Jim Stockton, Senior Lecturer in Finance at the Warrington School of Management (University of Chester), discusses profitability and liquidity planning – essential elements for every business to succeed!
Introduction
There are many reasons why these failures occur-some relate to the lack of a coherent business strategy, some to the absence of a focussed market research but many are simply due to the absence of some rudimentary financial planning, or to be blunter, basic budgeting. This brief article seeks to point out some fundamentals on this often neglected skill or to quote Monty Python the “bleedin obvious”!Budgeting
Budgets are generally regarded as having at least five areas of usefulness:-- Budgets tend to promote forward thinking and the identification of short term problems
- Budgets can help, in larger businesses to co-ordinate activity and ensure a common understanding exits on priorities-for example there is little point in the sales team aiming to deliver optimistic targets if the production team have a different aim in mind
- Budgets can motivate managers and staff to improve performance if “stretch “ goals are set
- Budgets can help control a business-simply put does actual performance, measured monthly, compare favourably or adversely with the budget?
- Budgets can also act as a means to authorise spending within a business
Profitability
Let’s consider some basics-business has to generate profit in the medium to long term-after all, in our capitalist society, that is what it is all about-why take the risk otherwise? Business entrepreneurs see an opportunity in the market place to launch a product or service and to do so in a way that will generate a profit possibly with an idea or expertise that others will find difficult to copy. A business plan can be developed around this which should be capable of being expressed in financial terms-in other words- a profit forecast based on the sales compared to the cost of those sales. All pretty straightforward so far hopefully. This forecast or budget can and should be expressed over a reasonable time scale and should be as detailed as possible especially in the early days of the business-certainly for the coming year (broken down into months) and hopefully for another two years after that in order to give a reasonable perspective on the future of the business.. Let’s assume our small business compiles a profit forecast and that it looks reasonable-losses can be incurred in the early months as long as the longer term position indicates future profitability on a sustained basis. This profit projection can be enhanced by compiling a forecast balance sheet which will indicate:-- The assets the business will own
- The liabilities it will generate
- The impact on the owners initial and subsequent investment
Cash flow/liquidity
It’s at this point where the cash flow forecast becomes important-even vital. Our profit forecast can and should indicate business profitability based on the assumptions made by the owner of the business. However the next question to be asked is how does this affect cash flow going forwards? Just because the profit forecast is positive does not mean that the business will generate a positive cash flow and enable the business to meet its short term liabilities which includes those nice people from HM Revenue and Customs as well as suppliers to the business. The profit forecasts need to be converted into cash flow forecasts that take account of:-- Credit terms to be granted to customers
- Credit terms obtained from suppliers
- Stock holding levels to prevent stock outs but avoid overstocking
- Investment in longer terms business assets
- Use of any agreed overdraft facility
- Longer term financing facilities
Summary
This article is necessarily brief and skips conveniently over numerous issues in order to deliver a fundamental point-(remember Monty Python above?). Business must financially plan to in order to succeed and that planning must involve profit planning and liquidity planning. One without the other is a business disaster waiting to happen.Jim Stockton, Senior Lecturer in Finance at the Warrington School of Management (University of Chester)
Straightforward & quite useful read on starting a business RT @InCheshireMag: Profit or cash? Which is more important http://t.co/nHSnOqkj7I
— Matt@NooksYard (@NooksYardCider) April 28, 2014