Are low margins and a lack of cash an issue?
Business owners go through phases with their attitude to managing the finances of their businesses. Initially, there is more concern about getting work in to survive. This is often done at the expense of any detailed analysis and they will adapt their business plan frequently as information emerges. At this point the connection between the finances and the business either clicks and they want to understand it better or they simply think it’s too complicated to understand and they would much rather get on with what they are good at and leave the finances to someone else. Many micro and small business do just this and simply have end of year financial accounts prepared by their accountant for tax purposes. Providing there is enough to pay themselves and the bills, they are happy.
Different sectors have different financial profiles. One of the most challenging is the construction sector. It is a service sector. Payments are made after work is completed, and the value of the work is subject to valuation in accordance with the contract, which can cause delays to payments. Also, the value of work tends to represent a large expenditure for a client, so they will tender the work, which means low margins for the provider.
Where there are such pressures on the finances, there needs to be a good understanding, otherwise the business will run out of cash. The numbers behind a business, tell a story. If the story is told well then it can be used to inform and make better decisions about the future. So which chapters of the financial story should business owners be most interested in?
There are five chapters in financial management which stand out for small and medium sized businesses:
Review and actions
You will notice that, sales are not included in the list. The reason for this is, that without sales you have not got a business. There is a saying “turnover from the sales is vanity, profit is sanity, but cash is king to keep a business going”. For the majority of SME’s, getting to grips with the five aspects of financial management will help retain their sanity and make running the business less stressful. Without keeping a grip on the five aspects, many owners get a report from their accountant months after the end of their financial year, by which time it’s too late to sort out any issue which has arisen. So, let’s start with the plan or forecast.
Unless someone is getting a loan to start a business, they often do not bother with doing a forecast. But without a forecast you cannot compare your actual activities with what you expected, or planned, and as a result an unpleasant surprise at the end of the year is almost inevitable. If you have a forecast of expected sales, out goings for production and for the business administration, then it will be easier to compare the forecast with the actual and act, sooner rather than later, when the variances are significant.
Cash is the lifeline of a business. It enables you to pay bills and continue trading. Without it the business will die. The rule applies to everyone, from start-ups to whole countries. Whilst an organisation might have assets they could sell, e.g. a building, if they do not have enough cash to meet their bills then they will fail. Having access to enough cash to meet your immediate needs is vital.
Business owners of small businesses generally check that the income is greater than the outgoings, which is the net profit. Because the way accountants manage business owners tax affairs, how well a business is really doing can be disguised by the tax arrangements. It is worth being hard on yourself and check if the profit is really adequate for the risks you are taking over being employed.
The “net profit” remains from the “gross profit” of the operations, after the cost of running the business is considered. Many small businesses do not consider the importance of gross profit sufficiently. Analysis of the profit derived from operations can be used to manage the portfolio of work, give staff rewards and determine if different geographic areas are performing differently. Very often this important part of the accounts is not appreciated by smaller businesses.
When a business makes a profit, some is taken by the shareholders, the remainder is retained in the business as a reserve or to be invested in more resources to allow more work to be carried out. Waiting for surplus profits before you invest in new resources to grow is known as “growing organically”. If you are confident the business will grow, and the figures tell the right story, then you can borrow money to speed up the growth rate and repay the loan from the business activities. To obtain a loan at the best rate the risk to the lender needs to be as low as possible. A lender considers low risk business, one that is well run and has a history of being well managed.
Review and action
Forecasting, investing, managing day to day payments all have different time horizons. It can get confusing as to what is impacting upon what, unless you have a structure to what is looked at when. The easiest way to do this is, is to have a general long-term goal and work towards that. Break the goal down into targets, then monitor against those. So there no surprises, do a forecast to the next intermediate target and adjust accordingly. This way you will be confident you will have the funds to invest or will not leave it to late if you need to make cuts.
Typical time horizons which are used to manage a business are:
General plan 3-5 years – heading towards your long term / exit plan
“Obtaining the story from the numbers” is known as the “management accounts”. They are done in a lot more detail than the “financial accounts” which your accountant will do for compliance reasons. If your accountant or bookkeeper does not do management accounts, then you can find out more by requesting more information on the chapters in the “story of the figures”:
Improving cash flow
Increasing prices and profits
Financial Planning, Review and action.