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The truth is in the cash flow

It’s the Vibe (On Overtrading) – Part 3

It’s the Vibe (On Overtrading) – Part 3

In this final instalment on Overtrading I will look at the actions a business owner can take to remedy overtrading.

Have a Plan

Growth doesn’t happen by itself. There is activity that you, the business owner, is planning to follow in order to generate growth.

As such, you have the opportunity to plan at the outset for the resources you need to support your growth ambitions – be it more people, more equipment, more space or more cash.

You need to prepare a budget that identifies the expected financial impacts of your growth plan on your profitability, balance sheet and cash flow.

By having a plan and a budget you have operational and financial reference points against which to track your actual progress. It will quickly become apparent whether you are growing quicker or slower than expected and whether the actual operational and financial impacts are within or outside expectations. This frame of reference will help you decide what changes you need to make to your plan and the required resources to support the revised plan.

If you haven’t planned, and find yourself in an overtrading situation, then these are the steps you need to take:

Self Help First

Firstly, you need to stay on top of your working capital.

This means being disciplined with invoicing and following up with a good collection process.

It means identifying slow-moving stock and considering whether it should be discounted for a quick sale to bring in cash.

It could mean asking creditors for a temporary extension to your payment arrangements.

Essentially, you need to be doing everything possible to increase the amount of cash coming into your business whilst slowing the outflow of cash as much as is commercially feasible. This will buy you time to reorganise the people and equipment resources needed to support your growth.

An Operational Plan Next

Secondly, you need to fix any operational problems.

Do you have all the fixed assets you need to support the level of growth being experienced? Is additional plant and equipment needed? How much will it cost, and how quickly can it be installed and operating?

Do you have road blocks in your processes and procedures that are slowing down your productive capabilities? Ask your employees about this – you might be surprised by their insight.

Do you have the right number of employees to support the new level of business activity? How long will it take to find and train new employees? Is there a need to use a labour hire company to help out on a temporary basis?

Is it possible to sub-contract out some of the work whilst your labour and equipment requirements are brought into line with the new level of business activity?

Is it possible to reschedule delivery time frames whilst these activities are undertaken?

Will the business continue to be profitable once the new resources are deployed?

A Cash Flow Forecast Last

The financial effects of the prior two steps now need to be incorporated into a cash flow forecast. It should be a weekly based forecast for the first three months, moving to a monthly based forecast for the following 9 months.

If the forecast indicates a need for additional finance you are now in a position to approach your financier with a cogent explanation of the issues you are facing, the steps being taken to rectify those issues and the short and medium term financing needs of your business.

If you can show a clear pathway out of your cash flow crisis then you have a chance that the finance needed will be approved, as it is only a temporary requirement.

If you can’t show a pathway out then you face a credibility issue with your financier – the precursor to a collapse caused by overtrading.

The Key Message

The key message for business owners (and their advisers) wanting to avoid the trap of overtrading is to plan for growth upfront, to track performance against plan, adjusting and revising the plan as dictated by the real world experience.

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It’s the Vibe (On Overtrading) – Part 2

It’s the Vibe (On Overtrading) – Part 2

My first post on this topic dealt with the consequences of overtrading and the difference between business growth and overtrading.

This post will help an owner of a small or medium-sized business identify when their business is overtrading.

I think there are a number of qualitative and quantitative signals that help a business owner identify when growth has become overtrading.

Here’s what I would be looking out for:

Qualitative Factors

  1. A feeling of being overwhelmed by the volume of orders on hand;
  2. Increasing volume of customer complaints, or customer complaints when previously there were none;
  3. Rapidly changing priorities;
  4. Lack of time to concentrate on other (staff training, financial, etc) aspects of the business.

Quantitative Factors

  1. Negative operating cash flow*;
  2. Rapid increase in net working assets#;
  3. Rapid lengthening of the Cash Conversion Cycle#;
  4. Rapid lengthening Debtor Days and Stock Days#;
  5. Extending Creditor Days# beyond agreed payment terms;
  6. Insufficient funds in the bank account to meet normal operating expenses.

* A quick way to measure Operating Cash Flow is to calculate the Net Profit after Tax for the period, less dividends paid in the period, plus depreciation expensed in the period less the increase / plus the decrease in Net Working Assets over the period.

# Follow the link to find out what these terms mean and how to use your financial information to measure and track them over time.

As the business owner generally works in the business I think it most likely that they will notice the qualitative factors first. As a business adviser often sees the business from a financial perspective I think it most likely that they will notice the quantitative factors first.

In isolation, I think of these factors as trip-wires. They alert the business owner to the danger that growth is becoming overtrading. So, whenever one of these wires is tripped, the business owner (or their adviser) should take a hard look at whether other signals are also present. For example, a business owner feeling overwhelmed by the volume of work should take a hard look at what is happening to the working capital of their business. Similarly, a business adviser seeing a trend of negative operating cash flow should ask the business owner about the volume of work, level of complaints, etc.

If only one type of factor is evident (ie: either qualitative or quantitative, but not both) then overtrading may not be an issue. However, I think overtrading is definitely occurring when both qualitative and quantitative factors are evident. 

So, here is the message for business owners (and their advisers): By knowing the difference between growth and overtrading, and the signals that help identify overtrading, a business owner (or their adviser) is in a position to take action to mitigate the damage caused by overtrading.

My next post, which will be the last on this topic, will look at some of the responses a business owner can take to remedy overtrading and return to growth.

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It’s the Vibe (On Overtrading)

It’s the Vibe (On Overtrading)

Do you remember Dennis, suburban solicitor and defender of the common man from the 1997 movie, “The Castle”?  Hopelessly out of his depth, he represents the Kerrigan family in court, to save their home from compulsory acquisition. In making his closing argument, Denis utters these immortal words “…in summing up, it’s the constitution, it’s Mabo, it’s justice, it’s law, it’s the vibe and uh, that’s it, it’s the vibe”.

I was reminded of that scene the other day, when I found myself musing over the difference between growth and overtrading. The train of thought had popped into my head because I have recently been helping owners of small and medium-size businesses that are undergoing rapid growth. I first heard the term “Overtrading” in 1988-89, just prior to the last prolonged recession in Australia. Whilst the “vibe” of the term was always clear, nobody I was working with at the time, or since, could cogently define overtrading for me.

Now, SME owners generally want to grow their business, but overtrading can quickly become fatal for a small or medium-sized business with only limited access to new capital (ie: new debt or new equity). In a 2011 research paper by Johan Van Der Spuy and Gideon Nieman, both of the University of Pretoria, they cite South African based research from 2007 where overtrading is listed as a cause of bankruptcy in 47% of cases.

With these thoughts in my head, I wondered, when does business growth morph into overtrading? What signs will help the owner of a small or medium-size business know that they are overtrading? And, how can the owner rectify overtrading?

In this article, the first of three, I will offer the SME owner (and their advisers) an answer to the first question. The second will help the SME owner identify when they are overtrading before it becomes fatal, and the third will set out for the SME owner the actions they can take to mitigate the effect of overtrading.

There is very little research on overtrading, other than the paper I mentioned earlier. In it were a couple of comments that I found particularly helpful in establishing a definition for overtrading:

  1. Overtrading…is the rapid growth of a business in which such strain is placed on the business’s capacity and/or resources, that when something (small) goes wrong the entrepreneur cannot deliver and problems grow in frequency.
  2. The…sustainable growth rate of a business, is the rate at which a company can grow without creating a cash flow problem.

The message for an SME owner (and their advisers) is that overtrading is incredibly dangerous to their business. It occurs when growth reaches a pace that overwhelms the physical resources of their business such that the quality of the product(s) or service(s) provided suffer and/or when growth reaches a pace that overwhelms the financial resources of the business creating cash flow problems.

Join me in my next post to find out how to recognise the symptoms of overtrading before it fatally damages your business.

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Leadership and SME Culture

Leadership and SME Culture

In my very first post (It’s Not Rocket Science) I outlined four major issues faced by small and medium business, as discerned by Enterprise Connect. One of them was Business Ecology, which I take to mean the workplace environment / organisational culture.

A recent article I wrote on the usefulness of KPIs (The Emperor’s New Clothes) received a comment from a reader, which put forward the proposition that an organisation’s culture is responsible for whether employees deciding to game or not game their KPIs.

Considering the foregoing, I’ve been mulling over business culture, particularly since the exchange with that reader of my earlier article. What is the nature of an organisation’s culture? How does an owner of a small or medium-sized business created a good business culture? What is the benefit of doing so? What qualities does an owner of a small or medium-sized business need to create the best business culture?

For the purpose of this article, and in the context of SMEs, I am going to define an organisation’s culture as being the relationship between an SME owner and their staff. Later in the article, references to “leader(s)” are interchangeable with “SME owner”.

So, what then of the other questions? I found three particularly insightful articles on The Conversation web-site.

The first, Why autocratic bosses are a dying breed, by Morgan Witzel provides fascinating insights into the nature of business leadership. This is more an opinion piece than research, but the author does back up his opinion with numerous examples of high-profile business leaders. Witzel’s central point is that the best that leaders can hope to do is bring people together and try to persuade them to work together.  He makes a couple of other points for SME owners to consider:

  • Leaders (SME owners) need to learn humility.
  • Leaders (SME owners) need to work in partnership with their organisations (people).
  • Leadership is something best done with people, not to them.

The second, Productivity Push should focus on frontline managers, by Daryll Hull offers insights into the qualities of an excellent workplace leader. It references previous academic studies in this area, and provides the links to those studies. In this article you will find a range of characteristics, sourced from research carried out by the article’s author on behalf of the Business Council of Australia. Some of the characteristics of an excellent workplace leader include: fairness, accessibility, ethical, empowering people, giving recognition where due, building trust and no bullshit.

This article also addresses the primary benefit from creating a good culture through leadership, being improved productivity. And to be clear, productivity in this sense is the amount of output per unit of input. To do this well, the author recommends that the business develop the leadership skills of their supervisors and line managers through training. My own view, in the context of an SME, is that the owner should undertake this sort of training first, and then follow it up with training for their supervisors / managers. This will ensure they have a “common language” when working on the business culture.

The final article, How individual firms can solve the ‘productivity paradox’, by Danny Samson is research orientated and offers an insight into the benefit of creating a good culture. It’s a great article which sets out in stark terms the scale and nature of the problem in terms of labour productivity, and then offers a solution, which is for the business owner to ask the workers on the “floor” to identify the activities that create noise in their day, engage them to find the supporting data, work with them to find a solution and empower them to implement that solution. In my opinion, an SME owner that follows this process will go a long way to creating a great workplace culture.

For my own part, I would add the following practical suggestions on how an SME owner can create a strong culture:

  • Smile.
  • Take an interest in your people.
  • Explain how their activities contribute to the success of the business.
  • Treat people the way you would like to be treated.
  • Listen (hard) to your staff.

In summary, the owner of a small or medium-sized business who treats their employees as people first, explains to them the importance of their role, demonstrates that their efforts are valued, engages with and empowers them will reap the benefits of a highly productive workforce.

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Seeing the Light (on Working Capital)

Seeing the Light (on Working Capital)

When I was in my teens, a favourite movies was the Blues Brothers. It was shown at the (then) decrepit Cremorne Orpheum cinema in Sydney. We’d watch, dance and sing along to this movie with its absurd plot, revelling in its wonderful sound track.

If you are familiar with the movie, you will know that Jake and Elwood are on a mission from god, to raise the money needed to save the orphanage where they grew up. They don’t know how they are going to source the money until Jake “sees the light” and they decide to put the band back together.

This blog will help SME owners “see the light” on why managing working capital is an easy way to increase cash flow. It picks up on a key message from the research set out in my first blog (It’s Not Rocket Science, 19 November 2013) being that a business with a shorter cash conversion cycle (ie: one that manages its working capital) has better liquidity, requires lower levels of capital and enjoys better returns on investment than a firm that does not manage its working capital. It will give the SME owner the tools needed to begin managing working capital.

First, let’s define a few key terms.

The Cash Conversion Cycle is the number of days between the outlay of cash (to acquire inventory, for example) and the recovery of that cash (the collection of sale proceeds from debtors). It is calculated by adding Debtor Days to Inventory Days and then deducting Creditor Days from this figure.

Debtor Days is a measure of the number of days it takes to collect debtors. It is calculated by dividing Trade Debtors at a point in time by the aggregate of Sales for the 12 months to that point in time and multiplying that result by 365.

Inventory Days is a measure of the number of days a business holds its stock before it is sold. It is calculated by dividing Stock at a point in time by the aggregate of Cost of Goods Sold for the 12 months to that point in time and multiplying that result by 365.

Creditor Days is a measure of the number of days it takes a business to pay its trade creditors. It is calculated by dividing Trade Creditors at a point in time by the aggregate of Cost of Goods Sold for the 12 months to that point in time and multiplying that result by 365.

The Capital of a business is the sum of the equity provided by the owners of a business plus the debt a business has raised from its financiers.

The Working Capital of a business is the amount of Capital invested in the Net Working Assets of the business.

The Net Working Assets of a business are its Inventory plus Trade Debtors less Trade Creditors.

To manage Working Capital an SME owner first needs to measure and track the value of the Net Working Assets and Cash Conversion Cycle.

Net Working Assets represent a Point in Time view of Working Capital. An SME owner who tracks the value of their Net Working Assets on a monthly basis will know the amount of Capital invested as Working Capital and whether that investment is rising (using cash) or falling (generating cash). By breaking the Net Working Assets into its constituent parts, the SME owner can establish the driver(s) for the movement in their Working Capital.

The Cash Conversion Cycle is a Relative view of Working Capital, which provides the SME owner with information about how their Net Working Assets are moving relative to the trading of the business. By tracking the Cash Conversion Cycle over time a business owner will receive information about how efficiently their business is using its available Capital – a falling Cash Conversion Cycle is a sign that capital use is becoming more efficient (ie: you’re stretching a dollar of capital further), a rising Cash Conversion Cycle is a sign that capital use is becoming less efficient (ie: you’re likely to run out of capital sooner).

This information is useful to all SME owners, in all business situations. It is essential for an SME owner with a growing business as nothing uses Capital quicker than growth.

Working Capital management begins when an SME owner uses the information from tracking Net Working Assets and Cash Conversion Cycle to identify and prioritise for review those operational elements of their business that impact on Net Working Assets. For example, the invoicing process, customer credit policy, and debtor collection process have an impact on the value of Debtors and on the Debtor Days ratio – by reviewing these processes it may be possible to reduce the value of debtors / speed up their collection without compromising Sales. Similarly, stock re-order triggers, minimum and maximum holdings, identifying fast and slow-moving stock, and supplier delivery times have an impact on the value of Stock and the Stock Days ratio – by reviewing these processes it may be possible to reduce the investment in stock / reduce its holding period without compromising Sales.

Process improvement can be measured by tracking subsequent changes to Net Working Assets and Cash Conversion Cycle. Using this approach, continuous improvement and low risk, incremental changes to working capital related process is possible. If done successfully, the SME owner will see a permanent reduction in the use of their Overdraft, or a permanent increase of funds in their Bank account.

The SME owner who has “seen the light” has options in the form of access to greater cash flow: they can use this cash flow to invest in the continued growth of their business, to pay a dividend, or increase the efficiency of their business. If you’re not already actively managing your working capital it is time to jump on the band wagon.

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It’s not Rocket Science

It’s not Rocket Science

I was recently at a function put on by Enterprise Connect, a Federal Government body, established to help small and medium size business grow and prosper.  It included a short presentation about their Business Review programme, from which a number of facts stood out.  The first was that Enterprise Connect had completed 6,200 business reviews since inception.  The second was the characteristics of the businesses reviewed: 63% were manufacturing businesses, 79% had sales between $1m and $10m, and 69% employed less than 30 staff.  Thirdly, the critical issues identified by most business owners where they needed help were Cash flow management; Profitability; Succession; and Business Ecology.

This presentation reinforced my belief that The Truth is in the Cash Flow, and that small and medium size business recognise this, but are not equipped, or do not feel equipped, to find their truth.  So, with this in mind, I am going to embark on a series of blogs to help inform owners of small and medium-sized business (and their advisers) about how to use their existing financial information to effectively manage their cash flow.

I thought I would begin by looking at the academic research on the importance of cash flow management to small and medium business.  I have drawn my inspiration for this blog from an excellent website, The Conversation.

You will find on that site four articles summarising various aspects of 5 research projects into small business cash flow management.  These articles were all published by Tim Mazzarol, Winthrop Professor, Entrepreneurship, Innovation, Marketing and Strategy at the University of Western Australia on The Conversation website between 1 January 2013 and 3 February 2013.  The research projects were undertaken in Australia, New Zealand, Europe, The United Kingdom and the United States of America.   In total these projects drew on information from more than 17,000 small and medium-sized business.

Whilst you can read the articles in full (and I encourage you to do so) I have summarised what I think are the relevant and practical findings for the time poor:

Although the research reviewed deals with different aspects of cash flow management, each paper shares a common focus on the benefits of working capital management (ie: the management of debtors, stock and creditors).

Businesses that have a shorter cash conversion cycle (ie: those that manage their working capital) have better liquidity, require lower levels of capital to support business activity and enjoy better Returns on Investment than firms that do not manage their working capital.

There is a significant and positive correlation between the level of involvement of the business owner in the financial management of the business and its financial performance.

Most business owners believed their bank statement and annual accounts to be the most useful sources of financial information.  Few business owners receive a cash flow statement on a regular basis.  A high proportion of business owners do not produce a budget profit and loss, or attempt to forecast their cash flow.

So, the Enterprise Connect presentation identifies that many owners of small and medium-sized business are concerned about cash flow management.  The research indicates that there are significant benefits to business from actively managing their cash flow/working capital but that few owners of small and medium size business are making use of their existing financial information to help them do this.  How do we reconcile the obvious concern about cash flow management, the benefits from actively managing working capital with the apparent lack of action from owners of small and medium-sized business?

My hypothesis is that business owners are not making use of their financial information to manage their cash flow because they are not confident that they can interpret it properly.  I cannot otherwise fathom how, in a world of sophisticated and affordable accounting software capable of producing myriad reports, business owners are not more actively engaged in managing their cash flow.

The practical lesson from the research, for owners of small and medium size business and their advisers, is if you are not paying attention to the movement in stock, debtors and trade creditors evident in your balance sheet then you are not even beginning to manage your cash flow.  So, if you want to improve your ability to manage your cash flow then as a first step you need to use all the financial information you have at your disposal.  In short, you need to Pay Attention to your Balance Sheet as well as your Profit and Loss Statement.

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