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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.

Making the best business decisions – how to evaluate your opportunities

One of the questions that I get asked most often by business owners is how to decide between one or more options – when faced with path A or B, how do you know which fork to choose and what the potential outcome may be?

These sorts of question arise for businesses of all sizes and they’re just as important for the small business owner as for the large business owner. In the past three months, I’ve helped a painter/decorator decide if he should change his van and I’ve helped a large food manufacturer decide whether to outsource production, or keep it in house. For both of them, their decision was important and could have an impact on their business.

The value of good advice

I wasn’t long qualified as an accountant when an old school friend, now a dentist, asked me if he should refurbish his dental surgery. He’d already asked his accountant, who replied “that’s up to you”. That answer wasn’t very helpful. We know it was up to him to decide but his accountant wasn’t providing him with any advice as to how to make that decision.

To put it bluntly, he wasn’t adding much additional value as an accountant.

But (thankfully) times have changed, and most good accountants now realise that a large part of their role it to help with this kind of decision making – whether it’s supplying the right numbers, forecasting the potential outcomes or looking at the strategic implications.

So how do I go about making financial decisions?

I focus on the cash flows in your business and compare the different cash flow relating to all the options.

The simplest way to explain my approach is to imagine that the business has a large barrel of cash and ask what will happen to the cash in each of the scenarios. What money will come in and what money will go out? Once I identify the cash flows, I enter them 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 (I’ll show you an example of a completed table shortly).

Before you do that, you need to decide what sort of a time period you’re going to consider.  Its common to look at a decision over the life of the relevant item – so if it’s a van and you plan on changing again in three years, then you might evaluate it over three years. If you’re looking at outsourcing production, you might just look first at one year and then consider whether you need to review a longer period.

So, let’s look at the van example.

How much will a new van cost?

Let’s say John is currently running an 8-year-old van. His garage has a good 3-year-old van for €12,000 and will give him €1,500 for the old one. John wants to know if he should change.

The first thing I will ask is what the current van is costing him. He tells me his current van works up the following costs:

  • €3,600 a year in diesel to fuel the van.
  • €300 a year to tax and €500 a year to insure it.
  • Repair costs as the van had been giving him trouble which needed repair
  • €100 per day to hire a replacement van while his own was off the road – he expects this to continue and suggests that I allow 5 days a year for being off the road with maintenance work.
  • 2 days a year in lost earnings while he is dealing with the van – where he normally earns €400 per day on average.
  • Overall the van is costing John about €2,000 a year in maintenance, €1,000 of which is normal wear and tear, the other €1,000 is due to breakdowns.

Next, let’s look at the costs of buying a new van:

  • The new van John has his eye on will cost €12,000
  • We can then subtract the €1,500 trade-in on the old van.
  • John reckons he’ll sell the van on in 3 years for €4,000.
  • He estimates that it will cost him about €3,100 a year in diesel.
  • It will cost him €250 a year to tax it but €600 a year to insure it.
  • He’s not expecting to have any breakdown days or van hire.

So, overall the new van should cost about €1,000 a year in maintenance, which is all for normal wear and tear.

Note – these are not real numbers. They’re my best guesses to develop a reasonable example for you.

I put my table together, taking three years into account.

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  

 

Positives in the cash flows are ‘cash in’ and negatives are ‘cash out’. In the difference column, positives show where the new option is better than the current option; i.e. cash in, or less cash out.

So, what the above table tells us is that a new van looks like it will save about €1,850 over the three years. We need to be careful and remember that we’re making assumptions, albeit reasonable ones, about the performance and reliability of the new van. We need to be confident that we are aware of, and considering all of, the costs.

We’re not taking into account intangible elements like the effect on his business profile of driving in a newer van. Also, we’re not taking into account the effect on customers of cancelling work because the van let him down. And we’re also not taking into account the effect of having a reliable van and less stress and worry on John himself. We can allow for those in our decision but it’s hard to quantify them and put them in the table.

The bottom line is that the new van looks like it will save him €1,850 over the three years but there are some intangibles that might also be worth a lot to John and only he can put a value on those. I think most of us would change the van based on the info above.

The time value of money

Another factor to take into account is what accountants call the ‘time value of money’.

If I ask you which would you prefer – €1,000 now or €1,000 in 1 year – you’ll all intuitively know that if I get €1,000 now I could invest it somewhere and maybe make another €10 to €30, say €20, in that year. That means that €1,000 now is really worth €1,020 in 1 year. This is what we call the time value of money.

For some decisions, it can be worth taking this time value of money into account.  If you have high interest rates and two options with very different cash flow patterns then it may be worth looking at. But for most day-to-day investments, it’s not worth the additional work – and in any event it will involve other assumptions.

A systematic approach to decision-making

So, that’s how I recommend that you approach decision-making – by systematically breaking down those cash flows and seeing which scenario works out best for your business.

  • Identify the options available to you.
  • Note down the cash flows for each option.
  • Put them into a table and see which one looks best.

Put a little bit of time into challenging your assumptions and into thinking through the options to make sure you have considered everything that is relevant. And armed with your outputs you can be confident you’re making the best decision for the future.

Next time we’ll look at some more practical examples of how this can be put into practise.

If you’d like any assistance with your business decision-making, please do get in touch to see how we can help

 

 

Putting your accounting knowledge into practice: an engineering perspective

What should a business owner do to make sure he or she has the best possible information at his/her fingertips?

We’ve already discussed how to identify the key transactions of the business and also how to record the information that’s important to your business and pull it into insightful reports. Now let’s look at how you put this all into action.

Making your finances work for you

So, with your understanding of the financial basics, how do you start putting this knowledge into action and making your finances work for you?

  • Firstly, you must have systems that are appropriate for the business and decide who’ll be responsible for the recording of information. The methodology for this and the level of detail you get into will depend on the size of the business.
  • Secondly, you must list the types of reports you need and what types of information and analysis will help you prepare these reports easily. This involves adapting your accounting system to capture the information needed and making sure it’s easy to pull the reports from the system, no matter how simple or complex.
  • Finally, you need to have a routine to help you check the information. You’ve no doubt heard the hackneyed phrase ‘garbage in, garbage out’ – it’s a truism that’s as applicable for accounts as anything else. When someone gives you financial information, you need to know how reliable this information is.

So how do we sanity check your reports? And what should you be looking for when carrying out these reviews?

Using your reports in the right way

In my experience, when business owners get their financial reports, most of them jump straight to the profit and loss report. However, I’ve learned that it’s more important to start with the balance sheet.

To explain why, I will ask you to remember the ‘Wile E Coyote and The Road Runner’ cartoon that used to be on television many years ago…

The road runner was always speeding along a road, with milestones at the side. If he first passed the 5km mark and later passed the 15km mark, he knew (and we knew) that he’d travelled 10km in total. However, what if the 15km had been mistakenly put in the wrong place, say at 14km? The roadrunner would think he’d travelled 10km when he’d actually only travelled 9km!

By relying unquestioningly on the miletones, our road runner is misinformed and doesn’t understand his performance correctly.

Accounts are similar. The balance sheets provides the milestones and the profit and loss is a measure of the progress or profitability. If you get the balance sheet wrong then the profit and loss will also be wrong.

I recommend that businesses start by looking at the balance sheet and ask if the figures for the various assets and liabilities look reasonable and reliable.  If they’re reasonable then the profit and loss is also likely to be reliable.

Checking your balance sheet

So, how do we check the balance sheet?

We check the bank accounts by comparing them to the records that the bank has – the bank statements – and being sure that we understand any differences. The only difference we should have are timing differences; e.g. we pay a cheque but it’s not cleared at the bank yet. Accountants call this checking process bank reconciliation, but what you’re doing is simply proving your records are correct by comparing them to another source.

We should also look at customer balances. I find that most business owners are very much on top of who owes them money. If I give them a list of customer balances with something wrong then they’ll quickly tell me. So check your customer balances, look for anything that looks dubious and correct when you find something that needs correcting. Remember, if a customer balance is wrong then your sales figure could also be wrong.

Lets move on to the supplier balances. Again, most business owners are very aware of who they owe money to, so they will quickly spot anything that’s wrong and we can fix that. Again, if supplier balances are wrong, then your purchased costs could also be wrong.

Your inventory or stock number is a key figure in your accounts.  If your inventory is overstated, this has the effect of making it look as if you got stock for free so you profit will be overstated.  If your inventory is understated, then it looks as if you lost stock somewhere so your profits will be understated.   It is very important to get your inventory or stock number right.

Finally, we can quickly look at the other assets and liabilities that might be in the balance sheet and check if they look ok. For example, if there’s machinery or equipment listed in your assets, do the balances look ok? If there are tax liabilities, do those amounts seem right?

Once you are happy that your balance sheet is reliable, then you can rely on the related profit and loss account.

Getting your head around shareholder funds

There’s one section of the balance sheet that sometimes confuses clients. This is the section called shareholder funds or sometimes called owners equity/capital. In essence, this section represents the value of the business to the owner.

To understand shareholders funds, you need to ask the question, ‘If the business makes money, who does that money belong to?’ The answer is that it belongs to the owners.

So the difference between what the business has (the assets) and what it owes (the liabilities) represents an amount owing to the owners. We think of it as a liability to the owners and we call it shareholder funds (or owners equity) for companies or owners capital for non-company businesses.

Shareholders funds are reduced by moneys taken out of the business as dividends or drawings.  So the difference between any two balance sheets represents the profits made by the business in the period, less any profits taken out in the same period – in other words, the profits kept by the business.

Check your reports regularly

Your reports are a real goldmine of information. So I recommend to my clients that they get into a routine of regularly – at least monthly – reviewing and checking their reports. By regularly looking at your reporting, you learn as much as possible about the business and can quickly identify where action may need to be taken.

If you are familiar with the ‘Lean thinking’ approach to business, you may have heard about the three voices in any business that give feedback, helping you to manage and improve.

  1. The first voice is the voice of the customer, giving feedback on the quality of the service your business is supplying to them.
  2. The second voice is the voice of the people working in the business. They see up close what’s actually happening and are often an untapped source of information regarding how well the business is operating.
  3. The final voice is the voice of the process. We access the voice of the process by identifying the key measurements that let us know how the process is doing.

Your accounts should be looked at as a voice of the process. When your accounts are designed and implemented well, they provide extremely valuable information about the performance of the business.

So, rather than thinking of accounts as a compliance-type chore, think instead of the rich information that’s hidden within your accounts – and consider how best to access this.

Getting in control of your business performance

When you understand your accounting basics, the value of good reporting and the insights provided by your business numbers, you’re in real control of your enterprise.

And when you add the benefit of working with an experienced, process-driven accountant, you’ll soon start to the postive changes and improvements in your sales, cash flow and the profitability of your business.

If you’d like to know more about working with AccountsPLUS, and applying our ‘engineer’s perspective’ to the machinery of your accounts, please do get in contact. We’d love to help you get complete control over your finances and business performance.

Get in touch to arrange a meeting with the AccountsPLUS team 

Turning your financial transactions into insightful information: an engineering perspective

Understanding the nuts and bolts of your accounting really does give you an advantage as a business owner. As we outlined in our last blog post, breaking down your transactions into inputs and outputs (and thinking like a process-driven engineer) is the first step in getting in proper control of your accounts and finances.

The next step is to start thinking about the process that takes the inputs and outputs – the transactions – and organises them in a way that provides information and insights.

Getting genuine insights from your numbers

To get useful business information, we need to group the transactions in a way that makes sense. At its simplest, we can think of sales, expenses, assets and liabilities. However, accounting packages allow us to get even more, and better, analysis.

For example, we can analyse our sales in multiple ways:

  • We can group the sales by product type or by customer type or by customer region.
  • We can group it by salesperson or by selling unit.
  • We can group sales by best-selling product or poorest-performing product.

By thinking this through when we set up our accounts, we can design the system to provide invaluable information about how the business is performing – information that keeps you in control of the future financial path of your enterprise.

For example, one of my clients is a business consultant. When he first came to me, he just had one figure for sales, with no further analysis. As we were speaking, it became clear that he had three very specific, and different, types of sales:

  • One-off projects – where he helped implement improvements for clients.
  • Recurring income – where he was retained by clients on a part-time basis.
  • Training income – where he provided custom in-house training courses for clients.

However, it also became clear from our discussion that he was most focused on increasing the share of sales that was coming from the recurring income. He’d set a goal of increasing that recurring income to be 66% of his business, but at present he had no way of measuring that – and no way of telling if he was meeting that percentage target.

I recommended that he use an accounting package and group his sales into four categories: Projects, Recurring, Training and Other – a final category, to catch anything that was not in the first three.

As he raised his invoices, he could then select the relevant category for the type of sale.  After that, at any time, he can run a report which summarises the sales by category. And, by doing so, he can easily see if he’s on target or not.

By adding these specific categories into your ‘Chart of Accounts’ (the list of different codes in your accounting system), we make it incredibly easy to track and measure every element of your business and its finances.

Insights into your spending and expenses

We can apply exactly the same categorisation and coding process when looking at expenditure – the cost element of your transactions, where you’re buying from suppliers, whether for resale or for use within the business.

I tend to think of expenses as having a number of main categories:

  • Sales & Marketing costs – creating awareness such as building a website, or producing flyers
  • Building or premises costs – such as rent or maintenance costs
  • Staff costs – such as payroll and bonuses
  • Office-running costs – such as utility bills or software subscriptions
  • Professional costs – such as engaging an accountant, or solicitor
  • Financial costs – such as bank repayments etc.

Within those categories, we can create subcategories to provide additional analysis as we choose. You should choose the categories. The accounts should be working for you – not just for the bank manager, and not just for the Revenue.

Some companies have one ‘big’ expense type in their accounts, while others will chose to break a category down if they think it will help understand what’s happening in the business.   For example, some companies have one category for telephone while others split the telephone cost into mobile and landline. It all depends on what’s most useful for the business. And, crucially, if you have an accounting package then it’s no additional work to simply create a new code in your Chart of Accounts and add a new expense category.

Additionally, many software packages provide a facility to group costs by job or project. While it’s easy to see how this might be useful for a construction company or a project based company, it can also be applied cleverly for other companies.

For example, I have one haulage company who use “projects” to gather the expenses for each truck. In this way, they can easily track fuel, repairs and running costs etc, by truck and can then decide which trucks need to be replaced. It might also indicate if some drivers are more fuel efficient than others.

So think about the type of business that you have and what type of information would be helpful to you in running the business. It’s probably a whole lot easier than you think to code, capture and collate this information.

Putting it all into practice

We’ve outlined how to understand your inputs and outputs, and how to turn this data into insightful reports regarding the performance of the business.

The final step is to combine your basic accounting and financial reporting with a proactive focus on your performance – a topic we’ll cover in the last blog post of this series – “putting your accounting knowledge into practice“.

If you’re looking for assistance with your reporting and business information needs, please do get in contact with us and we’ll show you the ropes.

Get in touch to arrange a meeting with the AccountsPLUS team 

Understanding the nuts and bolts of accounting: an engineering perspective

Understanding the nuts and bolts of accounting: an engineering perspective

I was a latecomer to accounting. I first completed a degree in engineering and only moved to accounting after that.  Almost everyone who heard what I was doing told me how difficult I would find it and that I would struggle to get to grips with it, never having done it before.

However, I actually found it find quite straightforward and not nearly as daunting as I was led to believe. While there’s a lot of jargon that can be off-putting to someone new to accounting, it becomes a bit easier if you try to think of it in terms of processes with inputs and outputs, as an engineering training would encourage.

Let’s start with the inputs.

Understanding your inputs

It’s useful to start by thinking of your accounts as a database of all the various transactions that happen within your business. So the first thing to do is ask what sort of transactions go on in your business – and, funnily enough, the types of transactions are relatively common across most businesses, regardless of industry and sector.

  • Sales – every business sells something to customers. This means that we need to record our sales and we need to have customer records to track what we’re doing for each customer.
  • Purchases – The business will also buy things from suppliers. This means we need to record purchases and we need to have supplier records to track our activity with each supplier.
  • Payment and receipts – Finally, we need to receive and spend money, so we need a way to record these as money in and money out to/from the business.

That gives us three main types of transactions – sales transactions, purchase transactions, and payment/receipt transactions.

Next, we need to think about how to capture and record those transactions – creating the financial records that, ultimately, will become your accounts.

There are a number of ways of setting up and maintaining those records. You can have paper records (traditional but on the decline in the digital age), you can use Excel spreadsheets or you can buy accounting software. Unless your business is very small, it’s better to use accounting software. Most accounting packages will do what we need fairly easily. However, if the software is well designed, it can also give you a lot of other useful information that would be impossible to collate with paper files or Excel files.

Understanding your outputs

Next, we should move to focus on the outputs for the business. What sort of information do we need our accounting records to provide?

  • Business health – we need a measure of how well the business is doing and whether were actually getting a return on our investment (both time and money).
  • Financial reporting – we need reports that will prompt us when actions are necessary; i.e. when to pay a supplier, or when to chase a slow-paying customer.
  • Business performance – finally, we need information that will help us to understand what’s going on in the business and why we’re getting the results we’re seeing.

To understand how well a business is doing we need to know the net worth of the business. The net worth is the difference between what a business has and what that business owes.  Accountants call “what a business has” the assets of the business and they call “what the business owes” the liabilities of the business. So the key report in accounting language is the balance sheet as this lists the assets and the liabilities of the business.

The other thing you will want to understand is where the business is getting money from and where it is spending money. You probably already know that this report is the profit and loss account (we’ll talk about this more in a future blog post). It’s the report that shows how money moves into, and out of, the business – a vital way of measuring performance.

The need for insightful information

So, we’ve explained the basic nuts and bolts of accounting for you. You now understand the importance of breaking your transactions down into the ‘inputs’ and ‘outputs’ that explain the flow of money through your business.

The next step is to start turning these financial transactions into insightful, useful business information – a topic we’ll cover in the next in this series of blogs.

If you’d like some help to understand your accounting basics, please do get in touch with us and we’ll be happy to help.

Get in touch to arrange a meeting with the AccountsPLUS team