Tim Keenan, Partner and National Director, Privately Held Business at Grant Thornton New Zealand, looks at reasons why companies are getting into financial strife, particularly in the Christchurch construction sector.
How can a sector such as the Christchurch construction market, that has billions of dollars slushing around it, have so many financial casualties? Or a more extreme case, how can a company that turns over $20 million make no profit?!
This is the “new” Christchurch, yet it need not be this way. Some basic financial reporting systems, that are readily available off-the-shelf or from the cloud, could help many of these businesses avert receivership or liquidation.
When the Financial Reporting Act and the Financial Reporting (Amendments to Other Enactments) Act came into force on April 1, it removed the requirement for an estimated 98 percent of New Zealand businesses to prepare general purpose financial statements. For some, deleting this requirement was like throwing away the company’s financial rudder.
The naïve business owner only prepares financial reports when the law requires. The astute operator prepares regular management accounts, cash flow statements and forecasts, which gives them a snapshot of where they are at and lets them plan for the future. The banks often insist on these reports as well.
The Canterbury construction industry is euphoric at present. There is such a high level of work that it’s like a “feeding frenzy” with many grabbing for the pie without fully thinking through the ramifications or having the systems to handle the escalating volume of work. Banks are regularly referring cases to the firm where companies have expanded rapidly, gotten into trouble, and then had no effective financial information systems behind them to understand or cushion the fall.
The common denominator through many of the distressed companies in the construction industry is their lack of understanding of their own costs and margins. They are pricing jobs without knowing these two important factors. There is also the difficulty of estimating the cost of materials, which are escalating hence the $20 million turnover and no profit outcome.
There are some simple steps that can help businesses keep away from the abyss. Buying some accounting software from the shelf or the cloud, rather than a new accessory for the recently purchased ute, is one such smart move and a relatively small investment. This will allow the following to occur:
A starting point is the preparation of financial statements, which is a formal record of the financial activities of a business. These statements allow business owners to:
- see the role cash plays in every business decision
- understand whether the business is running at a proﬁt or a loss
- calculate funds needed now and in the future to ensure short term positive cash ﬂow and medium to long term growth.
For lending purposes, financial statements help owners to:
- judge their ability to repay loans
- assess whether lending is justified and, if so, how much and over what term
- decide whether to buy or lease assets, and if buying, whether to seek financing for them
- assess what collateral is available to secure a loan.
The income statement summarises revenue (mainly sales) and expenses. The bottom line of the income statement shows net income. Net income, in turn, shows whether the business is profitable or not – right now.
The balance sheet is, literally, a snapshot in time. It lists a business’s assets and liabilities on a given date, comparing what the business owes against what it owns.
Like the income statement, however, the balance sheet is a powerful indicator of business health. As every business owner should know, cash is critical – and the balance sheet allows owners to calculate how many days of working capital they have available, which in turn measures the business’s ability to pay its bills during typical fluctuations in revenue.
Failure to understand this metric can lead even a profitable business to insolvency if it has a period of loss without a sufficient cash cushion. In the worst-case scenario, it can also lead to directors of the business facing litigation, or civil or criminal charges based on demonstrable mismanagement.
As a general rule of thumb, a business should have at least 60 days of working capital. A strong balance sheet (business) will typically have 120 days or more.
Cash flow statement
If you think cash is king for a business, you’re right. And the power behind the throne is the cash flow statement.
This statement shows how much money has come into and gone out of the business over a given period, and how much will be kept on hand to cover emergencies. Keeping the statement current and valid forces the business to make sound predictions about future sales and purchases – and, as far as possible, meet or exceed the former while staying within the latter.
Ignorance of forecasting, accounting, budgeting and cash flows is no excuse. Accounting packages can be bought easily and the interpreting the financial information can be made easier by the investment of some time with advisors and accountants who understand the construction industry. Too often a business owner has no problem in buying the latest ute or some other toy but will baulk at any form of investment in the financial/accounting advice. That’s unfortunate, because a relatively small investment in regular financial advice could mean that they ensure their business is profitable, sustainable and that they can hold on to the ute in the future.