Budgeting and Forecasting

The truth is in the cash flow

Vaulting Ambition

Vaulting Ambition

This is the first of a series of articles I wrote about Murray Goulburn on behalf of the Association of Virtual CFOs and which were published by Smart Company.

At the time I was astounded by the scale of Murray Goulburn’s miss, and their subsequent decision to make the farmer suppliers wear the brunt of what was a monumental head office stuff up.

I also knew there would be a lot more to come on this story.

In the end, I wrote another couple of articles/blogs dealing with different aspects and lessons as the story unfolded.

For business owners, in this article, you will learn how to:

  1. Construct a robust budget.
  2. Use as your starting point your current position, key industry and economic drivers.
  3. Gauge the scale of the task to shift from your current to your planned position.
  4. Track key business drivers throughout the year to understand the likelihood of meeting budget.
  5. Decide when your budget needs to be revised.

The key lesson is that the point of a forecast is not to be “right”.

The point of a forecast is to reflect your business plan, so that when things don’t go as expected you can ask the following questions:

  1. Have we taken all the actions required by our business plan to achieve our forecast?
  2. If not, why not? When will those actions be completed?
  3. If we have, then what has changed in the market for our goods/services that we did not anticipate?
  4. What, if any, action do we need to take as a result of the answers to these questions?

To grow with confidence you need a good forecast.

The three-way financial models that we build at Pro Veritate will help you understand the timing and amount of capital needed by your business to support your plan.

If you are a growing business you should Contact Us.  We can help.

Vaulting Ambition

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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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KPIs for All SME Businesses

KPIs for All SME Businesses

The play, “A Man for All Seasons” tells the story of Sir Thomas More, the C16th Chancellor of England who refused to endorse Henry VIII’s wish to divorce his wife, Catherine of Aragon. More was a man of great integrity, who whilst pragmatically adapting to changing circumstances, remained true to his beliefs despite enormous pressure being brought to bear upon him.

This article will describe a set of KPIs for SMEs that behave in a similar fashion to Sir Thomas More. These KPIs offer the SME owner a succinct and relevant insight into their business under all conditions, irrespective of Industry, external factors or pressures. Being easily identified and measured they are pragmatic. They are the “Universal KPIs” I referred to in The Emperor’s New Clothes (About KPIs).

Those of you who have read some of my earlier articles may have guessed the identity of my Universal KPIs. I introduced them in The Magnificent Seven and built on that introduction with posts on interpreting financial information (Cracking the Code) and understanding working capital (Seeing the Light (On Working Capital)).

The table below sets out my Universal KPIs and depicts a hypothetical business story (click on the table to expand it):

KPI Table

This table shows Monthly and Year to Date outcomes for my Universal KPIs. The stories told by the table are summarised below, which I hope will help the reader appreciate the clarity of the insight provided by these KPIs.

The Monthly Story

Sales are $45k below budget. However, the above budget Gross Margin of 47% has reduced this cash drain to $9.65k. Operating Expenses (which exclude Interest Expense and Depreciation) are $10k lower than forecast. The net outcome is a small inflow of $350, relative to the budget expectations.

Debtor Days have shrunk to 60 from 62 in the prior month, but the average time taken to collect debtors remains slower than the budget expectation (55 days). Nevertheless, the 2 day reduction in debtor days compared to the prior month has brought $30.7k of cash into the business. Stock Days have shrunk to 95 from 97 in the prior month, but the average time taken to sell stock remains slower than the budget expectation (90 days). Nevertheless, the 2 day reduction in stock days, relative to the prior month, has brought $16.7k of cash into the business. Creditor Days have expanded to 40 days from 37 days in the prior month, and Creditors are now being paid 1 day slower than the budget expectation (39 days). In the current month, the 3 day expansion in Creditor Days has resulted in $25k being retained in the business. Shortening the Cash Conversion Cycle by 7 days during the month has brought $72.4k of cash into the business.

Capital Expenditure in the month was $10k, in line with budget.

In summary: The cash brought into the business from its earnings during the month was in line with budget, albeit the manner in which this was achieved was different from expectation. The actual cash used for capital expenditure purposes met budget. The vast majority of the $72.75k of cash brought into the business during the month is due to a shortening of the Cash Conversion Cycle relative to the prior month.

The Year to Date Story

Sales are $400k below budget. However, the above budget Gross Margin of 45.6% has reduced this cash drain to $146.4k. Operating Expenses are $50k below budget, further reducing the cash drain to $96.4k.

Debtor Days are averaging 60 days, slower than the budget expectation of 55 days, leading to a $16.4k outflow of cash from the business. Stock Days are averaging 95 days, slower than the budget expectation of 90 days. Nevertheless, despite the slower stock turnover there has been a $20.8k inflow of cash in the Year to Date, reflecting the lower business activity and higher gross margins. Creditor Days are averaging 40 days, slower than the 39 days forecast, resulting in $18.8k of cash being retained in the business. Although the Cash Conversion Cycle has expanded by 9 days from 106 days per the forecast to 115 days there has been a net cash inflow of $23.2k, due to a shrinkage in Sales and the higher Gross Margin.

Capital Expenditure on a Year to Date basis is $40k, a saving of $10k on the budget, resulting in that amount of cash being retained in the business.

In summary: The net outcome is that the business has $63.3k less cash than forecast. This outcome has mainly been driven by the lower Sales, which an improved Gross Margin, lower Operating Expenses, lower Capital Expenditure and a modest inflow of working capital funds (as a consequence of the shrinking business activity, not due to a shortening of the Cash Conversion Cycle) has not been sufficient to offset.

All of these factors can be influenced by an SME owner. Indeed, if the Cash Conversion Cycle had met the budget expectation the result would have been a $10k cash inflow into the business in the year to date, relative to expectations.

The Message for an SME Owner

 When I worked in banking, these seven factors were the major drivers of our financial forecasting software (there were a few others: depreciation rates, interest rates, tax rates, dividend rates etc).  They are used because of their close link to the “operational” cash flow of an SME business.

This in part explains why they make great KPIs for an SME. The other significant factor in their suitability as KPIs is that the SME owner can make decisions and take actions that impact on each of theses 7 factors, and hence directly impact the cash flow of their business.

I regard them as Universal because all SME businesses, regardless of Industry, are capable of measuring Sales, Gross Margin, Operating Expenses, Debtor Days, Stock Days (or for professional firms, its equivalent, Work In Progress Days), Creditor Days and Capital Expenditure.

So, if you own a small or medium-sized business and would like to know more about its financial and cash flow health then a good place to start is by tracking these 7 factors on a monthly and year to date basis.

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Budgeting: A Means to an End

Budgeting: A Means to an End

In my last post, I made the point that for a business to properly understand its cash flow it needs to pay attention to both its Profit and Loss statement and its Balance Sheet. It follows then, that when preparing a budget, a business needs to complete one that covers both its Profit and Loss statement and its Balance Sheet.

However, my experience has been that: i) the majority of those businesses which prepare a budget, only do so for their Profit and Loss Statement, and ii) there is a high level of resistance to preparing a budget amongst SME owners (and this experience is confirmed by the research, again see my last post).

Why is this so? My hypothesis is that: i) SME owners (and their advisers) may not have the necessary skills to produce a budget balance sheet, and ii) SME owners resist preparing a budget because of the inherent uncertainty involved in such activity.

Is there a solution to these issues?  I think so.

I’d like to first deal with the inherent uncertainty in preparing a budget. I’ll start by referring you to this column by Ross Gittens, an economist who writes for Fairfax. I have been reading him since 1983 and have found that he writes with simplicity and clarity about a subject that is not the most approachable.

This particular column deals with, amongst other things, the accuracy of the Reserve Bank of Australia’s forecasts for Inflation and GDP.  It summarises the results of a review by the RBA of its forecasting accuracy, based on the range of the actual forecast errors it made between 1993 and 2011. The column is an easy read, but for the time poor, the relevant and practical messages from it are:

The accuracy of the RBA’s forecasts is not particularly high.

Their experience is typical of that of similar bodies around the world. For example, The Treasury Department of the Australian Federal Government completed a review in November 2013 of its forecasting accuracy, and arrived at a conclusion that is consistent with the RBA. If you are mathematically minded you will find the Treasury paper interesting.  However, for most people, the key take-away will be in Treasury’s conclusion, that “rather than focussing on precise point estimates, a more nuanced discussion would acknowledge that uncertainty is an unavoidable feature of forecasts…”

Gittens makes the point that the RBA’s lack of accuracy is not a major issue because: i) the RBA revises its forecasts every quarter based on the actual GDP and Inflation results as they come to hand, and ii) the RBA usually adjusts its cash rate in an incremental fashion, thereby limiting the impact of getting it wrong.

Lastly, Gittens points out that the RBA is not afraid to change direction if it becomes obvious that it should do so.

So, what lessons can SME owners (and their advisers) draw from the experience of organisations that are arguably the best in the forecasting business? I think they are:

  1. Budgets are best used as a tool, constantly reviewed and adjusted for real world impacts, and  
  2. A budget is a means to an end, but not an end in itself.

I’d also add that a further practical benefit of the budgeting process is it requires the SME owner to identify the specific steps they need to take in order to achieve their budget’s outcomes.  This provides the SME owner with a context from which to make informed decisions when the real world intersects with their budget. It enables the SME owner to review whether they have taken all the steps they identified or whether some other factor has changed (currency, economy, competition etc). This context means the SME owner makes an informed choice when deciding whether and what action to take in light of actual results to date.

Addressing the skill issue is relatively easy. There are many avenues of help available to the SME owner.  The first port of call is their accountant.  Other possibilities include their business banker, or finance broker (if the business uses one). Certainly, the business banker has access to off the shelf software that can be used for forecasting both balance sheet and profit and loss statement. The better finance brokers will use similar software, but it may be necessary to pay them a fee. Finally, there are specialist businesses, like my own, with the capacity to help.

Put simply, help is available and there is little excuse for a determined SME owner not being able to find it.

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