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Financial Risk Analysis and Debt Prevention in Sole Proprietorship

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By: Krishna Kumar
on 20th Nov,2013

This is the age of entrepreneurship and anyone with an idea is breaking free of organizational shackles and setting up shop on their own.
Financial Risk Analysis and Debt Prevention in Sole Proprietorship


This is the age of entrepreneurship and anyone with an idea is breaking free of organizational shackles and setting up shop on their own. For those who are not looking at large-scale operations, establishing a sole proprietorship is easy. It’s also relatively risk free. However, if you are someone on the new business bandwagon, you mustn’t let the assumption that you have less to lose, get in the way of putting a few debt-control measures into place.

 

Scale of Operations and Related Investments

A sole proprietorship could vary in business size, facilities and the number of people who work in the business. You may be flying solo as a freelance web designer, writer or graphic artist. In which case the investment in your business tends to be lower. You probably work from home so you don’t need to worry about spending on office rent. However, bear in mind that your home rent is also your office rent. So lack of earnings for whatever reason, will impact you both on the personal front and on the work front. Your investment in your business infrastructure is also possibly low. Maybe you decided to purchase a slightly higher end computer and printer, and shelled out a bit for a proper desk, ergonomically designed chair and a UPS. Last but not least, you possibly purchased some wheels in case you have to visit clients at their premises.

 

On the other hand, you may have dreamed a little bigger than a home-based office. Perhaps you’ve gone further and started a tiny bookstore, or you’ve rented a space and begun fixing motorcycles with the help of your best friend. You could be manufacturing small artifacts for sale to larger showrooms, or designing and displaying your own brand of clothing. No matter the scale of your business, you must never lose sight of the fact that in a sole proprietorship, you are solely liable for any loss of business or debts that you incur.

 

Financing and Capital

Financing a sole proprietorship may require taking a loan from friends, family or even a bank. When your initial capital is from an interest-based loan borrowed from an institution, you need to make sure that you earn enough from the very first month of operations to pay off your loan EMIs.

 

Risk Analysis

No matter how small your business is, you must account for possible financial risks that could impact you negatively. For example, during a financial recession companies are less inclined to spend on certain services. If your services fall into an area that is not crucial to other businesses, you will find it hard to gain new contracts.

 

One of the biggest risks you face as a sole proprietor is credit risk. Say for example, you’ve purchased some supplies on credit that you need in order to manufacture an item that you sell. Your assumption is that you’ll pay for your purchase once you sell the item you manufactured and earn some money. However, everything depends on how many items you actually sell. If for some reason, people are not buying your product, then you are in trouble as you won’t be able to pay your supplier on time. In order to prevent this, you always need to ensure that you have enough capital to repay your debts, in the event that you fall short.

 

There are other liabilities that you as a sole proprietor could face. Let’s assume you’ve rented a small space to do business. A freak storm hits the city one evening and when you come into work the next morning, you find your premises completely flooded and all your equipment ruined. If you need to continue your business, you must account for such unforeseen financial risks.

 

Some Precautions for Debt Prevention

Here are a few ways to protect your sole proprietorship from being buried under the burden of debt.

 

Spare Capital: Don’t always operate check to check. Ensure that you have some liquid capital set aside for emergencies and unforeseen financial contingencies. The general rule of thumb is that you must have enough spare finances to live debt-free for at least six months. This isn’t really over-ambitious, particularly if you have a bank loan to pay off every month.

 

Separate Personal Finance from Official Finance: When you’re a small operation, it’s tempting and sometimes unavoidable to separate your personal finances from your official finances. After all, you’re not used to listing a coffee you had at a local hangout, as a business expense. You tend to forget that the reason you were at the coffee house in the first place was to meet a client for some new business. Here’s what you should think of doing. Start a separate account for work, if you have to. Save all your business related bills neatly, in a separate folder and keep separate personal and business accounts.

 

Book Keeping: If you aren’t great at accounting, think about paying an outside consultant to keep your books. If you can’t afford to pay an experienced professional, look to hire somebody who in turn is looking to get some experience on the job. Perhaps you’ll get lucky and find a young candidate who is doing their CFA Level I training and is, therefore, to a large extend clued in with accounts, finance, banking and investments. If you find someone like that to help you, it would be a win-win situation for both of you, where you enjoy the benefit of good bookkeeping and your young helper benefits of some on-the-job learning.

 

Keep Records: Make sure that you send out invoices for every job and follow up on receiving your payment acknowledgements. Keep a duplicate copy of all finance-related documents and correspondence. Create a filing system that you are comfortable with and make a habit of doing your filing at the end of each workday.

 

Invest in Low-Risk, Easily Liquefiable Assets: Consult your bank to find out how you can make a few investments that give you suitable returns, without locking in your money for a long period of time. When you earn greater profits, channel them back into some sensible investments. These will come in handy on a rainy day. It’s also a great way to put away money for future investments when your business grows.

 

There’s a lot of satisfaction to be gained from being your own boss, doing your own business and watching your efforts translate into attractive earnings that you don’t have to share with anyone else. Unfortunately, it’s also easy to get carried away, or get lazy, when you’re responsible to no one but yourself. Sometimes you could get over-confident and over-stretch yourself in the belief that you will overcome challenges as they come along. Yes, when you do business, you must take a few risks. However, it is good to keep in mind that it’s far better to take calculated risks rather than dangerous ones. Stay free, stay solvent and stay free of debt.

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