Most Small and Medium Enterprises (SME) have an accounting software package, engage a book-keeper to balance the books, have an accountant prepare year-end financials and tax returns, and will retain boxes full of source documents for as long as they are required to do so1. Often the compliance burden is seen as exactly that, a burden that while relevant to understanding their position, performance and how much tax they need to pay, is not terribly helpful as a management tool to manage and drive their business forward. But this need not be the case.
There are a lot of things that differentiate a poor business from a good one. From a financial perspective, those businesses that closely monitor and respond
to changes in their position, performance and liquidity (cash resources), are likely to run operationally better and be in a stronger position to develop
and implement more effective growth strategies.
This blog explores at a handful of financial management tools that will help the typical SME business manage its day-to-day operations and help shape its strategy.
The three-way forecast
Most businesses will set an annual P&L budget built from a combination of previous years results, the owner’s growth aspirations, market demand and other economic factors, and sometimes with little or no science at all. This is an important business discipline.
The process requires you to develop a series of assumptions to drive each individual line of forecast income and expenditure on a monthly basis. Some assumptions are easier to formulate than others as they may be based on the fixed price nature of items of expenditure, while others will require more subjectivity and ultimately be a sensible estimate. To formulate assumptions you need to look at:
- your previous results – often this will be the best indication of what you have demonstrated you can deliver
- the pricing and length of current contracts both with customers and suppliers
- interest rate forecasts for variable debt
- annual rental increases stipulated in your lease
- economic factors including your industry’s growth
- your current sales pipeline can help some businesses more accurately forecast – particularly in the earlier months
- if you are a services business consider your capacity to deliver – make sure you have enough people with the right amount of time available to meet your budget
- if you are a retailer, wholesaler or manufacturer consider your available inventory levels and pricing
- think about your phasing of income and expenditure over the year and the seasonality relevant to your business
Once you have formulated your P&L budget you have a realistic base case operating scenario for the business to work toward achieving. Now it is time for the prudent to think about the things that if they were to occur would have the most material impact (positively or negatively) on your business’ ability to deliver its forecast. This is known as undertaking a sensitivity analysis to your forecast P&L so you can try to avoid negative scenarios and work towards achieving the positive outcomes..
It is once management have a forecast to work towards that for many SMEs the planning stops. This is an unfortunate trap that far too many businesses get caught in and it is not until the profits are delivered at expectations but the business has run out of cash, that management realise they may have a problem on their hands. Remember that an insolvent business is one that cannot afford to pay its debts as and when they fall due not necessarily an unprofitable business – although related, distinctively different and important to understand. This is why you need to take your P&L forecast and ensure it interacts with a forecast balance sheet and cash flow statement.
Getting a P&L, a balance sheet and a cash flow forecast to talk to each other and reconcile can be tricky, but essentially you need to:
- take your opening balance sheet position from your prior years financial results and your newly developed P&L forecast
- from the P&L forecast develop timing assumptions for the payment of creditors, receipts from debtors and the take-up of inventory. Often debtor days, creditor days and inventory days sourced from previous results can be helpful in determining realistic payment cycles. You will also need to unwind the opening balances on your balance sheet (ie. you need to pay creditors from the prior period in the current period). These assumptions are important and will have a large impact on your cash position
- link non-cash items of expenditure to the relevant asset on the balance sheet (ie. depreciation and amortisation). This wont impact your cash position
- consider the amortisation of any loans required over the period (this will reduce the loan and reduce cash)
- consider items of capital expenditure not considered in the P&L and the cash outlays required
You now have a P&L forecast, a balance sheet forecast and a cash flow forecast. The cash balance in the balance sheet should reconcile to the cash
flow forecast and the net profit on the P&L should reconcile to the increase in equity in the balance sheet.
Now it is important to keep yourself accountable. Prepare a set of management accounts every month and compare your actual results to your forecast results. Use this to identify and respond to trends. If you find that you are falling well short of your forecast, you can always re-forecast. The more accurate the forecast you are working to, the more control of your financial position you will have.
The short term cash flow
The short term cash flow is a tool to help manage the intra-month cash position of the business. It will be much more relevant for cash and working capital intensive businesses than others, but every business can benefit from a more detailed understanding of their short term cash position. Short term cash flow forecasts are often stand alone tools (without the need to link them to P&L’s and balance sheets) that involve more precise assumptions over a 13 week period. You are always going to have more certainty over your debtor collections next month than you will over your collections in 12 months time. Depending on the business, the short term cash flow will forecast the receipts and payments on either a weekly or daily basis (use your judgement). The tool should be used by management to identify and remedy any intra-month liquidity constraints identified by the forecast. Unlike longer term forecasts that will often be set in place for the year, the short term cash flow needs to be a dynamic tool that should be updated either daily or weekly to track the forecast cash position in as close to real time as possible.
The return on investment consideration
Entrepreneurial small business owners often have the ability to identify an income producing asset and quickly attribute a value to purchase the asset and start driving growth. This is great when the income associated with the acquisition, when adjusted for the time value of money, exceeds the expenditure following as short as possible “pay-back” period but can be troublesome if things don’t work out exactly how they thought. An SME owner should consider the following before committing to outlaying new capital on an income-producing asset:
- What are the cash flows (not profits) that the asset is forecast to generate once operational?
- What are the sensitivities to those cash flows?
- What are all the costs associated with the acquisition (consider professional fees, assessments, commissioning, decommissioning, training etc)?
- What is the rate of return required (a ten year government bond returns 3.45%2relatively risk free) or if debt funded the cost of funding?
- What is the pay-back period for the asset – how long will it take to pay back the outlay before surplus cash flows are produced?
- How do the sensitivities impact the length of the pay-back period?
As a chartered accountant and business advisor for over ten years, I have advised a number of distressed businesses on implementing turn-around strategies. A common theme with all clients of that nature is poor viability around their forecast position (or no forecasting at all). A small investment in developing and entrenching these tools within your business can accelerate your businesses growth. At Prosperity Advisers, we can work with you to develop a three-way forecast, implement a short term cash flow forecast and consider your return on proposed investments. Call us for an obligation free discussion.
- Seven years for a company per the Corporations Act 2001 and generally five years for small business taxpayers per the Income Tax Assessment Act 1936.
- As at 8 September 2014