|Focusing on the financial risk for business owners
Both current and potential small business owners face difficult choices when it comes to financial decisions. Many often wonder, “How much risk is too much?” Do you find yourself pondering this question? Although the answer is unique to each business, understanding some of the many types of financial risk may help you make more informed decisions.
Cash flow risk
Perhaps the most important priority in any small business is making sure enough money comes through the door to keep the lights on and the operation running. To help the business weather low-cash-flow periods, be sure to have several months’ worth of business expenses (including your own income, as well as your employees’) set aside in a safe, liquid account for easy access. Make sure your business budget accounts for the time it takes most of your customers’ bills to be paid. Also, plan a few tactical moves that will help you quickly cut costs during short-term cash crunches.
For example, when times are good, buy supplies in bulk so that you can cut back in those areas during the crunch periods. Also, identify the discretionary items in your budget that can be eliminated, so you’ll know ahead how much you can save by doing so. Finally, when faced with financial challenges, try to negotiate better deals for both fixed and variable costs. Suppliers, lenders and even landlords will often renegotiate rather than risk losing a good customer or tenant.
Eager to get under way, new business owners may overlook the importance of choosing the most appropriate business entity. For example, are you comfortable putting your family’s home and your personal savings on the line for the sake of your great idea? If not, you probably want to consider your choice of business structure carefully. Not only is it critical in managing your personal liability, but your decision will also determine how much control you maintain over the business itself. Following is a brief overview of several popular business structures:
• Sole proprietorships: Although the easiest type of business to set up, a sole proprietorship is among the riskiest in terms of personal liability. This structure can put nearly all of your personal assets at risk.
• Partnerships: In a general partnership, all partners can act on behalf of one another in managing the business, and each partner is personally liable for the acts of others. All partners are personally responsible (though not necessarily equally so) for the financial obligations of the business. In a limited partnership, one person typically acts as the managing partner while others act as limited partners. The limited partners have little involvement in day-to-day management, and their personal liability is generally limited to the amount they invest.
• Corporations: C corporations and S corporations provide the greatest liability protection. However, there are many drawbacks to these entities, including higher levels of complexity and the potential loss of control to shareholders and board members.
• Limited Liability Companies: LLCs offer protections that are similar to corporations, but with less complexity.
Credit and interest rate risk
Although there are likely many successful entrepreneurial tales that began with maxed-out credit cards, financing your business with plastic is a highly risky endeavor. First, you need to ensure you maintain enough cash flow to make at least the minimum payment each month. Second, if you do not ramp up quickly enough to pay off the credit cards over a short period of time, you will end up paying much more over the long term than the initial amount borrowed.
Business owners with established track records may consider traditional commercial loans from either their local banks or the Small Business Administration. Consider, however, these loans typically have adjustable interest rates. Although rates have been relatively low in recent years, a strengthening economy has led to talk of higher rates, which means higher minimum payments for those with adjustable rate loans. Business owners should always be aware of interest rate risk and how it may affect their cash flow. Consider securing fixed-rate loans whenever possible.
Above all else, with both credit cards and loans, be sure to make your payments on time. Late payments or worse, a default, can damage your credit rating for a long time to come.
So how much risk is too much?
Answering this question takes a good amount of knowledge and perhaps an even greater amount of soul-searching. For any business owner, it's a personal decision based on unique facts and circumstances. Understanding the different types of risk involved can help you consider your options wisely, and then make the decisions that are right for you and your business.
This article was provided by Ken Weise, an LPL Financial Advisor. He can be reached at 707-584-6690. Securities offered through LPL Financial. Member FINRA/SIPC. The opinions of this material are for information purposes only.