Budgeting & Forecasting
Budgets are most valuable during the launch phase for a new business, especially when modelling multiple investment scenarios. Once a business is more established, Forecasts will probably become more important, eg when you need to anticipate the financial consequences of changing business circumstances and plan your responses. Many experts believe that short to long term “Rolling Forecasts” can do both jobs well, eliminating the need for Budgets altogether.
Some golden rules about Budgeting and Forecasting:
- Never prepare a budget for its own sake – they are a waste of time unless you are going to actively use them in your business.
- Never draft your Budget first and then plan your Strategy (or, even worse, think that a Budget is a substitute for a real Strategic Plan).
- Forecasts are only useful if they are based on “real world”, forward looking data, eg your sales orders and pipeline, your staff commitments and your production capacity.
- Only those who are very close to the business will have the knowledge to make the right budgeting or forecasting decisions, so never try to outsource that accountability to an external accountant.
Working Capital Management
Working Capital consists of your Cash, Accounts Receivable, Accounts Payable, short term Debt, Inventories and Prepayments (where applicable), which are connected in a cycle:
- You need Cash to pay staff, rent etc when your business starts up – and maybe purchase inventories to process or resell.
- You may need to offer credit to Customers, which will generate Accounts Receivable that you eventually convert to Cash.
- You will probably want to have credit terms with your key Suppliers.
- You may need short term, variable Debt, such as credit cards, to supplement your Cash reserves.
- Even if you don’t have tangible Inventories, you may need to prepay for certain intangible costs of services that you need to operate, eg software licenses and insurance premiums.
Too much or too little of any of these could be a critical problem:
- You might not have enough Cash to pay your debts “as and when they fall due”, potentially triggering insolvency.
- You may not be collecting your Accounts Receivable quickly enough, or extending credit to Customers who turn out to be bad debts.
- You may be paying your Accounts Payable too quickly, leaving you short of Cash.
- You may have excessive Inventories, which are tying up your Cash and / or Accounts Payable capacity, and may even spoil.
The trick is to actively plan for optimal levels of each type of Working Capital, in line with your Budget and / or Forecast. And don’t let the total of your Accounts Payable and short term Debt exceed the total of your Cash and Accounts Receivable.
Gross Margin, Costs & Profitability
Gross Margin is your Revenues minus your Direct Costs of Sales (including labour costs that relate to those Revenues) – its also the short term litmus test of whether a business can pay its way.
Too many business owners and leaders get confused about what costs they should allocate against Revenues to calculate Gross Margin. Where small businesses are concerned, we think the following rules are sensible:
- If a cost has to be incurred even if you don’t sell anything at all, treat it as an Indirect Cost (or overhead).
- If a cost will go up or down when your sales and production (that drive your Revenues) go up and down, treat it as a Direct Cost.
Increases in Gross Margin percentages can be earned from price increases, by reducing supplier costs, or by running production processes leaner… and as your business grows its production volumes, those gains will make your business healthier, more profitable and more valuable.
Profitability is then determined by subtracting Indirect Costs from your Gross Margin. One measure that we recommend for assessing Profitability is Earnings before Interest, Depreciation and Amortisation (EBITDA), which can be used to compare businesses with very different funding and investment structures. Business valuers and sellers focus on this above all else, when appraising a business.
Finally, make sure that you know your business’s Break Even Point – the level of Revenues that you need to at least cover your Fixed Costs. If you are operating below that activity point, the clock is ticking on your business potentially failing.
Your business may have other compliance requirements, eg to be audited or to lodge accounts each year with ASIC, but it definitely has to stay on top of its Taxation obligations, eg lodging Business Activity Statements and paying GST to the ATO, and lodging its annual tax return and paying business income tax. The ATO also monitors compliance with superannuation payment obligations.
We always ask our clients how they are managing those obligations and whether they have the advice and support they need from a great tax accountant – but remember that many tax specialists aren’t always sufficiently knowledgeable about broader business issues.
Finally, make sure that you don’t focus too much on complex tax minimisation strategies rather than good business practices. Healthy businesses pay their fair share of taxes over time, in our experience – and those that are in good compliance shape will not be spending scarce time on creating complex business structures, or arguing with the ATO.
Finance Performance Monitoring
Once again, its not all about your Profit and Loss:
- If you or your accountant are not regularly “reconciling” Assets and Liabilities, your Revenues and Expenses may be highly inaccurate.
- We recommend that you compare actual financial results against your Budget and / or Forecast at least monthly.
- Monitoring your Working Capital at least monthly – or even weekly – will help you deal with Cash shortages, overdue Accounts Receivable, imminent Accounts Payable and excessive (or scarce) Inventories, before they become a big problem.
- Start learning more about Gross Margin and EBITDA, and how you can use those measures over time to better plan and assess your business, and make it healthier and more valuable.
- Stay on top of Taxation and other compliance, and make sure that your accountant is giving you the support you really need.