Owners of small businesses, in particular, are normally very optimistic about the state of the business and how things will be in a year’s time. But they often make forecasts based on best case scenario rather than allowing for some hurdles.
Peter Sherwin, a partner at Grant Thornton New Zealand, says that while working out the business expenses for a year can be relatively straight forward, working out income is totally different.
“The ‘back of the cigarette packet calculation’ that next year’s income will be 10% higher than this year seldom runs true. What is needed is a sensitivity analysis to outline the state of the business if the promised income was 20% less than expected.
“It’s also important to consider what would happen to your business if interest rates suddenly went up by 2% over the next two years. The sensitivity analysis should ensure a business has access to an emergency funding line. When discussing overdraft levels with your bank, always ensure that there is more capacity for assistance than is currently needed.”
Sherwin says it’s easy to use the wrong type of debt. As a rule of thumb, any debt should match or be less than the economic life of the asset you are borrowing to purchase.
“In simple terms, if you can’t pay your accounts and you have no overdraft left, then you are carrying too much debt. But with good planning, barring unforeseen catastrophes, businesses should never get to this stage.
“Too much debt can mean you miss that opportunity to expand operations (grow), get bulk purchasing discounts or not have capacity to take advantage of good deals when they arise.
“And if you start running out of cash because of excessive debt, missing payments and developing a bad credit rating can have an impact when looking for credit later on, be it from the bank for a loan or an overdraft, a hire purchase agreement or a normal 30-day terms supplier account.”
Sherwin says owners need to understand the ins and outs of their business. How much cash is needed to run the business and pay down debt? How much cash is the business likely to generate? When are the peaks and troughs in the business cycle? In which months will there be an extra wage payment and larger PAYE payment the next month? What supplier payments need to be made to continue supply of goods and services?
“Pulling this together creates a cash flow forecast. Cash is king when it comes to running a sustainable business and an owner needs to know, on a month-by-month basis, the demands that will be placed on their cash. Often business owners find out too late that their business is in trouble. Preparing a cash flow forecast should ensure the owner is alerted to these problems at an early stage. Banks will also demand a cash flow forecast so they can see the highs and lows of the business and know that there is planning in place before problems arise.”