A Guide to Financial Management Fundamentals for Smaller & Medium-Sized Enterprises (SMEs)

A practical guide to preparing a business plan

for smaller & medium-sized enterprises

(SMEs)

Foreword
It gives me a great deal of pleasure to welcome you to this first Finance Wales guide for business and business intermediaries. A key part of our role at Finance Wales is in the provision of good quality and practical management support. While much of this support is directly carried out on a face-to-face basis through the mentoring and investment support that Finance Wales offers, I have a strong desire to reach as many business people as possible. This guide and those that will follow are designed to fulfil that goal. The importance of robust business planning is well documented and widely accepted as best practice for all types of business. The reality is that planning is a difficult process and one that, if not done correctly, exposes a business to the risk of being unable to manage successfully unforeseen challenges. Despite this importance we at Finance Wales regularly see our clients having to juggle their time to cope with the myriad of responsibilities involved in running a business. In this hectic environment the routine task of business planning is often left behind. In this guide we have attempted to simplify the process of planning but it is not intended to be a replacement for sound professional advice or a template for accessing financial support. There can be no substitute for specific advice tailored to the businesss particular needs. Nor can there be a shopping list for finding finance. I am delighted that we have been given the kind permission of the Chartered Institute of Management Accountants (CIMA) to reproduce this guide, which was prepared by CIMA, in conjunction with the Fdration des Experts Comptables Europens (FEE), with considerable reliance being placed on CIMAs Making a Success of your Business: The Toolkit. We acknowledge CIMAs assistance and would like to thank them for their support. I hope you will find this guide a good starting point to long-term, sustainable business planning. For more information on the ways in which Finance Wales can assist businesses and social enterprises, contact us on 0800 587 4140. Email: info@financewales.co.uk Web: www.financewales.co.uk If you are a textphone user, you can contact us on 18001 0800 587 4140 or 18001 029 2033 8156. To find out more about the Chartered Institute of Management Accountants, contact: Stathis Gould, Head of Technical Issues, Chartered Institute of Management Accountants, 26 Chapter Street, London SW1P 4NP Tel: 020 8849 2379 Email: stathis.gould@cimaglobal.com Web: www.cimaglobal.com Colin Mitten Chief Executive of Finance Wales

Contents
Page

1. How to use this guide 2. Getting started essential preparation Basic questions for your business Basic information needed to run your business Rules of thumb 3. The business plan Introduction What the providers of finance want to see The budget The background 4. Step-by-step guide to writing the business plan Basic information for inclusion The business plan checklist Non-financial indicators 5. Doing it for yourself Charts for self-completion 6. Glossary of terms

5 5 8 10

11 11 12 13 13

14 14 15 18

22 23-42

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1. How to use this guide

We have laid out this guide in order to facilitate the total planning process. By following the steps set out in these pages any business will have a sound framework for a workable long-term plan. Firstly, managers should answer the basic questions set out in section two. It might be useful to talk these through with an independent third party such as a business advisor to ensure an objective view. Being forthright at this stage will clearly identify the businesss strengths and weaknesses. Without such a solid foundation the rest of the planning process may become flawed. The guide then sets out a basic framework for the body of the business plan. By addressing each of the sections and providing a detailed description of the key factors behind each section as they relate to the individual business, managers will have a comprehensive document upon which they can rely to assist with the day-to-day management of their business. In addition, this process will build a strong case to achieve success when applying for finance. Finally, we have provided a range of graphical representations for key financial ratios. Our experience has shown that this is an aspect that presents many of our clients with difficulty as it is not always easy to communicate the financial strength of the business proposal in words and figures alone. Such graphical representations can be very powerful tools.

2. Getting started essential preparation

Basic questions for your business This section contains fundamental questions that managers of any kind of business need to ask themselves. Negative answers, or inability to answer because of lack of information, should serve as warning signals of likely problems for management to review and resolve. Your business What is your business? Why are you in business? What factors are critical for success? Do you analyse these factors? Who buys your products and why? Where do your profits come from? Your strategy What are your business goals? How do you plan to achieve them? How do you intend to grow? What plans do you have for succession? The market Who are your customers? Do you have sufficient information on them? What are their needs? How satisfied are they? Who are your competitors? Do you have information on them? What is your market share? What sets you apart from your competitors and makes you so special? How long will you be able to maintain this special market position? and what happens when you lose this position?

The products What are your key products/services? What is your product (and process) life cycle? Is your product and process technology exclusive (patents), and how long is it defensible? Is the product range regularly updated in line with market needs? Who are your key suppliers? Do you know enough about them? What kind of relationships do you have with them (e.g. co-design, partnership etc)? Business plan What is your short-term business plan (of one to two years)? Does it have clear objectives which everyone in the business understands? Does the plan reflect your own ambitions, beliefs and assumptions (even if you have obtained help from your financial advisers in drawing it up)? How does your plan identify your business opportunities and vulnerabilities, and where it is strong and weak? Are you also taking a longer-term approach (say three or more years)? How do you and your staff use the plan to guide the business? How regularly is it reviewed? Do you check performance against plan? Budgets Do you have a budget and does it link into the business plan? Is it an action plan (e.g. orders, capacity planning, resource balancing)? How good is your budgeting process? Do you have a good early indication of your results, or do they come as a surprise to you? Is performance against budget checked regularly? And is action taken on variances? Do you realise that a first sign of trouble is when a business drifts off its cash targets even though it may still be meeting its profit targets?

Performance reporting Do you rely only on the accounts you prepare for legal and tax reasons to tell you what is happening? Do you have a monthly financial reporting system? Does it provide information in the same form as the budget? Do your financial and non-financial indicators follow the performance of the business during the month? How quickly are they produced? Do you use them? In case of declining results do you know which are the profit sensitive areas, which areas will affect cash and sales, and where you can act fastest to reduce costs? How do costs run through your organisation, i.e. your fixed and variable costs, your product costs, the stepped costs caused by expansion when you exceed current capacity? How robust are the information systems? Are there any private costing and information systems? Are you aware of the 80:20 rule in managing your information? Cash Cash is king: do you actively manage all aspects of your cash, from external financing, through working capital to cash balances themselves? Do you understand the crucial difference between cash in hand (and the bank) and paper profits? And that you can go bankrupt while seemingly making profits on paper? Do you use external finance? If so, do you know its cost? Do you realise that over-rapid business growth will put a strain on your cash resources? Do you also realise that excess cash may stem from a shrinkage in sales? Do you prepare regular cash flow forecasts (possibly with the help of your financial adviser)? How do you control cash collection from customers and overdue accounts?

Basic information needed to run your business This is a general list. While some indicators (such as the breakeven point) apply to all businesses, others (such as many of the non-financial indicators) do not. Managers have to determine what information is relevant for them. If, for instance, seasonal factors are important, they need to be aware of this so that they can include it in their business information, plan for it, and benchmark with other similarly placed businesses. All terms used are explained in the Glossary. Breakeven point Analysis of costs Fixed costs Variable costs (what they vary with and to what extent) Overhead costs Product costs Direct Indirect Gross margins Monthly earnings Actual revenue and expenditure compared with budget Non-financial indicators For example, quantities, number of employees, quality, service, complaints, defects, rework, scrap, amount of stock (and location), its value and saleability, labour hours, sales volumes, number of credit notes

Performance by product (as applicable) Geographical area By business location By customer (group) if applicable By salesperson Seasonal factors in sales, costs, purchases For example, factors affected by summer months or festival periods? Order book information Is it balanced with a varied customer base? Key suppliers and customers Who are they? Amount owed and owing (and overdue accounts) How good the debt is Monitoring Collecting Level of bad debts Borrowings (and repayment terms), cost of borrowing and what the loans are secured on: Short term/long term Level of gearing

Investment in fixed assets

Rules of thumb Key figures which should be updated regularly and be readily available: Amounts owed by third parties debtors (reported monthly) Accounts payable creditors (reported monthly) Cash balance (and the forward position) Short-term investments Short-term borrowings compared with credit facilities Number of employees Order book Sales Market share Customer satisfaction data Key ratios (as applicable to the business in question): Profitability ratios Debt/capital Debtor days Stock days Product and total margins Sales/net assets Turnover per employee (and comparison with competitors if known) Liquidity ratio Current ratio The methods of calculating these ratios are explained in the Glossary.

3. The business plan

Introduction The business plan sets out how the owners/managers of a business intend to realise its objectives. Without such a plan a business will drift. The plan serves six main purposes. It enables management to think through the business in a logical and structured way and to set out the stages in the achievement of the business objectives It enables management to plot progress against the plan It ensures that both the resources needed to carry out the strategy and the time when they are required are identified It is a means for making all employees aware of the direction of the business The document is available for discussion with prospective investors and lenders of finance (e.g. the bank) The plan links into the detailed, short-term, one-year budget. The purpose of a budget is: To monitor unit and managerial performance (the latter possibly linking into bonus arrangements) To forecast the out-turn of the periods trading (through the use of flexed budgets and based on variance analyses) To assist with cost control To project the businesss future performance A business plan has to be specific to the organisation in question, its situation and time. This guide sets out good practice. One thing is certain, however: a business plan is not just a document to be produced and filed. Planning is a continuous process. The business plan has to be a living document, constantly in use to monitor, control and guide progress. That means it should be under regular review and will need to be amended in line with changing circumstances.

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What the providers of finance want to see Invariably providers of finance will want to see a business plan before advancing finance. Not to have a business plan will be regarded as a bad sign. They will be looking not only at the plan, but at the persons behind it. They will want details of the owner/managers of the business, their background and experience, other activities, etc They will be looking for management commitment, with enthusiasm tempered by realism The plan must be thought through and not be a skimpy piece of work. A few figures on a spreadsheet are not enough The plan must be used to run the business and there must be a means for checking progress against the plan. An information system must be in place to provide regular details of progress against plan. Finance providers are particularly wary of businesses that are slow in producing internal performance figures Lenders will want to guard against risk. In particular they will be looking for two assurances (sometimes known as the two exits): That the business has the means of making regular payment of interest on the amount loaned, and That if everything goes wrong the lender can still get its money back (i.e. by having a debenture over the businesss assets) Forward-looking financial statements, particularly the cash flow forecast, are therefore of critical importance The lender wants openness and no surprises. If something is going wrong it does not want this covered up, it wants to be informed quickly

The budget A typical business plan looks up to three years forward and it is normal for the first year of the plan to be set out in considerable detail. This one-year plan, or budget, will be prepared in such a way that progress can be regularly monitored (usually monthly) by checking the variance between the actual performance and the budget, which will be phased to take account of seasonal variations. The budget will show financial figures (cash, profit/loss working capital, etc) and also non-financial items such as personnel numbers, output, order book, etc. Budgets can be produced for units, departments and products as well as for the total organisation. Budgets for the forthcoming period are usually produced before the end of the current period. While it is not usual for budgets to be changed during the period to which they relate (apart from the most extraordinary circumstances), it is common practice for revised forecasts to be produced during the year as circumstances change. A further refinement is to flex the budgets, i.e. to show performance at different levels of business. This makes comparisons with actual outcomes more meaningful in cases where activity levels differ from those included in the budget. The background Before preparing the plan management should: review previous plans (if any) and their outcome be very clear as to their objectives a business plan must have a purpose set out the key business assumptions on which their plans will be based (e.g. inflation, exchange rates, market growth, competitive pressures, etc.) take a critical look at their business. The classical way is by means of the strengthsweaknesses-opportunities-threats (SWOT) analysis, which identifies the businesss situation from four key angles. The strategies will be based on the outcome of this analysis

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4. Step-by-step guide to writing the business plan

Basic information for inclusion Management summary The rationale behind the proposal The owners/managements goals and objectives Key facts: figures, history, names, addresses, references The marketing imperative: why this business is different from all the others, and why it is better Assets, facilities, sensitivities, breakevens, vulnerabilities, SWOT What the funding requirement is Where the money will come from and how it will be repaid The financials should include: operating statement, balance sheet, cash flow, costings

Notes

Notes

The business plan checklist The checklist below is intended to cover as many eventualities as possible. Obviously, most plans will not be set out in such detail, particularly for the smaller business. The following should therefore be used as a checklist for the plan to be based on, with the structure respected, but omitting the detail that is not applicable. The title pages Title One-page summary, in plain words Key facts at a glance Contents page, with details such as partnership agreements set out in the appendices The appendices and attachments shown separately Introduction Background to the business including: when it was established, by whom, how long it has been running, previous years results if applicable Background to the owner(s) Key objectives Type of business: e.g. sole trader, partnership, private, public company Key assumptions behind the business plan The product/service Existing business Strengths, weaknesses, opportunities and threats What makes it special: unique features of the business Development IPR

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Marketing The present market Competitors and prospective competitors: products, prices, locations, likely developments Customers and prospective customers Key customers and how reliant the business is on them Future: prospective sales and market share Any other aspects, e.g. distribution Legal aspects Tax and liability implications for the owners Premises, assets, facilities and purchasing Premises, location, size, how owned, local taxes, planning permission, etc Plant and equipment, how owned, is it encumbered? Purchasing arrangements if applicable Key suppliers and how dependent the business is on them Security Insurance People Management: with details of the key managers/employees (supported by C.V.s) Employees and terms of employment Organisation chart if applicable

Notes

The financials Past accounts and key performance figures if applicable Budgeted profit and loss account for the current year, plus forward projections Cash flow forecast Projected balance sheets Ratios and comparisons, ideally internally, over periods of time, and externally Product/service costings if applicable Breakeven analysis Capital expenditure programme Funding Risk, particularly foreign exchange risk if there is foreign business Safety net if it all goes wrong What is the fall back plan? in particular, what will happen if there is a cash crisis? Long-term lines of credit Replacement of a key employee

Notes

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Non-financial indicators Administration Number of credit notes per period (broken down by reason and amount) Number of invoices per period and average invoice amount Number of packing notes per period and average size of packing note Telephone logging: number of abortive calls, time before calls are answered Invoicing errors Reconciliations Accounting errors and rectifications Customers/suppliers Top (say 20) customers Top (say 20) suppliers Inward quality failures Percentage of business accounted for by the top customers, and by the top suppliers Market share Complaints (detailed by cause, unit, person, customer, etc) New customers (and from which competitor) Lost customers (to which competitor and why) Returned goods (and why) Stock errors Lead times Warranty claims

Notes Distribution Delivery times Returns Breakages Lost deliveries Wrong deliveries Pilferage Out of stock Delays Chasing suppliers and expediting Manufacturing Production/output Set-up times Scrap Rework Breakdowns Downtime Cycle times Output/head Machine utilisation Process yield

Notes

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Personnel Succession plans Training schedules and achievement for key personnel Staff skill base and gaps against future requirements Staff turnover Absenteeism Staff sickness Staff feedback Results of exit interviews Third party opinion (from press comment) Quality Incidence of non-quality, broken down into prevention, detection and failure Incidence of failure Incidence of after-sales warranty service and repairs Timeliness in supply Safety Number of incidents Accidents (the accident, injury/loss of life, location, time, circumstances, etc)

Notes

Service Customer surveys Repeat business Unsolicited praise Third party views (from press comment) JIT record Delinquency in supply Adherence to plan Technology Number (and percentage) of new products being sold which were not in existence five (and three) years ago Percentage sales from new products Speed of getting new products/services to the market

Notes

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A Guide to Financial Management Fundamentals for Smaller & Medium-Sized Enterprises (SMEs)

5. Doing it for yourself

Contents Chart 1: Chart 2: Chart 3: Chart 4: Chart 5: Chart 6: Chart 7: Chart 8: Chart 9: Chart 10: Chart 11: Chart 12: Chart 13: Chart 14: Chart 15: Chart 16: Chart 17: Chart 18: Chart 19: Chart 20: The funding structure The cost of borrowing Profit and loss actual against budget Profit and loss summary Cash flow actual against budget Cash flow projection Capital commitments Capital project cost control Utilisation of production facilities Analysis of sales Return on sales Sales per customer Simple breakeven calculation Contribution breakeven chart Product contribution and costs Contribution by product Your market position Your market share Orders received Stockholding Page 23 24 25 26

Chart 1: The funding structure

000 600 500 400 300 200 100

27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42

0 Last year

This year

Equity

Long-term loan

Retained earnings

Overdraft

Creditors

This chart sets out the components of the financing of the business year by year (or over any period regarded as relevant), against the amounts in currency. The chart can also be used as a forecast, thereby aiding the planning of future financing. It shows the total amount as well as the make-up of the financing. It will be important to keep a good balance between equity plus retained earnings, and borrowings (gearing is explained in the Glossary). It will normally be particularly important not to rely too heavily on the most short-term items of all, creditors and overdrafts. Complete your own chart

000

0 Last year

This year

Equity

Long-term loan

Retained earnings

Overdraft

Creditors

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A Guide to Financial Management Fundamentals for Smaller & Medium-Sized Enterprises (SMEs)

Chart 2: The cost of borrowing

000 100 90 80 70 60 50 40 30 20 10 0 1 0 1 Interest 2 3 4 Year 5 Profit before interest and tax

Chart 3: Profit and loss actual against budget

% sales 100 80 60 40 20 0 Actual Budget Retained profit Tax and dividends Marketing, admin etc. Distribution costs Cost of sales

It is self-evident that businesses need to be managed prudently so that profits are not wiped out by interest payments on outside financing. This simple graph, which can be projected into the future, plots interest payments against profits to ensure that there is a proper balance between them. In the UK it is usual for the profits figure to be shown as profits before interest and tax. Complete your own chart

This chart is a graphical representation of the profit and loss account against budget. Both the period in question and the details of the profit and loss account are set out in the form most relevant to the company. The chart in the example shows typical details applicable to many businesses. The purpose of the analysis is to provide a quick identification of performance against budget, and therefore an indication of where corrective action would be required. This analysis can be linked to Chart 4. Complete your own chart
% sales 100 80 60 40 20 0 Actual Budget Retained profit Tax and dividends Marketing, admin etc. Distribution costs Cost of sales

000

0 Interest

Year

Profit before interest and tax

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Chart 4: Profit and loss summary

% sales 100 90 80 70 60 50 40 30 20 10 0 1 0 Retained profit Distribution costs 1 Tax and dividends Cost of sales 2 3 Marketing, admin etc. 4 Year 5

Chart 5: Cash flow actual against budget

000 25 20 15 10 5 0 J 5 10 Actual Budget F M A M J J A S O N D

This chart analyses the components of the profit and loss, again as a percentage of sales over a number of periods (usually years). The details depend on the company in question, and these can be further broken down into product or subsidiary unit analyses. Complete your own chart

The importance of cash flow management cannot be stressed often enough. Charts 5 and 6 assist in cash flow management and supplement the cash flow projections described in the Glossary. Chart 5 shows cash flow against budget highlighting variances to be actioned. In cash critical situations the time scale could be by week. Complete your own chart

% sales 100 90 80 70 60 50 40 30 20 10 0 1 0 Retained profit Distribution costs 1 Tax and dividends Cost of sales 2 3 Marketing, admin etc. 4 Year 5

000

Actual

Budget

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A Guide to Financial Management Fundamentals for Smaller & Medium-Sized Enterprises (SMEs)

A Guide to Financial Management Fundamentals for Smaller & Medium-Sized Enterprises (SMEs)

Chart 6: Cash flow projection

Inflows 100 50 0 50 100 150 200 Outflows Inflow/outflow 1

Chart 7: Capital commitments

000 14 12

Year

10 8 6 4 2 0 J F M A M J J A S O N

Danger

Chart 6 gives the forward look and projects the cash flow over the future (again this could be by years or quarters, etc). The purpose is to identify periods of cash richness and cash strain. This is especially important in seasonal businesses. Complete your own chart

Budgeted expenditure

Actual expenditure

Budgeted commitments

Actual commitments

This chart is applicable to businesses that spend heavily on capital and/or investments. It sets out actual versus budget commitments to spend, and then compares this with the actual versus budget spending pattern. As commitments can extend well beyond a year the chart should not necessarily be restricted to a one-year cycle. The chart will pin-point signs of strain, for example a divergence between actual and budget, and spend and commitment. Complete your own chart
000

Inflows

Year

Outflows

Inflow/outflow

N Month

Budgeted expenditure

Actual expenditure

Budgeted commitments

Actual commitments

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A Guide to Financial Management Fundamentals for Smaller & Medium-Sized Enterprises (SMEs)

A Guide to Financial Management Fundamentals for Smaller & Medium-Sized Enterprises (SMEs)

Chart 8: Capital project cost control

000 20 18 16 14 12 10 8 6 4 2 0 3 Plan 6 9 Actual spend 12 15 Month 18

Chart 9: Utilisation of production facilities

Product A Product B Product C Product D 0 10 20 30 40 50 60 70 80 90 100

Usage as % of capacity Acceptable output Unacceptable output Not used

This chart is applicable to businesses that have major capital expenditure projects: these could be IT projects, building projects, the installation of plant and machinery, etc. This is a standard chart and sets out spend against budget (plan). A variant could also plot percentage of work done against plan and monitor the estimated end date. Many businesses show their revised forecasts (spend, % of work done, end date) against the plan, so as to take action where these diverge from the original plan. Complete your own chart

There are many methods of quickly charting production. This chart sets out one such method. It shows the utilisation of total available production capacity by product (or by service or unit, as applicable). Some stated assumptions will have to be built into the chart: one such could be assuming maximum production capacity based on working 24 hours a day, seven days a week. Complete your own chart

Product A Product B Product C Product D 0 10 20 30 40 50 60 70 80 90 100

Usage as % of capacity Acceptable output

3 Plan 6 9 Actual spend 12 15 Month 18

Unacceptable output

Not used

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A Guide to Financial Management Fundamentals for Smaller & Medium-Sized Enterprises (SMEs)

Chart 10: Analysis of sales

000 60 50 40 30 20 10 0 J F M A M J J A S O Cost of sales Distribution costs, marketing, admin etc. Retained profit N D Month

Chart 11: Return on sales

% 18 16 14 12 10 8 6 4 2 0 1st quarter 2nd quarter Budget Actual 3rd quarter 4th quarter

This chart shows the sales development (or service performance) over the year and the analysis of the component sales costs and profit. The chart can be used to compare the sales components against competitors (if known) and can be shown by unit as well as in total. It will clearly be important to show the fluctuation of the sales (and the components?) in seasonal businesses. The total picture can also be monitored by showing the details in the form of moving annual totals (MAT). Complete your own chart
000

This chart sets the actual percentage gross margin on sales against budget to identify variances and sales patterns. This chart could be presented in the form of a graph, it could be set out by product/service or unit, it could be set out in periods more frequent than a quarter. Complete your own chart

% 18 16 14 12 10 8 6 4 2 0

Cost of sales

Distribution costs, marketing, admin etc.

Retained profit

N D Month

1st quarter

2nd quarter Budget Actual

3rd quarter

4th quarter

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A Guide to Financial Management Fundamentals for Smaller & Medium-Sized Enterprises (SMEs)

Chart 12: Sales per customer

Customer S Customer R Customer P

Chart 13: Simple breakeven calculation

Income from sales PROFIT Breakeven point Total costs Variable costs

Customer Q

LOSS Fixed costs

It is dangerous to rely overmuch on one or a few customers. This chart sets out the degree of reliance, and therefore of possible business vulnerability. The same type of chart can also be used to identify key suppliers, distributors, agents, etc. Complete your own chart

Volume

The importance of the breakeven chart has already been stressed in the Glossary. By identifying fixed and variable costs it is possible to calculate the amount of sales necessary in a given period to achieve breakeven. The business makes a profit once sales are above the breakeven level. Complete your own chart

Volume

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Chart 14: Contribution breakeven chart

Income from sales PROFIT Breakeven point Total costs Fixed costs LOSS Variable costs 0 Volume Marginal cost Contribution

Chart 15: Product contribution and costs

000 250 200 150 100 50 0 A Costs B Contribution point C Contribution D

Chart 14 is an expansion of Chart 13. It shows both contribution and profit. Complete your own chart

Charts 15 and 16 focus on the contribution (see Glossary) per product or service, over a period of time. Chart 15 compares the products (or services) and identifies the elements in their cost build up. Complete your own chart

000

Contribution

Marginal cost 0

Volume

A Costs

B Contribution point

C Contribution

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A Guide to Financial Management Fundamentals for Smaller & Medium-Sized Enterprises (SMEs)

Chart 16: Contribution by product

Chart 17: Your market position

Sales m 7

Product B 33%

Product A 50%

6 5 4 Total market Business X Your business Others Business Y 2 1 0 1 2 3 Year 4

Product D: no contribution Product C 17%

Chart 16 takes the total company contribution and splits it up among the products (or services). Complete your own chart

No business exists in a vacuum. All businesses exist in a market or market segment (which might be product/service or geographically oriented), and it is important for them to have as much information on their market and competitors as possible. This chart shows (where known) the businesss and the competitors position in the total market, and the development of the market and the positions over the years (past and, where possible, projected). Complete your own chart

Sales

Total market Business X Your business Others Business Y

Year

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A Guide to Financial Management Fundamentals for Smaller & Medium-Sized Enterprises (SMEs)

Chart 18: Your market share

Company Y

Chart 19: Orders received

000 70 60

Others Your company

50 40 30 20 10

Company X

0 J F Actual M A M Budget J J A S O N Month D

Chart 17 can also be shown in the form of a pie chart, plotting the businesss market share against its competitors at a given point in time. Complete your own chart

The forward order position is a figure every chief executive needs to know. It shows the businesss position with regard to breakeven; it identifies the future operating figures; it identifies possible bottlenecks and areas for action. This chart is a quick picture of the order position. It can be shown in many ways: against budget, by moving annual total, against sales (past and projected), against stocks, against capacity, etc. Complete your own chart

000

A Actual

J Budget

N D Month

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Chart 20: Stockholding

Months stock 8 7 6 5 4 3 2 1 0 J F M A M J J A S O N Month D

6. Glossary of terms
Balance sheet
Year 1 Year 2 Year 3 Year 4

The balance sheet sets out the financial position of the business at a particular date in the past showing what the business owns, what it owes, and the owners equity in it. What is important to realise is that a balance sheet is a photograph of the business at a particular point in time. The main components of a balance sheet are set out below. Fixed assets Any asset, tangible or intangible, acquired for retention by a business for the purpose of providing a service to the business, and not held for resale in the normal course of trading. Net current assets Current assets: cash or any assets likely to be converted into cash or consumed in the normal course of business within the normal operating cycle (usually one year), i.e. cash, stocks, good debtors (receivables), and Current liabilities: amounts owed which are expected to be repaid within one year, i.e. bank overdrafts (in the UK), dividends, tax, amounts owing to trade creditors Long-term liabilities and loan capital

This chart shows the level of stockholding month by month over a period of years. It can be used to compare the years with each other, to identify seasonality, to show against budget. Complete your own chart

Months stock Year 1 Year 2 Year 3 Year 4

Long-term liabilities: amounts payable to external creditors (how the business is financed and how the proceeds from asset sales would be shared if the business were sold) Loan capital: debentures, bonds and other long-term loans to a business. Overdrafts, being theoretically repayable on demand, are not usually shown in this category Long-term liabilities are items payable more than one year after the balance-sheet date. Short-term liabilities are included under working capital.

N Month

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Equity The issued ordinary share capital plus reserves. These latter represent the investment in the business by the ordinary shareholders (the owners). Retained earnings Included in equity, retained earnings are the amounts set aside (usually apportioned out of profit) for continued investment in the business. Budgets and planning It goes without saying that without a plan a business merely drifts, without knowing where it is going. A plan gives direction to a business. The short-term plan (the budget): Enables the business to organise its resources for the period in question Enables it to gauge the impact of unforeseen events during the period, and provides a framework for dealing with them Sets performance standards for subordinate managers and therefore can be a powerful means of motivating them Above all, a budget provides a safeguard against the managers biggest dread, unpleasant surprises. A business plan enables providers of finance to a business to evaluate it. They will usually not lend money unless there is a viable plan. Budget A financial or qualitative statement of policy expressed in financial and non-financial terms and prepared and approved by management prior to a defined period of time (usually the businesss financial year). It is normally financially focussed and will show income, expenditure, sales and profitability. Budgets are usually phased over the months (or quarters) of the year in question, and it will be particularly important to do this where the business is seasonal.

Business plan A plan which typically covers in both the long and short term: Customers Market analysis Resources (e.g. staff, finance) Service and distribution Selling and supplying Future strategy Product development Manufacture Stock holding and control Management and staff Finance Business planning The systematic review of business strategy and the development of a long-term plan to enable the business to achieve its objectives. Cash management Managers hardly need to be reminded that balance sheets and profit and loss accounts are all very well, but that cash is the lifeblood of business. A business that cannot pay its way is bankrupt. Cash has to be planned for to ensure adequate funds are always readily available (either on hand or from the bank or other outside parties) and to provide for any seasonal factors (such as a build up of stocks), or heavy special one-off payments (such as tax or VAT or expenditure for fixed assets). The cash flow forecast is the document that providers of finance such as banks place most emphasis on. Cash flow forecast The cash generated and spent in a given period is called the cash flow. Cash flow forecasts, linked to the bank balance show the movement (receipts and payments) week by week or month by month for a period in the future. This alerts management to future cash shortages or surpluses.

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Costs and costing There is a whole series of internal indicators used by businesses as appropriate, to guide them in their financial management. Breakeven point The level of activity at which contribution (i.e. sales revenue less variable costs) covers all fixed costs so that there is neither profit nor loss. It may be calculated by the use of a breakeven chart or by the use of formulas. For example: Total fixed cost = number of units to be sold to break even Contribution per unit

Overhead costs: general expenses that cannot be related to products and services, typically head office costs Marginal costs: the amount, at any given volume of business, by which aggregate costs are changed if the volume of business is increased or decreased by one unit, in other words the extra cost of one further unit or the cost that would be avoided if the unit was not produced or provided. In this context a unit is either a single article or a standard measure such as a litre or kilogram, but may in certain circumstances be an operation, process or even part of an organisation Financial ratios Business managers need to be aware of the more important ratios used by outsiders (such as banks) to evaluate the financial strength and the profitability of businesses. Gearing

Breakeven chart A chart which indicates the approximate profit and loss at different levels of sales volumes within a limited range. The breakeven point is critical to the understanding of the business, i.e.: Where profits begin to be made in a period Where there is scope for marginal pricing The cost/volume relationship Costs An understanding of the nature of the costs running through the business is essential to proper business management (such as the definition of the breakeven point) and to cost management. Fixed costs: costs that do not vary with the level of business but remain constant over a period of time and which, within certain operational limits, tend to be unaffected by fluctuations in the level of activity. Examples are: rent, business rates, insurance Variable costs: costs that vary with the level of business Direct costs: costs which can be economically identified with a specific product or saleable service, e.g. employees, material, etc Indirect costs: costs that cannot be related directly to a specific product or service, e.g. managers covering several areas, power, floor space in general use, general stores, etc

The ratio of fixed-interest capital and long-term borrowing to equity capital. It is calculated as follows: Fixed dividend capital + long-term loans Equity funds x100%

The significance of this ratio is that finance providers are usually unwilling to lend to a business with an unfavourable balance between the owners investment and borrowing from outside. Businesses in this situation which are able to attract outside lending will find themselves paying a heavy price for such loans. A ratio of up to 1:2 between fixed-rate capital and equity capital is usually regarded as satisfactory. This ratio also shows the scope for further borrowing should it be necessary.

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Current ratio This is the ratio of current assets to current liabilities. Current assets are stocks, plus amounts owing and due to be received within a year, and cash. Current liabilities are amounts owed and due to be repaid within a year. The significance of this ratio is that it indicates the cushion available to short-term creditors against a possible shortfall in the realised value of current assets. The rule of thumb often quoted is that the ratio should be about 2:1, though the averages in some industry sectors tend to be lower. A ratio in excess of 2:1 may indicate excess stocks, inadequate credit control or under-utilised cash.

Methodologies Benchmarking The assessment of how well a business is doing against competitors and similar firms and the analysis of what must be done to improve performance to be as good as, and do better than, the industry leaders. Benchmarking covers non-financial as well as financial figures. It goes without saying that for benchmarking to be carried out properly, the business has to prepare figures (financial as well as non-financial) that can be compared with other businesses. Factoring

Liquidity ratio (also known as the acid test ratio) This shows the ratio of liquid assets to current liabilities. Liquid assets are debtors (amounts owed) plus cash. Current liabilities are debts the business has to repay within a year. The significance of this ratio is that it relates short-term obligations to funds likely to be available to meet them. The rule of thumb is that the ratio should be about 1:1 though some sector averages tend to be lower. Ratios below 1:1 however, may indicate financial stress. A ratio much in excess of 1:1 may indicate inadequate credit control or under-utilised cash. Profitability ratios The most commonly used profitability ratios are profit on net assets (or return on capital employed ROCE ), and return on investment (ROI) showing the return on the total investment in the business. These show how well the business has used its investment in capital and has turned it into profit. Two ratios combine to give the main ROCE ratio. Profit/sales: indicating margins achieved and expressed as a percentage of sales Sales/net assets: indicating efficiency in the use of assets and expressed as the rate of turnover of net assets in relation to sales Each of these has a group of subsidiary ratios, the purpose of which is to indicate: The order in which improvements in performance should be sought The maintenance or improvement of performance (by observing trends) The effect of improvement in each area on the main ratio, profit/net assets

The sale of debts (normally only clean debts, however) to a third party (the factor) at a discount in return for prompt cash. The factor in effect takes over the running of the sales ledger. Invoice discounting As with factoring, debts are sold to the factor but here the business continues to operate its own sales ledger and deals with customers when collecting outstanding debts. Just-in-time (JIT) A technique for the organisation of work flows to allow rapid, high quality, flexible production while minimising manufacturing waste and stock levels. This is usually done in conjunction with suppliers who supply the products exactly when (and only when) they are needed. The management of supermarkets is an excellent example of the use of this technique. Just-in-time production A system which is driven by demand for finished products whereby each component on a production line is produced only when needed for the next stage. Just-in-time purchasing Matching the receipt of material closely with usage so that raw material inventories are reduced to near zero levels.

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SWOT analysis A critical assessment of the businesss strengths, weaknesses, opportunities and threats (SWOT), in relation to the internal and environmental factors affecting the business, in order to establish its condition prior to the preparation of a strategic review or a long-term plan. Total quality management (TQM) The continuous improvement in quality, productivity and effectiveness obtained by establishing management responsibility for processes as well as output. Key suppliers and customers The 80/20 rule is useful here, i.e. the 20% or so of the customers/suppliers that account for 80% or so of the business/management time/activity/problems. It is remarkable how constant this rule is and how widespread its application, e.g. the 20% of employees who take up 80% of the managements time, the 20% of the fleet vehicles that cause 80% of the problems, etc. Try to ensure diversity in clients and suppliers to avoid over dependence on any one organisation. Turnover per employee It is very common to view the trends and relate this ratio to competitors and to industry averages. Profit and loss account The profit and loss account sets out how the business has performed over a period of time (a month and/or a quarter, and/or a year), the beginning and end of the period being marked by balance sheets. It can be seen as the movement from one balance sheet to another in operating terms. In particular the profit and loss account will show how well the business is doing and whether it is paying its way. A business that consistently fails to make a profit cannot survive. An operating statement is a shortened form of profit and loss account which excludes the non-trading items such as interest payable, rents receivable (where there are non-trading items) etc. The key items in a profit and loss account are as follows. Sales revenue or turnover Shown net of VAT. Cost of sales Usually includes only those costs that would be allocated to stocks, i.e. costs incurred in manufacture materials, direct wages, power, etc. In a service business the cost of sales would cover the payment to third parties for items comprised in the service provided by the business. 50

Operating expenses Expenses, other than cost of goods sold, incurred in the normal operation of the business (typically administration, distribution and selling expenses). Gross margin The difference between sales revenue and cost of sales. Contribution Sales value less the variable cost of sales. It may be expressed as total contribution or as a percentage of sales. Profit Gross profit: excess of sales revenue over cost of sales Net profit: profit after all expenses (which can be before or after tax and/or interest, provided this is made clear) Working capital Working capital is the capital available for conducting the day-to-day operations of the business. Working capital is defined as the excess of current assets over current liabilities (i.e. cash, plus amounts owed by debtors, plus stocks, less amounts owing to creditors). It consists of short-term items all of which have a direct and immediate impact on cash. The details below describe the main items of working capital and the main indicators used in its management. Stocks (or inventories) Goods held comprising: Goods or other assets purchased for resale Raw materials and components purchased for incorporation into products for sale Products and services in intermediate stages of completion (work-in-progress) Only goods that can be and are expected to be sold are included, i.e. obsolete and defective stocks must be excluded. Stock holding period The period during which stock is held in relation to sales. Normally the aim of a business is to reduce this period to the minimum consistent with sales and continuing production.

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Stock turn The number of times stock is turned over or utilised during a given period, generally a year, but adapted to individual requirements for internal control purposes. Where individual product margins are small (as in sales of canned foods for instance), the aim would be to turn over the stock very frequently. Where the stock cannot be turned over so frequently (e.g. luxury clothes or cars), the objective will be to achieve substantial margins for each individual item sold. Stock days These are calculated as follows: Stock at the due date (i.e. period end) x days in the period (i.e. 365) Total cost of sales for the period (say a year) The significance of this statistic is that (in comparison with trends over time within the business or with other businesses), it can indicate whether excessive levels of stock are being held, tying up cash unnecessarily. Amounts owed by third parties (also called debtors, outstandings and receivables) Money owed to the business by its customers or others. These should be split up according to when payment is/has been due so as to identify those within the due period and the overdues (30, 60, 90 etc. days overdue). The significance of this split is that it shows the company where to focus the credit control, i.e. on the overdue element, particularly the long overdues (e.g. 90 days or more). Debtor days These are calculated as follows: Debtors (at the due date) x days in the period (i.e. 365) Sales (inc. VAT) in the period The usual period taken is a year, thus a years sales would be taken and 365 days could be used. It is also usual to show this ratio in terms of months or weeks. The significance of this ratio is that it indicates the effectiveness of credit control procedures in general. The figure of days outstanding should be compared with trends over time within the business, with the standard terms of business, and with ratios achieved by competitors. The organisation cannot benefit from money tied up unnecessarily in receivables. Borrowings and repayment terms These should be identified by: amount borrowed, terms, when due to be repaid. Disclaimer CIMA (data and other material) (2003) Finance Wales (cover design) 2003 All rights reserved. No part of this publication may be reproduced, transmitted in any form or by any means or stored in any retrieval system of any nature without permission, except for permitted fair dealing under the Copyright, Designs and Patents Act 1988 or in accordance with the terms of an appropriate licence. Application for permission for other use of copyright material including permission to reproduce extracts in other published works shall be made to the copyright holders. Full acknowledgment of author, publisher, copyright holder and source must be given. This document is aimed primarily at intermediaries operating between Finance Wales and its prospective clients but may also be provided to other types of organisation from time to time. No representation is made as to whether Finance Wales will provide funding to those who follow the relevant guidelines detailed in this document. In all cases this document is intended for guidance only and Finance Wales gives no warranty, either express or implied, as to the accuracy of any data used by Finance Wales in preparing this document or as to any other data set out or opinions expressed in this document. Except for any misrepresentation made fraudulently, CIMA and Finance Wales do not accept any liability for any loss or damage arising in any way whether directly or indirectly out of or in connection with the use of or reliance on this document or for any defect or error in this document. This document is not intended to be a substitute for obtaining professional advice as appropriate. This document is available in Welsh or English, electronically, in large print, braille, and alternative formats on request.

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Notes

Notes

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Contact details: Chartered Institute of Management Accountants 26 Chapter Street London SW1P 4NP Tel: +44 (0) 20 7663 5441 www.cimaglobal.com For further information about CIMA, email stathis.gould@cimaglobal.com

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