The Entrepreneurial Challenge - I : Setting Financial Foundations
When we talk about someone investing and managing their money, the predominant image that tends to cross our mind an employee having a stable job that pays a fairly satisfactory monthly salary. And the fact that they have a steady stream of income flowing in every month would mean that they can dedicate a fixed percentage of their take home income every month to their savings and then invest the same. The stability and security of the income also takes a lot of uncertainty with regard to money management and financial planning out of the picture. But if we were to try and paint a similar picture for those who employ others and operate as their own bosses (entrepreneurs in other words), it would be impossible. This is simply because the income profile and financial stability of an entrepreneur is likely to be radically opposite to a salaried professional. Therefore the challenges that entrepreneurs face with regard to their investing and money management would have their own peculiarities. Therefore, over the course of this post and the next, I will try and provide an in depth view of the issues entrepreneurs face with regard to investing and money management and suggest solutions to each of them. This week I will focus on issues regarding the bigger picture in terms of money management and financial planning.
The broad areas that need to be addressed as part of an entrepreneur's financial plan would be the same as those addressed in a financial plan for anyone of us. Those areas being cashflow management, creating a buffer for emergencies, ensuring adequate life and health cover, creating investment portfolios for financial goals and managing taxes. But a major peculiarity to be kept in mind when creating a financial plan for an entrepreneur is the fact that entrepreneurs are completely responsible for managing the finances of their businesses while also being completely or partially responsible for managing the finances of their households. This means that any financial plan created for an entrepreneur must allow them to balance and meet both their personal and professional needs for money. Therefore, the processes and procedures employed to design and implement financial plans for entrepreneurs must be slightly more advanced relative to a financial plan for a salaried professional. I will now delve into planning strategies for each individual area of an entrepreneur's financial plan in detail, starting with cashflow management.
As with any other financial plan created for any individual, an entrepreneur's financial plan must be built on the foundation of a robust cashflow management system. A cashflow management system is doubly essential for entrepreneurs since any cash inflows that entrepreneurs recieve are likely to be sporadic and discontinuous, especially in the early years of the life of the business. And these sporadic inflows would have to be effectively managed and apportioned between the business and the household. In most cases entrepreneurs would need to set up two separate cashflow management systems, one for their business and one for their househould. The cashflow management system set up for the business would be most effective when it allows for multiple modes of digital payments to be used. This would improve transaction efficiency and provide a clear audit trail for each transaction. Cashflow forecasts must be prepared for shorter periods rather than longer periods to provide for potential seasonal fluctuations in cash inflows and outflows. Having a dedicated invoice management system in place would also be helpful. A few more tips for a robust enterprise cashflow system are given in the graphic below.
A part of the cash and profits generated by the business would be withdrawn by entrepreneurs to manage the needs of their households. The best way to set up a sound cashflow management system for the household would be to set up separate savings bank accounts for expenses and investments, and ensure that the amount in either account is used solely for their designated purposes. Preparing a comprehensive budget of household expenses would also be useful. It would tell us how much we are spending on each expense and help us prioritise and manage our spending a lot better.
The benefits of having a sound cashflow management system in place can be supplemented further by having an adequately sized buffer for financial emergencies in place. In most cases a buffer to the tune of 6-12 months worth of expenses is widely considered to be adequate. But, given that entrepreneurs face the risk of having to deal with financial emergencies in two different spheres with potentially irregular income streams, a buffer of this size would be grossly inadequate. Therefore entrepreneurs must maintain a bare minimum emergency buffer of 12-15 months' worth of their monthly expenses. Also, entrepreneurs who have EMIs to pay must ensure that they always have at least 5 EMIs worth of cash on hand in addition to their regular emergency fund. This can be understood better looking at the graphic below.
As with any other emergency buffer, entrepreneurs must maintain this amount in avenues that can be easily converted into cash at short notice (say a few days). Ideal options would therefore include hard cash, ultra short term and liquid mutual funds, savings accounts and fixed deposits with a sweep option. The size of the buffer must be monitored at regular intervals. The size may be changed as and when necessary. The emergency buffer must be fully replenished anytime it is dipped into.
Helping entrepreneurs provide for adequate amounts of life and health insurance coverage also involves a lot of meticulous forethought and planning. Most obviously, entrepreneurs and any other income earners within their families must invest in adequate life insurance usually to the tune of 10-20 times their annual income. The outstanding amount of any loans that entrepreneurs are yet to pay off must also be included and provided for when calculating the amount of life cover required. Entrepreneurs must also ensure that everyone in their families enjoys adequate health insurance coverage at all times. The best way to do this is to purchase a comprehensive health insurance plan with a family floater option.
But, entrepreneurs also have to ensure that the insurance needs of their employees are also taken care of, especially during the early years in the life of the business. Investing in group life insurance and health insurance plans that cover the employees and their families is the best option to meet these needs. In addition to this, entrepreneurs and important personnel within the organisation may explore the option of purchasing keyman life insurance policies. Keyman insurance policies compensate the organisation for financial losses suffered on account of the death of an influential person within the organisation. If a keyman insurance policy is purchased in the name of the entrepreneur, a portion of the death benefit may also be passed on the entrepreneur's family to compensate them for the loss of income they would suffer. The operational model of a keyman insurance policy is explained in the graphic that follows.
Designing a financial plan for entrepreneurs using the procedures discussed above would allow for enough flexibility to enable entrepreneurs to meet both their personal and professional financial needs. It would ensure that entrepreneurs have enough money to be adequately insulated against any interruptions in the consistency of the cash inflows generated by their businesses at all times. It would give entrepreneurs a solid foundation on which to build investment portfolios for their various financial goals. But this is a topic that needs to be covered in a lot more detail for full justice to be done to it. I will therefore end this post here and cover the specifics of building investment portfolios and optimising taxes for entrepreneurs in my next post.