The concept of being in debt is something we pretty much hear every day during our daily activities. To the layman on the street, it simply means when a person owes a lot of persons and is not able to settle them when the obligation arises. The average individual has at one time or the other been in a little debt situation, so basically the word Debt is not new in any way.
This article however, does not focus on the debt of an individual but on the debt of Companies, with a focus area on SMEs. I intend to explain why Companies (SMEs) in general find themselves in a debt situation. We find ourselves in a period of time where the economic situation in the business environment of the country does not particularly support the sustenance of businesses, but is that to say that’s the sole reason or reason at all why your business is in debt? This article seeks to give answers to this and more questions surrounding the topic area.
It is a well-known and documented fact that Nigeria is facing an economic recession this of course directly affects businesses in Nigeria. But how does it really translate to the profit level of a business? A good guess any average person would make is higher cost of acquiring raw materials. Another question is, must the economic condition force a company into debt? Are there not businesses still thriving in the same business environment? So what are those businesses doing that your business is not doing? Well the good news is this answers would be provided in the succeeding paragraphs.
To start with, the number one reason for why your business is in debt is the High cost level. Profit is simply when your Revenue is greater than your expense. So when the cost of operation in the business is more than the revenue the business makes it means the business has made a loss, and when a company starts making a loss, watch closely, that business would probably start being in debt. A business that has made or has been making a loss is a major starter pack for a business in debt. The raw materials that were gotten from the suppliers were most likely on credit, a business that has made a loss may not have available cash to settle its creditors. So in essence, it is paramount that the cost level of a business must be closely monitored because this can make or mar the success of the business. Cost itself has several elements that makes it up, whether direct or indirect cost this should be kept to the barest minimum without affecting the quality of its output.
Another reason why your company is in debt is its low liquidity position. You may hear someone saying something like “I made profit last year how can I be in debt?” Yes Sir/Ma, as a matter of fact you can attain beautiful profit levels and still be in debt. The rational question on your mind now is, how? Permit me to say, the term profit is “Notional”. It’s notional in the sense that it does not really exist. You made a N4M profit but that doesn’t mean you have cash of N4M, in fact it’s possible you barely have cash of N100,000. The reason for this is because some notional items have been imputed to determine profit. A good example is depreciation. Again Sales most times are not recorded when cash moves in but when it’s probable that future economic benefits would flow to the entity. What this means is that you might have sales of say N20M but the cash you have gotten is only N1M. So it is very pertinent that a business monitors its liquidity positions and not be deceived by its beautiful Profit margins. Luckily, there are tools that can be used to keep an eye on your business liquidity position, it’s known as Liquidity Ratios.
Also, your business is in debt because of improper books of account being kept. It is a habit for most small and medium scale businesses not to audit their books of account either because there is no law mandating them to or just because they can’t afford to pay the fee for having their account audited. The downside to this is the risk of having material errors made in the books of account or the risk of not detecting fraud if one has been committed. Another risk that the business is open to, is window dressing financial statements. This is an incident that has sunk major corporations (Enron, Worldcom etc.) and can sink your small or medium scale business. It will be worse when you as the owner is not aware of this practice going on in your organization, consequently, led to believe that your business has a good health. Having your financials Audited by an independent party can’t be overemphasized. You shouldn’t do so when you’re mandated to, either by the Tax man or your bank but to kind of check the health of your business.
Make or Buy decisions. This is simply a decision to have a component of a product either made in-house or bought from outsiders. In this period of economic recession where the cost of raw materials have risen, it is important for businesses to analyze if it will be cheaper to have some components of the products made in house instead of buying from outsiders. Most businesses would complain about how the cost of the components for its product has gone so high. While this is most likely true it’s not to say that there are no cheaper ways of acquiring the component like making it in house. A Cost Accountant would assist you in determining the make or buy decision of your business.
A common reason for most businesses going into debt and a common one at that is Poor decision making on the part of a business owner. In the business environment, it is important that for whatever product is to be introduced to the market a proper survey has to be conducted to determine the success or failure of the product. Also, the target market has to be identified in other to have good margins on the product. You can’t develop a product that would appeal more to the youths while you push for sales of the product to a market that has more elderly people. Lack of planning and hasty decisions can lead to business failure. Lack of education and experience in Accounting and finance can lead to the likelihood of poor decisions, but no company is immune to making mistakes.
Another reason for your business being in debt is the prevailing market conditions. A business more often than not has a direct relationship with the overall economy. What it means is that when there’s a boom in the economy the business would experience a healthy period an when there’s a glut, well, the business experiences a downturn, all things being equal. During a downturn, customers don’t tend to spend a lot and this translates to a low revenue being made by a business. Again, for businesses operating in certain sectors that are susceptible to customers’ preferences, when there’s a change in preference this again may translate to low margins made by the company. Lastly, it could be as a result of competition. Competitive rivalry can drive a company out of business if it doesn’t have a good share of the market. The BCG matrix is a good tool that can be used to analyze the market share a business has in relation to its customers. Business should conduct environmental analysis to determine the prevailing conditions in the market and map out adequate strategies so as to be able to stay afloat and not be caught off guard.
The question on your mind now is, how can I reduce the cost level of my business? How can I manage the liquidity position of my company? Or your question could be how can I effectively analyze my business environment? This questions and many more would be answered on another edition which would be a follow up to this topic.
Otto Ekpe-Juda, ACA
About the Author
Otto Ekpe-Juda is a Chartered Accountant that loves engaging issues in Finance and Accounting, with specific bias in Audit, Forensic Accounting, Tax, SME Advisory, Accounting Advisory, Business Valuation, Insolvency & Corporate Re-engineering and Mergers & Acquisition