If you don’t plan your budget, how will you know what sort of finance you need, how much and when? Dennis Mattiske looks at ways of integrating finance planning, reporting, analysis and adjustment to smooth the way from start-up to expansion.
As all of our young guns can tell you, starting up a business is a very exciting time but requires a great deal of work, planning, and preparation to increase the chances of success.
One of the most important areas to get right is financing. Good financial planning can be the key to whether a business makes it through the start-up phase, or fails to find its feet.
Unfortunately, people often underestimate the costs involved and can be over-optimistic about the time needed to get the business to a profitable level of trading. It’s essential to identify right from the start all the costs that are likely to be incurred, both as one-off start-up costs and then ongoing costs as the business develops and grows.
These costs may seem innumerable. They include rental bonds, fit-outs, purchase of equipment, computers and software, website development, employee hiring, stationery, logo and packaging design, and setting up marketing channels. On top of this is the investment in working capital, such as the stock and level of debtors (net of creditors) required to run the business, as well as the initial losses that may be incurred in getting the business to a break-even level of trading. Sometimes this will be amplified by the need to offer discounts to buy market share.
As well as identifying these specific costs, the appropriate type of finance should also be considered from the very beginning. As a rule of thumb, longer-term expenses are best matched with longer-term debt. So, for example, costs relating to premises fit-out, the purchase of machinery and equipment, and the expected hardcore on-going working capital could be financed by leasing. While it is usually a little more expensive than bank loans, it is often the most practical finance for this type of expense.
For the remainder of the set-up costs and hardcore working capital, a bank term loan for a minimum of five years is cheaper than financing all by bank overdraft. An overdraft should only be used to cover the fluctuating working capital that is always required to cover the differences in timing of payments and collections—it should not be used to fund long-term expenses.
Debtor financing, which is currently in favour with some lenders, is not so easy to procure in a start-up business unless it has very good systems and the customer debt is really ‘blue chip’. It involves selling business debts, at a discount, to a financier who then has responsibility for collection. It can help cash flow considerably, reduce risks and overcome slow payment by customers.
A good bank manager should be able to match the right funding to requirements if given the right information. Whatever the method of funding, personal guarantees and freehold property security will be necessary for the funding. The lender will also want information on the business’ capacity to pay both the interest and any loan repayments. Wherever possible, business owners should avoid using personal assets to secure business loans.
As the business grows it is important to manage and record cash and finances from both a micro perspective and a wider, long-term perspective. At the micro level, from day one the business owner should estimate (daily or weekly) the expected cash inflow and outflow so finance limits are not unknowingly exceeded. This kind of track record can help business owners get a much more favourable response to future requests for a temporary increase in limit, should it be required.
Micro-managing cash levels requires the management of both ‘cash in’ (debtors) and ‘cash out’ (creditors). The importance of ensuring all customers pay within their agreed credit terms should not be underestimated. It needs constant follow-up but it is far better to keep on top of this from the very beginning rather than trying to change the habits of slow-paying customers once they develop.
Credit checks are also essential and a business should be prepared to refuse a sale to a potential customer if they have a bad credit rating. A bad debt means you have lost the whole amount of the sale (plus the associated, direct and indirect costs of collection), while the loss of a sale only means you have lost the margin!
Creditors should be paid on a regular basis within an agreed timeframe to keep a good relationship and help ensure the cash position of the business is up-to-date. Once the business is well established, major suppliers may respond positively to a request for better credit terms if the size of the account warrants it, and there is a history of consistent payments.
A formal business plan, whether long or short, will help all businesses, particularly start-ups, to focus on their objectives. Every plan should follow the same basic format, including where the business is now, and the issues it is facing; where the business wants to go and its vision, objectives, and competitive advantage; and the strategies and actions to get there.
Business objectives should be measured regularly to see if they have been met. The ultimate measurement is usually financial—the profit or loss earned or balance sheet achieved. However, short-term objectives should be measured with non-financial methods such as an increase in the number of visits by new sales representatives, or increased levels of customer satisfaction. As with all plans, actions must be taken to achieve the objectives, so the plan should outline who is to undertake the action, and the timeframe.
To manage the long-term aspects of finance, it’s a good idea to have a forecast of both the profitability of the business and the resultant cash flow. The cash surplus from trading is very rarely the same as the net profit. In a growing business there will invariably be a shortfall due to an increase in purchases to fund stock increases, and a reduction in cash receipts as a result of an increase in trade debtors.
Ideally, a business needs a budget for expected profit (or loss), the expected balance sheet (that includes the stock, trade debtors, trade creditors, plant and equipment), and a forecast of the resultant cash flow.
There is computer software available to assist with this, or an accountant can undertake it on your behalf. The use of software from suppliers such as MYOB or Quicken helps make reporting quicker and easier for business owners and is usually compatible with the accountant’s requirements.
To ensure that the cash flow forecast ties in with the forecast profit, allow for an increase in stock and debtors, capital expenditure, and repayment of borrowings. Check the calculations by adding the total allowed for the increases in stock and trade debtors to their opening balances and consider whether the result is reasonable.
Once written, make sure that the budgets are used, by regularly reporting actual results against the budgets. Too often budgets are prepared (perhaps for the bank) and filed, never to be used again!
Particularly in a start-up phase, trading invariably fails to follow the plan. There can be a temptation to use this as an excuse to not prepare a budget at all but business owners shouldn’t fall for it. Even if a forecast proves to be incorrect it is still useful as a benchmark when reviewing why the actual results aren’t in accordance with the budget.
To maximise the usefulness of a budget as a benchmark, record the rationale when it is being developed. A budget is usually created by considering areas such as the level of sales to different categories of customers, the level of sales of different product groups, and the length of time expected for customers to make payments. Record these criteria and if the actual results don’t proceed according to the budget, analyse the reasons. It may be that sales of one product didn’t meet expectations, or the forecasted level of debt collection was optimistic.
Decisions can then be made to correct the situation–for example, a change in marketing or a change in the method of debt collection.
If budgets need to be adjusted, do so six-monthly, and continue to record the reasons for the adjustments.
Over time, business owners will develop the analytic data needed to better manage and control the business. This should include, as a minimum, the details of sales by both customer and product in some form of logical categorisation that suits the needs of the business. For instance, businesses could consider how they market to different customer groups and use that for categorisation. For products, track the 10 or 20 most popular or profitable products.
A growing business will almost always require an increasing level of finance. Additional financing may be needed for an increase in stock and debtors. Over time, it will also be needed for increasing costs in areas such as equipment, larger or changed premises, another location or increase in administration.
These requirements must be predicted to ensure that finance is procured on a timely basis to cater for growth requirements. Keep in mind that as the business develops, the best method of financing may change. With growth comes an increase in core debt for the increased working capital. Initially, this is often funded by an increase in the relatively expensive overdraft. However, this portion of the debt should instead be transferred to longer term and relatively cheaper funding.
Business owners should always aim to receive a return on their investment commensurate with the business risk. At start-up, any profits are usually retained in the business. Over time, these profits can build to a higher level than is advisable in an efficiently run business. Business owners should therefore seek to receive a return of around 20 to 25 percent of the capital invested. If the profits left in the business aren’t providing such a return, once a business is established some of this should be substituted by third-party finance that can be procured for a much lower rate of return. The funds extracted from the business can then be invested elsewhere to attract a higher rate of return.
So, while good planning is the key to managing finances, this must be complemented by the regular reporting against that planning, and the continual monitoring of the need for the right amount and type of finance.
—Dennis Mattiske is a business services partner at accountants and business and financial advisers HLB Mann Judd Sydney.