Forecasting tools for every SME business toolbox

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%2 relatively 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?

 

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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.

 

Sources:

  1. 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.
  2. As at 8 September 2014

 

 

How business can level the playing field after Budget blues

After the Federal Treasurer’s rhetoric on his Government being the government for small and medium business, the Federal Budget delivered on 8 May 2012 is remarkable in that if contains no new meaningful support to businesses that are not loss making.  If poor business conditions mean you are a loss maker this year (2012), please defer your loss until 2013 because the loss carry back rule to refund overpaid tax does not activate a refund until 2013. You must pay tax in 2012 to play.  Only a bureaucrat could come up with such a commercially inastute approach for suffering businesses.

Many business owners who have put in the kilowatt hours and made their way through difficult trading conditions to remain profitable have seen their positions deteriorate under recent budgets.  A working family in business may have seen their relative ability to contribute to their annual after tax wealth deteriorate by more than an annual $17,000 in post tax money. Losing that much cash hurts.  For someone selling out of their business or retiring in 2012/13 this position could snowball to more than $70,000 if you take into account a clever play to change tax rates to remove the benefit of a higher general tax free threshold from the “wealthy”, the exclusion of the middle to upper middle class in compensation for the effects of the carbon tax, lowering of tax deductible superannuation thresholds for those over 50 and the increase in superannuation contributions tax (see below).  One single measure causes most of the damage – the loss of a tax rebate on golden handshakes worth up to a whopping $52,500 if you do not retire before July 2012. Because so many of these measures hit people nearing retirement, some business owners will justifiably feel that the Government is changing the rules of the poker game just as they prepare to take some money off the table.

It is an article of faith in business that win-win deals produce better and more enduring results.  It is therefore deeply disturbing for the psyche of SME’s that an increasing focus on means testing full access to fundamental elements of our taxation system, such as the superannuation system or compensation for a scheme such as the Carbon Tax which has a universal effect, is producing winners and losers.  Losers often stop playing.

In 2012/13 when your tax deductible superannuation contribution is taxed at an extra 15% if your personal “adjusted taxable income” is greater than $300,000, you may feel a desire to throw in the towel and give away the superannuation system entirely.  Particularly if you and your spouse have been in business together but an act of history means one of you has all the family income counted mainly to one name only.  Take the case where one spouse owns all the shares in a trading company. It is time to pass out some profits to pay the bills. In such a case, let us take the example where there is a family cash income of say $200,000 funded as a dividend (effectively $100,000 for each spouse).   An add-back of your super and franking credits will easily take you over the $300,000 limit.  So could one-off leave pay-outs and gearing cash losses.  This creates what many would call the artificial result of placing you in the over $300,000 category. To have full access to super concessions denied to you feels unjust – why not just withdraw?

Don’t take the bait.  Leaving the superannuation system will ultimately do you far more harm than good.  Some of the people in Treasury would probably love to see you give away all those compounding tax concessions in a lifetime – they could be worth hundreds of thousands.  Instead, look at better ways to level the playing field and change the rules of the game to better protect yourself from any further unfavorable policy changes that this or any future Government might have on you.

Maximize what opportunities remain on the table and in particular at the State Government level with a modest improvement in the NSW state taxes landscape and strengthen your business against the general risks of difficult trading conditions.  Put a passive holding company over your trading company to create improved asset protection.  Examine shifting your wealth into structures that are separated from your personal names so that the income does not get counted towards your “$300,000” limit.  If you and your spouse are in business together and the allocation of equity is actually unfair and articificial based on contribution, look at restructuring this to create an enduring platform that can benefit both you and next generations of the family.  The Government has demonstrated its agenda to distribute wealth away from the middle to upper middle class.  You do not just have to sit there and take it.

If the Government is not going to help you grow your business, it’s time to take matters into your own hands.  There are many constructive and efficient actions that you can take to outmaneuver a “lose” position. Take control.

Stephen Cribb is a Partner, and the leader of the Growthstar program at Prosperity Advisers.