RSS feedsThe success of the UK banking sector seems to suggest that bankers know how to run a business. One characteristic that bankers share with accounting firms and consultants – all of whom have enjoyed something of a mini boom recently – is that they spend a lot of time looking at different businesses. With such an impressive track record, perhaps companies should take note of the bankers’ favourite mantra: “Turnover is vanity, profit is sanity, but cash is king”.
This may sound odd, especially as growth is a prerequisite for success. But what the bankers’ mantra highlights is that it has to be the right kind of turnover. Business should not merely chase increased turnover.
Whenever bankers advise businesses with ambitious growth plans, they are listening out for a particular idea or venture that will help boost the top line and, equally importantly, the bottom line. In other words, a story of increased sales should always be linked to a tale of piling on the profits.
More turnover does nothing for a business, unless it proves to be profitable. If it is not profitable, increased turnover puts a strain on a company’s finances. Stock and debtors increase, and so does the risk of bad and doubtful debts. Yet for startup companies and growing businesses, gaining extra sales is often their biggest goal. New business in itself simply isn’t enough; it has to be business that delivers a certain level of profitability.
Bigger picture
The trouble for many business directors is that they are so busy running the business on a daily basis they don’t get the time to look at the bigger picture. Assessing the financial performance of a company – and that includes looking at the profit and margin trend – is part of the overall business planning.
Without the discipline of setting targets and then reviewing them on a regular basis, the business is likely to drift or, worst still, crash. Setting targets is not a secret to be shared only by the directors; it should involve all those who are expected to turn those plans into a reality. Sharing plans at a draft stage will act as a spur to improve performance. It will also act as a reality check, ensuring that vaulting ambition has not entered the equation.
Planning financial performance may reveal some problems; in particular, with products or services, which may be barely profitable. So, should they be scrapped? Should more time be spent on new ideas or building up existing revenue generators, or are the loss leaders there for a reason?
For privately owned businesses without the pressure of outsider shareholders demanding a certain level of performance, it is necessary to generate some internal tension. Family businesses need to be clear about the sort of earnings needed to fund the expected lifestyles, and it is always useful to start thinking about what should happen in the medium term – the next three-to-five years. Should they stay the same, expand or sell? A key part of business planning has to reveal how successful the business is at generating cash.
Working capital
Just as some individuals are beholden to credit cards, some companies are permanently using their overdraft. The reason why many businesses need credit from their bank is because of difficulty planning cash inflows and outflows.
Businesses that are profitable over the long term should wean themselves off their dependency on an overdraft, or at least find a cheaper alternative – especially after the recent rise in interest rates.
Businesses that use credit facilities should check the terms and conditions – not only the rate of interest, but the cost of other associated banking facilities, such as paying cheques and making deposits.
One of chancellor Gordon Brown’s favourite sayings is, ‘borrowing to invest’ and companies need to adopt a similar mindset, and stick to it. Over the business cycle, the inflow of cash from normal activities needs to be positive. Even so, it should be possible to improve cash inflows and outflows by managing working capital – debtors, creditors and stock – a lot better.
Debtors
A company should be aware of its expected level of bad debt. If it is worse than expected, investigate why. Credit control is vital. Make sure it is clear who is responsible for credit control in the business. There is often confusion between sales people and finance staff over whose job it is to chase payments. Have clear policies on payment terms. When disputes arise, resolve them quickly.
All businesses, even small ones, should know their ‘outstanding day sales’ and should have a target to work towards. So many businesses seem to think that payment days of 65 against terms that state 30 is somehow custom and practice, and therefore acceptable. It’s not, and it can be improved.
Think differently
Rather than paying interest on an overdraft, it may be cheaper to offer discounts for early settlement. Be warned, companies shouldn’t be suckered into offering money off the bill and still await settlement.
Creditors
Responsible businesses pay their bills on time. But rather than just using the same suppliers, check out the terms and conditions, payment times, prices, etc from others in the market. In addition, negotiate the definition of “on time”.
Suppliers are often willing to alter payment terms. So it should be possible to negotiate payment in, say, 90 days when times are tough, provided that bills are paid in 15 days when business is good.
It is also essential to keep the purchase ledger up to date so a company knows where it stands with its creditors. This may sound blindingly obvious, but it is amazing how many finance departments lose staff in a futile bid to encourage the business to cut costs – and it always seems to be the purchase ledger that suffers. After all, an FD can’t do the corporate dieting for the entire business.
Stock
Any business holding stock has a fine balancing act between holding too much and running out – always, of course, at the wrong time. Those responsible must be aware of the potential cost of holding too much stock. For example, one client in particular advised engineers not to carry around too many spares. They were shocked to learn the carrying cost of the stuff rolling around the back of their vans. A reassessment of stock policies also helped to tighten up on security procedures.
After the working capital has been reassessed and improved, it is time to return to the issue of the cash management. While many businesses can produce historical management information, and many produce reasonable trading forecasts and budgets, producing cashflow forecasts remains one of the toughest tasks for companies. The number of uncertainties seems to defeat us. It is still worth performing the exercise. Often the outflows are easier to predict (rent, rates, salaries, insurance, VAT, PAYE) and trade creditors are, to an extent, flexible.
Business may find that a cash crisis can happen at certain times in the year, and it may be cheaper to seek specific help from the bank rather than fall back on the ongoing support of the overdraft. When a business has surplus cash, it should have a policy of how to improve the bottom line by earning interest before it is needed for investment or distribution to shareholders.
Capital costs
A client recently saw an opportunity for winning new business in a specialist sector of the medical supplies market. He realised a profitable opportunity existed and was confident he could win against some bigger competitors. It would make a big difference to his business.
This opportunity would not only boost his business’s top line and bottom line, but also the company’s profit margins, which had been flagging.
He realised what many companies don’t: that many companies destroy value. They pump money into business and achieve returns less than the cost of capital. The cost of capital is the expected return required on investments to compensate you for the required risk. It represents the discount rate that should be used for capital budgeting calculations. The cost of capital is calculated on a weighted average basis (WACC). If you are achieving a cost of capital of less than, say, the 10-12% mark, depending on interest rate, then the business is not pulling its economic weight.
Each business should have its cost of capital explicitly stated in its business plan. Many companies set themselves a target for the return on capital they are going to achieve, then promptly forget it in the daily grind.
One good discipline is to include the cost of capital benchmark in the planning stage for every new venture/product or business idea. This helps to remind the company that it needs to produce an overall return by achieving individual returns.
Business plans should also include mini management accounts and cashflow planning as this helps to clarify the working capital needs of every new venture.
Peter Charles runs a consultancy and turnaround company
