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Are you in control of the finance for your business?

By Paul Furber on 03/11/2014 - 0 Comments

Since poor cash flow is a primary driver for business failure, as an owner / director / manager of a small or medium sized enterprise (‘SME’) are you in control of your finance function? Do you have robust systems and process in place to review progress? Do you know what sort of management accounting you need, if any? These are critical questions that need to be answered if you are to succeed.

SMEs make up 99.9% by number of all businesses in the UK. And 95% by number of all businesses employ 9 people or less (micro-businesses).

What is the official UK definition of an SME?

  Small Medium
Sales less than  £6.5m  £25.9m
Net Assets less than  £3.26m £12.9m
Employees up to  50  250

 

 

 

 

A recent Open University (‘OU’) study challenged the perception that SMEs were failing to grasp the benefits of management accounting in the operation of enterprises. OU identified external reports which suggested that many owners of SMEs are not aware or not convinced of the usefulness of management accounting for control and decision making purposes. Further, it is held that improved information would help owners manage better and access finance more easily (United Nations report).

My own professional body – the Institute of Chartered Accountants in England & Wales (‘ICAEW’) – also supports these external views in its helpful series for SMEs. ICAEW says that “Many businesses do not have adequate systems for identifying the amounts of profit or loss generated by different products and services, or even by the business as a whole, yet this information is absolutely essential if the business is to grow stronger.”, and also “Businesses need to plan ahead and compare forecast figures with actual results. Break-even analysis, business ratios, budgets and discounted cash flow, perhaps built into a financial model on a computer, are some of the methods which can be used to set realistic financial targets and then keep you on course to achieve them.”

What are the key management accounting tools are we considering here?

The OU study included;

- Costing of products and services
- Breakeven analysis
- Working capital measures
- Budgetary planning and control
- Cost / profit centres
- Decision support tools such as

o Payback
o ROI
o Marginal Costing
o Contribution Analysis

The OU study reviewed seven small (turnover between £750k and £5.3m) and four medium (£7m - £23m) sized businesses and found that, in their sample, all businesses used costing, breakeven analysis and working capital measures. However the small businesses rarely used any of the other tools listed and none of the SMEs chosen used decision support tools.

Decision making in SMEs is typically down to the owner’s intuition or “gut-feel”. This is usually due to uncertainty of future cash flows which will render formal management accounting tools which rely on an element of forecasting fairly useless. The management accounting that is used focuses – as do the SME owners themselves – on the situation today and in the immediate future. Circumstances, rather than formal analysis, usually dictate investment decisions. In addition, it is rare for (particularly micro-) SMEs to employ formal financial management staff and often such tools that are used are generated by the business owner. External accountants of such businesses rarely offer management accounting tools or advice.

The conclusion of the OU study was that management accounting tools are actually used more often than previously reported and that “all enterprises found management accounting of critical importance in running their business.” They noted that there was scope for greater use of planning and decision support tools. There is no mention of the effectiveness of the tools used by the SMEs in this study. In our experience this is often limited – sometimes due to time, often due to the inability to extract useful information from the tools in place. Even where such tools are available to owners, often the data is out-of –date or simply not measured.

The OU sample included few, if any, micro businesses which make up the vast majority of the UK’s enterprises and our experience in this sector suggests that the use of the management accounting tools is much less widespread. Very often the only management accounting “tool” is the bank statement.  We agree with the United Nations report and with ICAEW that (appropriately sized) systems are essential to the success of any business.

Budgeting and Planning – why?

It is desirable to put together a business and financial plan (going forward three or five years) whatever the size of your venture. You should do this even when you do not need to raise external finance but if you are looking for external finance a business plan is essential. It should include details of markets served by the business, history, management, future plans, etc. Similar plans will be required if the owner is considering selling the business. The plan will include a projected profit and loss account, cash flow and a balance sheet. Understanding what drives cash flows is vital for any business plan.

Budgets are normally used internally to help the owner run the business, monitor its progress and develop action plans to achieve objectives. Budgets usually contain the same basic information as plans i.e. forecast of profitability, cash flow and financial position. However, budgets usually deal in shorter timescales and can be broken down into weekly, monthly or quarterly periods. They set a framework against which actual performance can be monitored, but should not be accepted as the best that a business can achieve. Targets should also be set for the business and these should aim to beat the budget levels. You will not get penalised for beating your budget.

Management accounting information is compared with the budget to monitor progress and to decide if changes in planned actions are required. A comparison of performance figures with budget, together with key ratios, is often a primary source of information for the effective running of a business. This enables the owner to get a better understanding of the enterprise and establish where he needs to focus his time. Such understanding will also help convince a lender that you know what makes your business tick and they will be more inclined to help finance your venture.

Decision Support Tools

As has been stated, the SME owner often relies on experience and intuition in coming to decisions on investments. As with budgeting and planning, putting a formal case together to check the owner’s “gut-feel” provides a framework for measuring what success the investment brings.

For example, take this simple payback model;

Period

Project

 

Actual

 

Cash out

Cash In

Cum net

 

Cash out  

Cash In

Cum net

0

-£5,000

 

-£5,000

 

-£6,250

 

-£6,250

1

 

£250

-£4,750

   

0

-£6,250

2

 

£3,500

-£1,250

   

£3,000

-£3,250

3

 

£3,500

£2,250

   

£2,750

-£500

4

 

£3,500

£5,750

   

£3,000

£2,500

Payback (periods)

2.4

     

3.2


 Before the expenditure is committed the owner can establish whether the projected payback is satisfactory. If not, he should explore other options – which can include doing nothing. If the payback is satisfactory, the investment is approved and actual performance should be measured against the project. If necessary corrective actions will be taken and lessons learned for future investments.

In our example measuring the actual performance tells us;

This is a simple example and in reality any forecast will be different from actual results. However the more such techniques are used the better the understanding of cash flows in the business. And the decision maker should measure actual performance, in the same way as described in the budgeting and planning section above. Future decision making will start to be based on knowledge rather than just intuition – however good that might be! If you don’t think you have proper control of your finance function, maybe it’s time to get help as your business may be at risk.

Paul Furber FCA
ICON Business Solutions Advisor

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