeting calculations. In practice, the effect of taxes needs to be taken into account. Tax laws vary from region to region but in general, taxes have two major effects:

  1. Companies have to pay taxes on the net cash benefits resulting from an investment.
  2. Companies can use the depreciation cost of a capital investment to offset some of the tax burden.

Tax rates and the methods companies are allowed to use to depreciate acquisition costs of their long-term assets vary. Nevertheless, the concept is usually the same – taxes are paid on income from the investment while depreciation expense from that investment reduces taxes paid.

To continue with our example, let’s assume Frodo’s bakery is taxed at a rate of 40% and has an after-tax cost of capital of 7%. To convert all pretax cash flows to after-tax cash flows, we need to know the amount of depreciation that will be claimed each year. Using straight-line depreciation, Frodo will claim $12,000 depreciation each year, as mentioned earlier.

We can now compute the after-tax cash flows resulting from this investment:

Net Present Value Calculation With Taxes
NPV with taxes

As we can see, the project’s net present value is positive ($6,013) which means the investment is desirable.

Credit Management

Credit ManagementWhen a company makes a sale, it can either collect payment right away in cash, or extend credit to the customer and collect payment later.

Granting credit can provide a company with increased sales but it also carries costs.

Costs of granting credit include the:

  • Delayed receipt of cash from sales
  • Costs incurred for the management of accounts receivable
  • Losses from bad debts

Granting credit increases sales because:

  • Of added convenience for the customer
  • Customers may spend more using credit than they would with cash
  • It “signals” potential customers that the product is of high quality because time is given to return the product if it is deemed unsuitable or defective

Credit policy has several components:

  1. Terms of sale
  2. The decision to grant credit
  3. Optimal credit policy
  4. Assessing customers’ credit worthiness
  5. Collecting payment on overdue accounts

In this article, we take a look at these components.

Terms of Sale

The terms of sale are the conditions for which credit is granted to customers. This includes the payback time period and cash discounts (if any).

If you offer customers credit terms of “2/10, net 30”, this means that invoices must be paid within 30 days and that a 2% discount applies to invoices paid within 10 days. If the terms are “net 60”, this means invoices must be paid within 60 days and there is no discount for early payments.

Cash Discounts

Cash discounts are often provided as part of the terms of sale. Cash discounts help speed up the collection of the receivables. It’s important to balance the cash discounts with the cost of the discount.

Credit Period

Credit periods vary widely among industries. A consumer electronics wholesaler might provide terms of “2/10, net 30”, while a jewelry retailer may sell diamond necklaces for 5/30 net 5 months.

Important factors to consider when establishing a credit time period are:

  1. The size of the account: Customer who buy small amounts are less important and managing credit for these customers is more expensive. Smaller accounts generally have shorter credit periods.
  2. The probability customers won’t pay: In industries with high-risk customers, businesses often offer more restrictive credit terms.
  3. The perishability of the products: If the collateral value of the goods can be sustained for only short periods (such as fresh fruits and vegetables), normally less credit is granted.

Credit Instruments

Usually, the only formal credit instrument between companies is the invoice. Credit offered in this way is said to be on “open account”.

For large orders or when a company thinks there may be a problem collecting payments, there are several credit instruments available that may help avoid controversies.

  • Commercial draft: The seller writes a commercial draft calling for the customer to pay a specific amount by a certain date. The draft is sent to the customer’s bank with the sellers invoices. The bank has the buyer sign the draft and then gives the buyer the invoices. The goods are then shipped to the customer. In cases where immediate payment is required, the draft is called a slight draft.
  • Banker’s acceptance: When a commercial draft isn’t good enough for the seller, the seller might require that the customer’s bank pay for the goods and then collect the money from the customer. When the bank agrees to do this in writing, it’s called a banker’s acceptance.
  • Conditional sales contract: An arrangement where the seller delivers the product but retains ownership of the goods until it is paid for in full is called a conditional sales contract. The customer usually pays in installments with interest costs built into them.

The Decision to Grant Credit

When deciding whether or not to grant credit, companies can try to asses the potential increase in sales and the costs associated to granting credit. If it’s found that the benefit exceeds costs, credit should be granted.

In practice this assessment can be complicated because it means taking into account various factors including:

  • The delayed revenues from granting credit
  • The immediate costs of granting credit (cost per sale that is not paid for)
  • The probability of payment
  • The rate of return for delayed cash flows.
  • The cost of better estimating the probability of default for any given customer
  • Long-term future sales increase by granting credit

The above factors are sometimes linked, which adds further complexity to the assessment. For example, expenses incurred to find the credit worthiness of customers have the benefit of weeding out high-risk ones. This decreases the overall probability of default.

Optimal Credit Policy

It’s helpful to think of the decision to grant credit in terms of opportunity costs and carrying costs.

  • Opportunity costs are the lost sales from not granting credit.
  • Carrying costs of granting credit include the delay in receiving cash, the losses from bad debts and the costs of managing credit.

Opportunity costs of lost sales decrease the more credit is extended. Carrying costs of granting credit increase the more credit is extended. In theory, the optimal amount of credit is where the incremental cash flows from increased sales are exactly equal to the carrying costs from the increase in accounts receivable. In practice, the optimal amount of credit can be tricky to find.

Usually, firms extend credit when it’s advantageous for them to do so. Extending credit tends to be advantageous if the firm:

  • Has a cost advantage over other potential lenders
  • Has monopoly power it can exploit
  • Can reduce taxes by extending credit
  • Sells products with quality is difficult to determine

In general, a firm should extend credit more liberally than others if it has:

  • Has excess capacity
  • Has low variable operating costs
  • Has repeat customers
  • Is in a high tax bracket

Assessing Customers’ Credit Worthiness

Several sources of information are available to help determine whether or not a customer will pay.

  • Financial statements: When granting credit, you can ask for the customer’s balance sheet and income statement. Use the financial statements to see if the company looks healthy and perform some liquidity ratio tests as discussed in our article on financial statement analysis.
  • Credit reports: Many companies sell credit information of business firms. Dun & Bradstreet is a well-known credit reporting agency. Others can be found on this list of credit reporting agencies. Ratings and information are available for a many firms, large and small.
  • Banks: As a business customer, your bank may provide information on the credit worthiness of other firms.
  • The customer’s payment history: A good predictor of future behavior is past behavior. If collecting from a given customer has been problematic in the past, consider reducing or revoking credit.

Once customer information has been collected it’s time to evaluate the customer and decide whether or not to grant credit.

Financial institutions have developed elaborate statistical models for credit scoring. This involves the studying the relevant and observable information available about a large pool customers to find their historic relation to default rates. This method has the advantage of being more objective but it may be out of reach for most firms.

Once information is gathered, many companies use the more traditional and subjective guideline known as “the five Cs of credit”:

  1. Capacity: The customer’s ability to pay credit obligations out of operating cash flows. This is the most important of the five factors.
  2. Character: The customer’s willingness to meet obligations. It’s primarily a subjective impression the potential customer makes on the lender.
  3. Capital: How much net worth the borrower has, or the borrower’s financial reserves.
  4. Collateral: Pledged assets in the case of default
  5. Conditions: General business conditions surrounding the customer that affect the customer’s ability to pay.

Collecting Overdue Payments

Collection of past due accounts requires the credit manager to first keep a record of the payment history of each customer. Credit managers will set up an “aging schedule” to tabulate receivables by age of account. Many accounting packages do this automatically. The aging schedule shows which customers have overdue accounts.

Many firms use the following procedure for customers that are overdue:

  1. A delinquency letter informing the customer of its past-due status is sent
  2. A phone call is made to the customer
  3. A collection agency is hired
  4. Legal action is taken against the customer

Firms sometimes hire an independent company (referred to a “factor”) as an “outside credit department”. The factor checks the credit of new customers, authorizes credit and handles collections and bookkeeping. As accounts are paid, the factor keeps a small percentage as compensation. If any accounts are late, the factor still pays the seller after an agreed upon time.

Factoring is conducted by many small businesses. It is especially popular with manufacturers of retail goods because it lets outside professionals deal with the headaches of credit.

Cash Management

Cash ManagementMost companies hold some of their assets in cash – even though cash earns no interest. Why hold cash instead of investing it in promising projects or short-term securities? Of course, one reason for holding cash is to pay for goods, services and wages. A company might prefer to pay its employees with short-term government bonds but that simply wouldn’t be practical. The main reason for holding cash is to facilitate the payments and collections for the regular activities of the firm. Cash inflows (collections) and outflows (payments) are not perfectly synchronized. Some cash holdings are necessary as a buffer.

Given that carrying cash has a cost, the objective of cash management is for the firm to hold as little cash as possible while still operating effectively and efficiently. Three important aspects of cash management are:

  1. Finding the target cash balance
  2. Collecting and paying cash efficiently
  3. Investing excess cash

Finding the Target Cash Balance

Holding too little cash might mean running into difficulty paying suppliers and workers. It could mean being forced to sell other assets or borrowing, which comes at a cost. The cost of holding too much cash is that it just sits in the back account, collecting little or no interest, instead of being put to work to generate more cash.

Larger firms sometimes use mathematical models to estimate the ideal casn range to hold
(if you’re curious about some of these models, do a search for the “Baumol” and “Miller-Orr” models) .

For smaller firms, a more practical approach starts with a cash budget, as outlined in our article on short-term financial planning. It helps determine when cash short-falls might happen. Experience also plays a large role when setting a lower cash limit.

Collecting and Paying Cash Efficiently

The traditional way of receiving payments is to first mail out an invoice, wait for a check to arrive, depositing the check at a bank, and waiting for the check to clear. This process can take days or weeks.

More recently, electronic payment systems have been introduced that can speed up payment processing dramatically. Electronic data interchange (EDI) is the general term used to refer to the practice of direct, electronic information exchange between businesses. EDI allows for the seller to bill the buyer electronically, let the buyer authorize payments, and have funds transferred. This allows businesses to avoid the postal system completely. Another advantage of EDI, is that payments to suppliers can be made right on, or just before, the due date more easily. There’s no need to estimate mail transit times.

Older EDI systems were expensive and complicated to set up. Today, with the growth of the Internet this has changed. E-commerce systems that allow for online transactions have become affordable even for small businesses.

Investing Surplus Cash

Instead of leaving cash idle in a checking bank account that pays no interest, why not make some relatively safe, short-term (money market) investments?

Many large companies manage their own short-term financial assets, transacting through investment dealers and banks. Smaller companies often use third parties for a management fee. The fee is compensation for the fund manager’s professional expertise. Banks will often have short-term investment options available for their business customers. This is a convenient (and relatively safe) way for a smaller business to invest idle cash.

Long-Term Financial Planning & Growth

long-term financial planningSmaller startups are often less concerned with long-term planning than getting off the ground and surviving. While many businesses may benefit from long-term financial planning, the more established businesses tend to have the resources and stability to analyze the long-term.

Why do companies bother with financial planning? Because financial planning establishes guidelines for the firm. Additionally, a company’s growth rate and financial policy are linked. The goal of financial planning is to:

  1. Identify the firm’s financial goals
  2. Analyze the difference between goals and current financial status
  3. State actions needed for the firm to achieve its financial goals.

Short-Term & Long-Term Defined

The short-term is usually defined as the coming year. The long-term is usually defined as longer than one year. Often, the long-term is defined as the coming two to five years.

What is Corporate Financial Planning?

A financial plan is a statement of what needs to be done in the future to achieve company goals.

Long-term financial planning is required to implement decisions that have long lead times. For example, if a company wants to build a factory next year, contractors probably have to be lined up this year.

Financial plans are made up of the combined capital budgeting analyses of each the firms projects. So, the smaller investment proposals of each operational unit are added up and treated as one big project.

Financial plans are meant to:

  • Make the link between different investment proposals and the financing choices available to the firm.
  • Help the firm work through finding the best investment and/or financing option.
  • Help the firm avoid surprises by identifying what may happen in the future if certain events take place.

Elements of a Financial Planning Model

Companies come in all different sizes and sell different products. There is no boiler plate financial plan template for all companies. There are however, some common elements that are found in a financial plan:

  1. Sales forecast. Financial plans require a sales forecast. Perfectly accurate forecasts are impossible but specialists can hep assess the impact of unforeseen events.
  2. Pro forma financial statements. Financial plans have a forecast balance sheet and income statement. Financial statements that estimate future financial position and earnings are called pro forma statements.
  3. Projected capital spending. The plan describes required assets and proposes uses for net working capital.
  4. Financial requirements. The plan discusses dividend policy and debt policy. Firms may also consider selling new shares. In that case, the plan should take into account what types of securities are to be sold.
  5. Economic assumptions. The plan describes the state of the economic environment that the firm expects over the life of the plan such as interest rates.
  6. Plug variable. The “plug” (or “balancing item”) is a mathematical concept that is important to note because it is used in financial plans. Let’s say the financial planner assumes net income will grow at a particular rate. The financial planner also expects assets and liabilities to grow at different rate. In order for the financial statements to remain balanced and consistent, the growth rate of stock outstanding may be chosen as the “balancing item”. Outstanding stock growth rate is then set to whatever value that allows the financial statements to remain mathematically correct. Of course, dividend payout or another variable may be used as the plug, it doesn’t have to be outstanding stock.

What Determines Growth?

Specified sales growth rates are often stated as corporate goals. Why sales? Because it is assumed that if sales grow, the value of the firm (shareholder value) will grow accordingly. This logic is flawed because profitability can decrease even with increased sales.

Growth should not be the goal, but it should instead be a consequence of the firm’s chosen projects that maximize net present value (NPV). If the firm accepts negative NPV projects just to grow in “size”, it generally makes shareholders worse off.

In our article about the time value of money we discuss net present value. To summarize, the NPV of a project is the today’s dollar value of the future income that project generates, minus today’s value of the costs incurred by the project.

Financial Planning Models – Caveats!

Of course, financial plans are only as accurate as the assumptions that go into the plan. The GIGO principle applies – garbage in, garbage out.

There are other concerns about financial planning models.

  • Financial models don’t uncover which financial policies are best.
  • Financial planning models are too simple. In reality, their assumptions don’t always hold.
  • In practice, especially in large corporations, financial planning relies on a top-down approach. Senior managers determine a growth target, and financial planners tweak the plan with overly optimistic figures to match that target.

A financial plan can serve to provide guidelines but don’t rely on the plan blindly.

Short-Term Financial Planning

Short-term financial planningShort-term financial planning is important for virtually all businesses – from small startups to large established businesses. Even large businesses with seemingly healthy income statements have gone bankrupt, simply because they couldn’t meet their current obligations.

Short term planning helps answer important questions like:

  • How much cash should you have available in the bank to pay bills?
  • How much inventory should you keep on hand?
  • How much credit should you extend to customers?

Short-Term Finance Defined

The main difference between short-term and long-term finance is the timing of cash flows. Usually, short-term financial decisions are defined as those that involve cash flows within the next 12 months. The long-term is usually defined as longer than one year.

Operating Cycle and Cash Cycle – Unsynchronized!

A common reason firms get into cash flow problems is because of the timing of cash flows during short-term operating activities.

To illustrate, we can look at some typical short-run operating activities of a manufacturing firm:

  1. Buying raw materials
  2. Paying for raw materials → cash out
  3. Manufacturing the product.
  4. Selling the product
  5. Collecting cash → cash in

The operating cycle is the time between the arrival of inventory and the date when cash is collected from receivables. As we can see, cash is usually paid out before it is collected.

The cash cycle starts when cash is paid out for materials and ends when cash is collected from accounts receivable.

Imagine a company could buy inventory, sell its product, collect payment, and pay suppliers all in one day. The company would have a cash cycle of zero days. It’s hard to think of many examples of this type of firm because most companies have a positive cash cycle. The longer the cash cycle, the more the need for financing.

Strategies for Reducing Cash Flow Problems

Decrease cash cycle time

Decreasing cash cycle time can help significantly reduce the chances of cash flow problems. This is why companies frequently try to decrease their inventory and receivables time periods. Cash cycle time can be decreased further if payments to suppliers can be delayed.

Cash reserves

Keeping cash reserves and few short-term liabilities can go a long way to help avoid financial distress. However, this comes at a cost. Having idle cash that is not put to work or invested means future revenue is foregone.

Maturity hedging

Maturity hedging is a fancy term that simply means paying for short-term costs, like inventory, with short-term loans. It is usually better to avoid financing long-lived assets (such as machinery) with short-term borrowing. That type of maturity mismatching requires frequent refinancing, and is riskier because short-term interest rates are more volatile than long-term rates. Maturity mismatching also increases risk because short-term financing may not always be available.

It’s important to note that short-term interest rates are normally lower than long-term rates. This means that it’s generally more expensive to use long-term borrowing than short-term borrowing.

Cash Budgeting

The primary tool for short-term financial planning is the cash budget. It gives managers a “heads-up” about when short-term financing may be needed. A cash budget simply records estimates of cash receipts and payments.

Cash budgeting starts with a sales forecast, usually by the quarter, for the upcoming year. By using the sales forecast and factoring in the receivables period, we can get an estimate of the timing of cash collections by quarter.

Next, cash payments are taken into account. Cash payments are often put into four categories:

  • Payments of accounts payable
  • Capital expenditures (cash payments for long-term assets)
  • Long-term financing costs (interest, dividends etc.)
  • Salaries, taxes and other expenses

Finally, the quarterly cash balance is found by subtracting the quarterly cash inflows with the cash outflows. Financing arrangements have to be made for quarters with a net cash outflow.

Larger companies often go beyond the “best guess” outlined above and use multiple “what if” scenario analysis, and sensitivity analysis.

For more details, see our article that covers cash budgeting in depth.

Common sources of short-term borrowing

Operating loans

Operating loans from banks are the most common way to finance temporary cash deficits. It’s an agreement where the company can borrow up to a certain amount for a given period – almost like a credit card. Operating loans can be unsecured or secured by collateral.

Interest is charged on the loan and is set by the bank. It’s usually the bank’s prime lending rate plus an additional percentage. The bank may increase the rate over time as it assesses the borrower’s risk.

Banks lend mainly to low-risk borrowers. This is why they often decline risky business loans. Many loan requests that banks turn down come from small businesses, particularly startups. These startups then often turn to alternative financing sources.

Financial institutions may require collateral (called security) for a loan, such as property, accounts receivable, or equipment. These are called secured loans. For secured loans, the interest rate charged is often less than with unsecured loans.

Letter of credit

Letters of credit allow borrowers to pay off a balance and borrow funds as needed. This differs from a short-term loan where the borrower receives a lump sum of cash and can borrow more only after the short-term loan is repaid.

Other sources

Larger companies use a variety of other sources of short-term funds. Commercial paper are short-term notes issued by highly rated firms. Banker’s acceptances are similar to commercial paper except that they are guaranteed by a bank in exchange for a fee charged by the bank.