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Financial Management - Part 2
Financial Management - Part 1 (January 2005) discussed the importance of setting up a solid accounting system comprising four key elements: When set up correctly, these four elements ensure the information you look at on a daily, weekly, monthly, quarterly, and yearly basis is as accurate as possible.
Financial Management - Part 1 (January 2005) discussed the importance of setting up a solid accounting system comprising four key elements:
- Chart of Accounts
- Internal controls
- System documentation
When set up correctly, these four elements ensure the information you look at on a daily, weekly, monthly, quarterly, and yearly basis is as accurate as possible. However, these elements only help you look at the past. Solid financial management looks at the present and future as well.
To ensure a solid financial future, consider the following questions:
- When do I want to be financially independent and/or retire?
- How much money will I need to achieve financial independence?
- How much money do I need to make each year to meet my living expenses?
You may choose never to retire, but it is ideal to have the choice. If you have no idea — or only a vague idea — of when you want to be financially independent, how will you get there? Not having a plan is like driving across country without a map — you may make it from one coast to the other; then again, you may wind up in Mexico.
No matter your age, you need to set a target date for financial independence. The date won't be set in stone, but you'll at least be able to make some decisions based upon that date. Once you pick a date, you'll need to figure out how much money you'll need for the goal to become reality.
Money, however, shouldn't be the only goal. Other goals should include being able to decide how much vacation to take or how many hours per week you'll work. These goals need to be discussed openly with your family as well as any other professionals that will help you meet your short- and long-term goals.
Several sources can help with financial planning; however, if you're not sure where to start, contact a Certified Financial Planner (CFP). Certified Financial Planners should be used only as a tool, not a crutch.
To map out your long-term financial plan, you'll need to answer questions about current living expenses, plans for children (you have or plan to have) for college, weddings, braces, etc. You'll also have to plan for homes, taking care of parents if need be, and any other major life expenses. In addition, you'll need to lay out your non-financial goals with a planner so he or she can factor these into your financial plan as well.
It can take weeks or months to thoroughly plan for your financial future. Remember that you will need to continually revise your plan as unforeseen things happen.
It is important to realize that expenses are inevitable. However, when you have a sound financial plan you start to gain control over your business and your life.
Understanding the logistics of financial planning allows you to have choices. For example, you can say no to extra jobs because you are on target to meet short- and long-term goals. Or you can say yes to those jobs because they'll knock one year off your timeline to retirement. Either way, if you've planned your financial future successfully, you get to make the choice — not the other way around.
Once you understand the logistics of long-term financial independence, start to build your business around your goals. Observe the following example.
Chris Smith is 45 years old and would like to retire at age 60. Chris is married; his spouse does not work outside the home; and he has two young children. It will be at least 10 years until the oldest is in college. Chris has not saved a lot of money thus far, but recently read an article on retirement and decided to meet with a financial planner. Chris has about $150,000 of net worth. This amount is based on a 401K from a previous job, a small inheritance put into a CD, $15,000 in savings and equity in a home.
This is Chris's sixth year in business. His sales revenues last year were slightly more than $1,800,000 from six fixed-contract custom homes with an average gross margin of 14.3 percent. Chris took a salary of $85,000 and had net profits of a little over 3 percent (about $54,000). Chris has a full-time superintendent and a part-time bookkeeper/administrator. All three employees work out of his home office; a situation that will have to be remedied sooner than later with an office outside of the home. Chris hopes to retire drawing $150,000 pre-tax per year.
Chris has a strong sales background from a previous job but very little financial or accounting experience. In addition, Chris rarely completes detailed estimates before a job starts. Chris works 60 to 70 hours a week with little time or energy left over to spend with the family.
Chris has never prepared a yearly budget but took a basic financial management course at the local HBA. Chris is determined to prepare a yearly budget this year. Chris also learned that industry gross margin targets for top performing builders are double the margins the company earned the previous year and is even more determined to remedy this situation. Chris got some help from an outside professional to help get the company's accounting systems in order. Chris now feels ready to take the next step — working with a financial planner — to set some long-term goals.
Chris was nervous about meeting the financial planner; however, during the meeting Chris learned several key lessons:
- The Smith family lived off of nearly all Chris made. It would be difficult to dramatically change their lifestyle.
- The Smiths would need between $2 million to $2.5 million in retirement savings. This meant putting away an average of at least $65,000 a year toward retirement. The more money the Smiths put away in the early years, the better off they will be.
- Realistically, retirement would need to be pushed back five years to age 65.
Chris was a little disappointed at first, but soon realized it was better to know exactly what would need to happen over the next 20 years than to be blissfully ignorant and wake up at age 60 not ready for retirement.
Chris learned that the quickest way to improve profitability is to increase the gross margin of each job sold. Chris realized there are only three ways to increase the gross margin:
- Sell each job for more
- Build each job for fewer direct costs
- Utilize both of the above options
Chris had been using the same mark-up for every job he'd done throughout the past six years. Having also recently learned the difference between mark-up and gross margin, Chris realized he had been making mistakes when setting the final sales price. Chris is confident that future jobs can be sold for more profit (at least 3 percent more) by utilizing the sales skills learned early in his career.
Building homes for fewer direct costs could pose a problem. Chris has struggled with estimating and thought that it would be much more difficult to improve in this area. Other builders Chris knew had full-time estimators who also helped with purchasing. Chris thought this could be a viable alternative for improving gross margin by reducing costs.
Chris spent an average of 10 hours per week working on estimates. Having learned that a good estimator could reduce costs by as much as 2 percent for a builder, hiring an estimator sounded like a good idea.
To realize his dream of being financially independent, Chris wrote down the following goals. He planned to discuss his goals with a financial planner later in the week during a work.
Chris's goals included the following:
- Work fewer hours and spend more time with the family (reduce work week to 50 - 60 hours)
- Take two full weeks of vacation this year (plan the vacations this month and book them in calendar)
- Spend more time learning about corporate and personal financial management (2 hours per week)
- Prepare a month-by-month yearly budget for the family (review with the family once a month)
- Prepare a month-by-month business budget for the year.
- Improve gross margins by 3 percent. Sell jobs for higher prices and build them for less.
- Consider hiring a full time estimator. Explore how realistic this is.
- Earn $50,000 more in net profit this year. Examine how much more business is needed to achieve this goal.
- Move the office out of the home and into a more visible location in the community by June. Look into building a model home and using that as an office vs. leasing office space
After creating his list of goals, Chris felt comfortable discussing his long-term goals with the financial planner.
In Financial Management - Part 3 we'll discuss how Chris and the financial planner worked through each of the goals and how they set the budget for the current year.