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Decision-making and the importance of understanding cash flow

As I said in my last blog post, one of the most common areas where my business clients want advice is around decision-making – knowing which of the options they’re faced with will be most beneficial for their business.

Whether you’re a brand new start-up business, or an established family business, it’s vital to make the right decisions over the course of your business journey. Make the right move, and you’re on the pathway to profits and success. Make the wrong move and you’re likely to miss opportunities and reduce your overall profitability.

So how do I help my business clients to improve their decision-making and make the very best of every situation?

A clear focus on cash flow

I originally qualified as an engineer and that systematic, rational approach is something that informs my approach to decision-making and the assessment of financial options.

To know which outcome produces the most financial benefits, I focus on the cash flows in your business. Once we know the different options, and the cash flows that relate to them, we can compare and contrast the various financial outcomes.

 With the cash flows noted down, I enter this information into a table with three columns:

  • The first column is for the cash flows in the current situation.
  • The third column is for the cash flows in the alternative situation.
  • The middle column is for the difference in cash flow between the two options.

Here’s an example of how this table will look, using the example of ‘John’, a painter/decorator who’s looking to buy a new van for his business – you can read more on this example in the previous blog here.

Current Van Difference New Van Comment
Investment 0 -10,500 -10,500 As I’m only looking at what will happen from now, I don’t consider the cost of the current van.
Fuel -10,800 1,500 -9,300 This is fuel cost over 3 years, based on the info supplied.
Maintenance -6,000 3,000 -3,000 Maintenance cost over 3 years. based on the info supplied.
Van Hire -1,500 1,500 0 5 days pa for 3 years at 100 per day
Lost Earnings -2,400 2,400 0 2 days a year for 3 years at 400 per day
Tax -900 150 -750 Info as supplied
Insurance -1,500 -300 -1,800 Info as supplied
Resale Value 0 4,000 4,000 Info as supplied
Net Cash In/(Out) -23,100 1,850 -21,350  

 

The important number here is the final figure in that middle ‘Difference’ column. Using the cash flows we know, and estimating things like costs and wear and tear, we can reliably say that John will save €1,850 over the year by buying the new van he’s looking at.

For a small, one-person business, having €1,850 more in your pocket will have a positive impact on the company’s overall cash flow – giving you more scope to invest in other areas, like marketing, or new equipment.

Putting the cash flow approach into practise

My previous post mentioned two examples of businesses that were at a crossroads with their decision-making.

  • The dentist – One was a dentist friend of mine, who many years ago asked me if refurbishing his dental practice was a sound financial move.
  • The food manufacturer – The other was a food manufacturing business who came to me recently to ask whether they should keep production in-house or outsource it. 

Lets look at both these scenarios and see how the systematic cash-flow approach helps us to choose the best option for each business owner. 

For the dentist, the decision looks a little easier. He already had a quote for the cost of the refurbishment. This would be a tax-deductible cost, so we could say that the after-tax cost to him was 50% of the quote – all sounding pretty rosy so far!

Then I asked what would happen to his practice if he didn’t do it up. He replied that he wasn’t sure but he would expect to see a slight decline in the number of patients. He considered the quality of dental care would be most important but having a rundown surgery could lead patients to think he was not doing so well and maybe he was not so good – in other words, a shabby surgery could have an impact on the perception of his brand.

Finally, I asked him how he would feel working in a somewhat tired, run-down surgery. He was very strong about that and replied that he would hate it. So, he decided to do it up.

I think that was the right decision and was what he’d really wanted form the outset – he just wanted some reassurance that he was making the right decision.

An important lesson here is that not everything can be quantified. Yes, I know that is heresy for an accountant to say. But some factors in decision-making just can’t be expressed as hard numbers, even though these factors could be vital to the outcome of the decision. Always keep that in mind and consider these less quantifiable factors, even though it is hard to do so.

The right decision for the manufacturer

 Let’s look at the more recent example of the food manufacturer and the thorny question of whether to outsource production, or keep it in-house.

The business owner looked at the costs of producing in-house vs outsourcing to a contractor, and this was what we found:

  • The contractor had much bigger buying power and was able to save on the cost of raw materials (applying the benefits of economies of scale).
  • Labour costs for both alternatives were similar.
  • Overhead costs were lower for the contractor as he had a much larger operation with economies of scale again.
  • There were going to be additional costs for freight and for quality control as the outsourcer wanted to ensure the contractor would maintain standards.
  • By way of intangibles, the outsourcer was concerned that the contractor might gain his production know-how which could lead to contractor becoming a direct competitor – but they put agreements in place to deal with that.

I put my table in place for the food manufacturing decision. As I said already, it’s not always about the numbers. Reviewing the table gave rise to a series of discussions about the various elements to be considered, about the reliability of the numbers and particularly about the intangibles or the less quantifiable factors.

By having both the tangible numbers AND the intangible considerations all worked into the decision-making process, we came to an informed (and ultimately more profitable) conclusion – outsourcing production would be cheaper, more efficient and used all the outsourcers’ buying power and economies of scale to improve margins and profit. [I’m making an educated guess that this was the outcome as it’s not expressly stated, but it seems like the outsourcing option makes most sense]

The importance of process and good information

A key point to remember is that while having a good process is important, having good information to feed the process is vital. That information comes from having reliable and insightful management information available – something that I, as your accountant, can help you refine and make into an efficient management reporting system.

With up-to-date business information, a systematic approach to assessing your cash flows and a healthy consideration of the most intangible elements, you’ll make the best possible decision-making for the future of your business. It’s a framework and approach that will let you address most of the decisions that are likely in your business.

If you have any questions, or items needing clarification, feel free to drop me an email.  Remember, we’re available if you want to bring an external perspective to your decision.

Why a good budget is vital for every business owner

In one of my recent blog posts, I mentioned the need for a business to create an annual budget.

One of my readers contacted me, saying “I don’t really know why I’d need a budget if I’m already doing the basic bookkeeping”. So, in this post, I’m going to set out why I think budgets are so important for every business owner, whatever the size of your venture.

Feedback for improved decision making

However complex or simple your business model may be, you still need to be constantly monitoring progress and adapting your processes as you go. I come from an engineering background, and in that world we often talk about an ‘engineering feedback loop’, where outputs of a system are monitored and used to help the system operators decide how to respond and adapt to what is going on in the system.

 

It’s not just engineers who exploit feedback. Pyschologists use an approach called Test-Operate-Test-Exit (TOTE), which is a process to apply the same approach to people. With the first Test of the TOTE, we consider what’s happening and make a plan. Then we move on to execute the plan – Operate. After operating, we Test again to get some data or information on what happened. Was the outcome what we expected, or did something different happen? In the final step, Exit, we use the data to decide whether to continue what we’re doing or whether to make changes, possibly even terminate the exercise.

Your annual budget should be understood as part of a feedback loop for your business plan. We start off by creating a plan, which we express in financial terms as a budget. Then we operate the business, getting feedback from our management accounts. We use that feedback to make decisions – whether to continue as is, or to make some changes. So we are going about improving our understanding of performance and feeding that into our management – in short, we’re tracking how well you’re performing against that all-important budget, and then acting if change is needed.

Prompting a review of the business

In the normal running of a business, it’s very easy to get caught up on the treadmill and not take time out for important reviews. But there’s real value in making the time to focus on your budget and to make proactive use of it.

To prepare a budget, you must start with some key assumptions. These include:

  • What will we be trying to achieve in the budget period?
  • What will be happening with our key inputs – raw materials, labour, overhead, distribution etc?

Your budget provides, indeed prompts, a forum for these key discussions about the direction of the business. And the budget process forces you and your management team to formalise those discussions, reducing them to a set of guidelines that will be used in developing the budget to make it work comprehensively for your company.

Helping to anticipate what might happen.

In the western films that I watched when I was younger, the wagon trail or cattle drive would send someone ahead to scout out the land coming up, identify obstacles and find the best path to be followed, while the main train or drive remained behind – in other words, they never put the whole wagon train at risk, only the poor scout who’d pulled put the short straw!

We can’t really do that in a business – running a business comes with inherent risks that impact on the whole ‘wagon train’. But what we can do is to build a model of what we think is going to happen and use that to identify obstacles and make plans for how to deal with those obstacles.

For example, when we prepare a budget, comprising profit and loss, balance sheet and cash-flows for a business with peak sales at Christmas, we might see that it’s necessary to build up a substantial stock in the run-up to Christmas. This means we’ll need to buy raw materials from our suppliers to build this stock up, but we won’t have sold the product yet and won’t have received the sales proceeds. So we’ll be spending, without recouping any revenue and that’s going to put pressure on our cash flow.

By planning a sensible budget we can quantify the scale of the problem and plan how to address it. We might ask the suppliers for extra credit or we might ask our bank for an extra short-term credit facility – anything that eases the pressure of that increased outlay.

But unless we run some numbers, we wouldn’t be able to quantify the issue – we’d be basing any decisions on estimates and guesses, and that’s never good practise.

Developing our understanding of the business

To prepare a budget, we start by making some assumptions about what will happen in the business and how the different elements of a business relate to each other.

Depending on our experience and our knowledge of the business, the quality  of assumptions can range from very poor to excellent. The only way we know how good these assumptions are is by comparing what actually happened with the budgets and studying the outcomes so that we improve our understanding.

By doing this on an ongoing basis:

  • We gradually increase our understanding of what is happening.
  • We improve our ability to predict.
  • We also learn to identify key predictors of performance.
  • We use these key predictors to make early interventions if things are not progressing as we expected – and keep the ‘wagon train’ on a safe passage through the pass.

Using our budget, we can also determine some key metrics for the business. For example, we should always know the break-even point for the business – the point at which our gross profit will match our overhead costs.

If the business is still in its early stage, the budgets can help determine just how viable that business is.

Budgets vs forecasting

Budgets and forecasts are very similar. They’re both financial projections of what’s expected to happen in the business in the future, with the aim of helping you move forward as effectively and profitably as possible.

Budgets are usually annual while forecasts can be run as often as needed. Well-run businesses will prepare an annual budget and then prepare less detailed forecasts during the year. These forecasts will usually incorporate changes that are occurring in the business and help management decide how best to respond to these changes.

Additionally, budgets are often used to set spending limits. In larger companies, the budgets are broken down by departments or cost/profit centres and individual managers are allocated responsibility for their portion of the budget. Usually, they won’t be allowed to spend in excess of a budget without first getting additional approvals from more senior managers – in other words, they place a restriction on the costs that department can incurr.

In smaller companies, the control process won’t be as formal. Usually, an owner manager will hold the purse strings tightly. However, the budget can be used to help them decide on how much they can spend on different types of expenses and, also, if there are better times than others for spending. Once the busines owner know what their limits are, they’ll soon realise if spending is exceeding the pre-defined plan.

Getting product costing right

An area that many businesses struggle with is product costing – working out the amount it costs your business to produce each product or service in your range.

Some businesses use product costs to set selling prices. Even when prices are set by the marketplace, using product costs to understand profitability will help you determine if it makes sense to be trying to sell in the market place.

Most product costs have two fairly distinct components:

  • Direct costs – these are usually the easiest to determine and will include things like labour and raw materials etc.
  • Overhead costs – these can be more difficult, and can include things like building rent, repairs to equipment or utility bills etc.

To determine overhead costs, the first thing we must do is determine the total amount of overhead costs we expect to have – that will be provided by the budget. Then we should figure out the best way of allocating the overhead costs to the products – effectively spreading the overhead costs across our products so that each product gets a fair share of the overall costs.

While all elements of the costing process are important, we must start with a reliable estimate of what the overhead will be and that’s provided by the budget.

The foundation on which your business plan is built

So, there you have it – a number of strong reasons why every business, both small and large, should take the time every year to build a budget and to spend some time comparing actuals with budgets.

Your budget is the financial foundation on which the whole of your annual business plan is built, so the more detailed, the more accurate and the more realistic you make it, the more solid your financial progress and agility will be over the course of the year.

If you’ve got any questions about building a solid 2017 budget for your business, please do get in touch to see how we can help.

Tips for Managing Cash

In the past year, I have spoken to a number of different audiences on Managing cashflow. In the course of my work as a mentor on Bank of Ireland’s Enterprise Builder Programme, it is clear that managing cash remains an issue for many companies. So here are the key points from the presentations that I made.

  • Prepare Plans and Forecasts
    These help you to understand what is coming up. They identify early on any overall problems and any “lumpiness” in your cashflow. You should be clear about your key assumptions – these will include Activity levels/Collection and payment times/Once off investments etc. You should also determine how much to put aside for tax, annual payments such as insurance etc
  • Prepare a Rolling 6-week forecast.
    This will be similar to the annual forecast but will be working in smaller time intervals. Watch for weeks where you might be hitting up against your overdraft limits. This rolling 6-week forecast highlight possible breaches of your limits and gives you a chance to do something about it.
  • Choose your customers
    Remember that you don’t have to take everyone. A customer that does not pay or a customer that costs too much to services is not worth it. You should have some a process for evaluating prospective customers. This would consider factors such as their payment history, their profitability, the quality of interactions with them (do you like dealing with them?), are there ongoing issues (returns, hidden costs etc). Check their credit rating.
  • Be clear about your credit terms and stick to them.
    Your customers should know exactly when you expect payment and you should enforce your terms. Your terms with include the timing of payment and the maximum amount that you extend to any customer. It is much easier to set and enforce these from the start than it is to try to tighten up with an existing customer. Put on hold, those customers who are not compliant with your terms – whether this be relating to the time or the total amount. Consider asking for deposits or stage payments – this is more appropriate for some sectors than others.
  • Have a process for invoicingis
  • Invoice in a timely way. Know who/where to send invoice. Before invoicing, ring the customer to ask if everything is ok – they can’t come back with issues later. Consider if you will need Proof of Delivery – do you have it?
  • Have a reliable collection routine.
    Before payment is due, send out a reminder. Have a standard defined procedure for follow up or escalating overdue payments. Send out statements – Some customers only pay on statements.
  • Manage Cash Tied Up
    Many businesses overlook the amount of cash that can be tied up unnecessarily. Review your Stock Levels , your Debtors and your Prepayments. Are you paying too early with some of your suppliers? Do you have clear rules for purchasing stock – is there a logic to these? Do you take Credit where you can (and where it saves you)?
  • Control Your Expenditure
    Remember that you have most control at rhe start of the Purchase to Pay process. Do you have a Purchase Order (PO) authorisation process? Review all costs and consider whether they are really necessary and that you are getting best prices. Consider Asset Finance for computers, vehicles, plant & machinery
  • Working with the bank
    Keep your bank manager informed. This demonstrates that you are in control and devleops confidence in you and your business. Remember that when there are some signs of problems, lack of communication from you is the single thing that worries them most.
  • Managing Shortfalls
    Become aware of shortfalls as soon as possible. Understand whether they are temporary or longer. Look at all the options to overcome the difficulties. Talk to your bank. Talk to suppliers. Consider invoice factoring/discounting. Offer early payment incentives to customers. Careful payment of bills

So overall then the message can be summarised as follows. Understand and Plan – aim for early warning of issues. Be proactive – choose customers, set credit limits, have process. Review business for cash tied up. Manage your bank manager

As always, if you have any comments or questions please email me – jim (at) accountsplus (dot) ie.

Simple things to improve Cash Collection

I have been working with a number of clients lately where cash management is an issue. I am sure that’s true for every accountant now.

There are so many simple things that make a difference here.

  1. Think before you extend credit.
    Decide if you want to give the customer credit and how much credit you want to give.
    Set limits – on both time and on amount of credit.
    Then if they don’t with within the time or if they have already used up their credit allowance, don’t give anymore credit.
  2. If you are in a sector where Credit is the norm, offer discounts to people who pay up front – make it an attractive option.
  3. If the amount of credit asked for is big, do a credit check.
    Think, how much would it be worth now to know if this customer has a good record.
    If the cost of a credit report is less than that, get the credit report.
  4. Don’t give credit to someone who is already over their limit.
  5. Chase the money when it becomes due.
    In my experience, they who shout loudest get paid.
    So be methodical and keep a log of calls, letters etc
  6. Through it all, be Consistent – if you make a decision, stick to it.

If you have any comments on this article or if there are any areas you would like to address, please do let me know.

Best Wishes

Jim