It is true that some companies will be able to fund operations from internal cash flow and will never need more than the occasional loan to achieve the objectives of their shareholders. However, this is the exception and usually only applies to companies where a relatively slow and methodical growth or a sustained level of performance is sufficient to meet the needs of the owners and management. In the vast majority of growing companies there will be the need to strike a balance in the capital structure between debt and equity at different times during the company’s life cycle.
Once it has been determined that additional capital will be needed to fund the company’s development and that equity is the appropriate form of funding – it is important to take it when you can get it. Certainly negotiate the best possible terms, but do not be unrealistic about your “promising future.” Do not fall into the trap of “if we can raise it now, we can always raise it later and probably on better terms.” Although it is certainly a possibility and you should always explore every opportunity to find the best alternative, there are no guarantees it will happen that way.
In fact, the principals of many very promising companies have been reluctant to take equity capital because it was thought to be too expensive. The owners/shareholders did not want to be diluted and the belief was that there would always be other opportunities to raise capital at the future date of their choosing. It was thought that the company could continue to generate sufficient cash to fuel growth or support the current operations until the time they were in a better position to get “a better deal.” This can be a grave mistake. Later when it becomes clear the company cannot generate the needed cash and additional funding is truly vital to the company, the world you live in has changed, the possibility for funding is gone and the company is found wanting without the means to fund growth with disastrous results. More often than not these companies do not survive or at a minimum their growth is impeded and they never achieve their full potential.
Monday, November 2, 2009
Thursday, September 17, 2009
Back to Basics: Budgeting Methodologies
There are proponents of a myriad of budget methodologies and there are very legitimate arguments that can be made in support of their diverse opinions.* However, careful consideration should be given to the specific requirements of your organization and the level of resources available to manage the process. The last thing you want to do is establish a complicated and difficult process without the organizational wherewithal to pull it off. The chaos created under that scenario would do much more harm to the company (on many different levels) than any benefit that might be derived from the process.
1. Zero Base budgeting, by definition, requires that each effort begin with a clean slate – at zero dollars. The details for each line item are then built up based on the fundamentals associated with the specific requirements in support of an anticipated level of business. There is no presumption that a service or function will be necessary for continuing operations. Theoretically, any resources believed to be important in support of particular line items must be justified independently for each budget period. Although it is expected that historical data or trends will not directly influence the current budget decisions, there are certain situations where allowances can be made for minimal operating requirements to be considered essential while still requiring the remaining portion of the line item be validated separately.
This approach is often used in governmental budgeting processes since it reduces the entitlement mentality when appropriations are being determined for the allocation of public funds. It forces management for each program to re-justify the level of funding every budget year, and therefore, does not allow any inaccuracies of the past to directly affect the new budget. At a minimum, it would appear to eliminate the “creep” that can occur in an incremental process when proper controls are not in place.
Although this approach is reasonable in the public arena because of the unique requirements of a political environment, it requires a substantial effort in researching and collecting data needed to complete the budget process. The requirement for resources to support this effort seems to be quite onerous for any but the very largest private sector organizations.
2. Activity Based budgeting is founded on the notion that certain cost drivers or major activities exist in any particular operation. A driver could be anything that exists as a major activity in the business of the company (i.e. the processing of an order, a policy or a claim or, the presentation of a customer, a patient or a component for a certain service). All of the costs associated with the specific drivers (direct materials, direct labor, administrative salaries, office expenses, telephone, any associated overhead, etc.) are compiled as a cost per unit of activity for the purpose of presenting the budget in terms of the company’s products or services being delivered at some expected level. Each unit of activity would carry with it a specific and predetermined level of cost.
Depending on the number of individual drivers or the multiple variations resulting from unique characteristics in a specific driver (i.e. customers presenting for several different levels of service), you could have many smaller budgets developed somewhat independently. The compilation of these various budgets would represent the total budget for the organization. Once the information has been compiled, you must make certain that all cost components have been properly accounted for in the total and are representative of the company’s overall operating profile.
3. Incremental budgeting assumes that a valid baseline exists in the line items of the company’s historical financial information. Specific changes in conditions cause each respective line item to increase, decrease or possibly remain flat relative to the prior year(s).
This approach requires a disciplined effort of analysis in order to avoid any unjustified “creep” in the values associated with the prior years’ standards. To make this process effective, each line item must be reviewed with the purpose of validating the underlying factors that make up the overall total. For example, the application of some arbitrary “inflation factor” can grossly distort the results and seriously damage the potential of the organization through the pursuit of an improper target.
Although this method is most likely the least resource intensive to manage, without the proper controls there is the potential to allow errors from prior years to be perpetuated and anomalies in the numbers to be ignored going forward. In order to avoid these problems, careful consideration must be given to the changes in the operating details of the company relative to the expected volume of business when developing the budget.
Only you can decide the most appropriate method for your business given the available resources and specific requirements of the organization. Choose an effort that causes the organization to stretch a little and work to revise (improve) the process incrementally over time. The point is to start at a level that does not cause unmanageable stress in the company. If you persist in improving the process, you will continually reap benefits in the business.
*The Profit Experts can help you sift through the method that works best for your business. Visit us to find out how.
1. Zero Base budgeting, by definition, requires that each effort begin with a clean slate – at zero dollars. The details for each line item are then built up based on the fundamentals associated with the specific requirements in support of an anticipated level of business. There is no presumption that a service or function will be necessary for continuing operations. Theoretically, any resources believed to be important in support of particular line items must be justified independently for each budget period. Although it is expected that historical data or trends will not directly influence the current budget decisions, there are certain situations where allowances can be made for minimal operating requirements to be considered essential while still requiring the remaining portion of the line item be validated separately.
This approach is often used in governmental budgeting processes since it reduces the entitlement mentality when appropriations are being determined for the allocation of public funds. It forces management for each program to re-justify the level of funding every budget year, and therefore, does not allow any inaccuracies of the past to directly affect the new budget. At a minimum, it would appear to eliminate the “creep” that can occur in an incremental process when proper controls are not in place.
Although this approach is reasonable in the public arena because of the unique requirements of a political environment, it requires a substantial effort in researching and collecting data needed to complete the budget process. The requirement for resources to support this effort seems to be quite onerous for any but the very largest private sector organizations.
2. Activity Based budgeting is founded on the notion that certain cost drivers or major activities exist in any particular operation. A driver could be anything that exists as a major activity in the business of the company (i.e. the processing of an order, a policy or a claim or, the presentation of a customer, a patient or a component for a certain service). All of the costs associated with the specific drivers (direct materials, direct labor, administrative salaries, office expenses, telephone, any associated overhead, etc.) are compiled as a cost per unit of activity for the purpose of presenting the budget in terms of the company’s products or services being delivered at some expected level. Each unit of activity would carry with it a specific and predetermined level of cost.
Depending on the number of individual drivers or the multiple variations resulting from unique characteristics in a specific driver (i.e. customers presenting for several different levels of service), you could have many smaller budgets developed somewhat independently. The compilation of these various budgets would represent the total budget for the organization. Once the information has been compiled, you must make certain that all cost components have been properly accounted for in the total and are representative of the company’s overall operating profile.
3. Incremental budgeting assumes that a valid baseline exists in the line items of the company’s historical financial information. Specific changes in conditions cause each respective line item to increase, decrease or possibly remain flat relative to the prior year(s).
This approach requires a disciplined effort of analysis in order to avoid any unjustified “creep” in the values associated with the prior years’ standards. To make this process effective, each line item must be reviewed with the purpose of validating the underlying factors that make up the overall total. For example, the application of some arbitrary “inflation factor” can grossly distort the results and seriously damage the potential of the organization through the pursuit of an improper target.
Although this method is most likely the least resource intensive to manage, without the proper controls there is the potential to allow errors from prior years to be perpetuated and anomalies in the numbers to be ignored going forward. In order to avoid these problems, careful consideration must be given to the changes in the operating details of the company relative to the expected volume of business when developing the budget.
Only you can decide the most appropriate method for your business given the available resources and specific requirements of the organization. Choose an effort that causes the organization to stretch a little and work to revise (improve) the process incrementally over time. The point is to start at a level that does not cause unmanageable stress in the company. If you persist in improving the process, you will continually reap benefits in the business.
*The Profit Experts can help you sift through the method that works best for your business. Visit us to find out how.
Monday, July 6, 2009
When to take out a loan?
I was recently asked by a small business owner when it’s appropriate to take out a loan. This question is more important than it seems on the surface.
The purpose of external financing is to meet the company’s cash needs beyond its ability to generate cash flow internally. Therefore, the first step is to understand your internal cash flow dynamics and how changes in the business will affect the expected cash availability. What cash will you need and when will you need it? Without this information you could very easily take on debt that is unnecessary or put the company in a position where the debt payments are higher than your ability to pay. Either way you ultimately do long-term damage to the company.
Ideally, you should only take on debt to finance an opportunity in the business. Growth opportunities could be through increasing organic revenue, additional product/service lines, sales & marketing initiatives to improve market penetration, acquisition of another business, etc. Cost reduction actions could result from an equipment purchases for operational efficiencies, implementation of certain operating strategies, staff training or upgrades, etc.
However, you must be careful to avoid falling into the trap of believing your own propaganda and “counting your chickens before they hatch” so to speak. Make sure you know how long it will take to reap the benefits of these actions before you pull the trigger. In my experience it always takes twice as long and costs twice as much as originally thought to do anything. Also, given the difficulties in finding a willing lender and the cost associated with business loans, be sure to have sufficient availability (of cash or loan capacity) in place at the outset to accomplish the desired results. Otherwise, you may be short of cash at a critical stage.
If you find yourself borrowing to fund a stable or static business you must quickly understand the reasons for the funding requirement. The only reasons for a cash shortfall in this situation are short-term seasonal or timing issues, an imbalance in your asset allocation or significant profit leaks in the business.
The purpose of external financing is to meet the company’s cash needs beyond its ability to generate cash flow internally. Therefore, the first step is to understand your internal cash flow dynamics and how changes in the business will affect the expected cash availability. What cash will you need and when will you need it? Without this information you could very easily take on debt that is unnecessary or put the company in a position where the debt payments are higher than your ability to pay. Either way you ultimately do long-term damage to the company.
Ideally, you should only take on debt to finance an opportunity in the business. Growth opportunities could be through increasing organic revenue, additional product/service lines, sales & marketing initiatives to improve market penetration, acquisition of another business, etc. Cost reduction actions could result from an equipment purchases for operational efficiencies, implementation of certain operating strategies, staff training or upgrades, etc.
However, you must be careful to avoid falling into the trap of believing your own propaganda and “counting your chickens before they hatch” so to speak. Make sure you know how long it will take to reap the benefits of these actions before you pull the trigger. In my experience it always takes twice as long and costs twice as much as originally thought to do anything. Also, given the difficulties in finding a willing lender and the cost associated with business loans, be sure to have sufficient availability (of cash or loan capacity) in place at the outset to accomplish the desired results. Otherwise, you may be short of cash at a critical stage.
If you find yourself borrowing to fund a stable or static business you must quickly understand the reasons for the funding requirement. The only reasons for a cash shortfall in this situation are short-term seasonal or timing issues, an imbalance in your asset allocation or significant profit leaks in the business.
- If the problem is short-term then make sure you understand the associated dynamics and manage your cash very carefully. This is not the time to spend on unnecessary items. Be sure you can come through the timing issues debt free. Otherwise, there’s something else happening in the business.
- If you find the asset allocation is inappropriate – accounts receivable, inventory, fixed assets are sucking up too much cash – take action to correct the issues as quickly as possible. Depending on the extent of the problem and the market conditions this could take time. Stay focused and diligent. The problems must be corrected for the long-term health of the company.
- If the issue is the result of profit leaks (which always translate into cash problems) you must take action immediately to adjust the business to the current market conditions. Get your expenses in line with revenue until the company’s profits stabilize. Once the company is stable you can then begin to build the business with a careful and balanced approach.
Thursday, July 2, 2009
AR Management Tips
Accounts receivable represents the largest and most accessible source of non-financing cash that your company has available. In order to optimize cash flow there must be a concerted effort to manage A/R each and every day. Unfortunately, experience has proven that most managers don’t attempt to manage A/R with more than a passing thought until there is a problem with cash or a question arises regarding the validity of the recorded balances. Usually, by the time a problem is recognized, the possibility of a full recovery of the cash collection potential is remote.
Revenue without the ability to convert it to cash is of absolutely no benefit whatsoever. In fact, it’s worse than having no revenue because it will surely cost something to generate the revenue that is being wasted. Apart from cash sales, effective accounts receivable management is the means by which revenue is converted to cash. If it does not already exist, you should immediately establish a sustained effort to manage the A/R of your company. You must uncover any issues that impair your ability to collect all amounts billed and develop a plan for working through each to a successful conclusion.
It seems a brief discussion of a few underlying principals would be very helpful in shoring up the conversion process.
Bill promptly and as often as possible. Revenue is the beginning of the process. Therefore, any delay in billing produces corresponding delays in the receipt of cash. Most companies pay on their predetermined cycles (weekly, bi-weekly, monthly, etc.). It’s unrealistic to expect customers to expedite payment of your company’s invoices just because you were late in getting the invoices to them. It may happen a few times, but after a very short time your payments will be delayed until the next cycle comes around. In fact, if you’re always late and the timing is erratic, your customers will most likely place less importance on your payment because you have indicated by your action that the process is not very important to you. Project an image of consistency and urgency and people will respond.
Collect all payments as and when due. If your business requires that certain payments be made as deposits or at time of service, be certain to collect those payments. For example:
- Printing companies will often require that a large deposit be made for orders of preprinted materials.
- Medical practices that have contracts with certain payor groups will need to collect co-payments or deductibles from patients when the services are performed.
- Other companies may require that down payments be made to facilitate a financing arrangement.
If these types of payments are not collected at the appropriate time, the odds of collecting them later are significantly reduced. If problems develop, it’s almost certain you will not collect the cash.
Eliminate all barriers to payment at the outset. Make certain you have the appropriate agreement for the terms of the sale BEFORE you provide the service or deliver the product. Get the appropriate documents signed and the necessary approvals confirmed.
Provide all documentation necessary to facilitate payment at the beginning of the process. It’s very unlikely that you will be paid without a full explanation of the charges and sufficient information to support that explanation. For example, unless a medical practice provides full documentation that corresponds directly to the billing codes entered in the correct boxes on the right forms, they will not get paid, period. There is no discussion or appeal. In fact, the payor has the right to adjust the payment according to their interpretation of the information provided. Why leave that decision to someone who benefits from paying you less money? What information is required to support your charges?
Aggressively follow up on overdue invoices. Although some companies and individuals will pay without prompting, there are many that will be less concerned about a vendor that is not interested enough to call and ask for the check. Often, all that’s needed is a call to ask for an update on the timing of the payment. Other times, you will need to take a firm stand and demand the payment be made. Unfortunately, you have to be willing to be tough when necessary. Otherwise, people will take advantage of you.
DO NOT work only the old accounts. A balanced approach is absolutely necessary. If the focus is only on the older accounts, you ensure that you will always have older accounts. You must work the more current accounts in order to collect them before they become “old.”
Stay on top of the situation. The fact is that the longer you wait, the more unlikely it is that you will collect the full amount that has been invoiced.
Who would you pay first…, a vendor who is sending invoices on a consistent schedule with full supporting documentation and is very diligent in contacting you to determine the status of a timely payment or a company that sends invoices from time to time with little explanation and no follow up?
Wednesday, July 1, 2009
Break out of old management patterns
Given the vast changes that have taken place in the economy and the uncertainties going forward, it’s imperative that you don’t get locked in to the “that’s the way we’ve been doing things for years” mindset. You have to take a fresh (critical) look at every aspect of your business. Question not only what you’re doing, but also why it’s being done at all. Every decision must be made with only one thing in mind – cash flow.
Regardless of your political affiliation or whether you’re in favor of any of the new administration’s policies, changes are underway. Everything from healthcare to energy to the financial system and the taxes required to pay the bill will change the rules. Long-standing needs and operating conditions must be reevaluated constantly. You must be willing to abandon old ways of thinking and hone your skills in change management. Do not get locked in to any particular approach with the hope that revenue will rebound or cost will come down. Leave no rock unturned and do it now. The longer you wait the deeper you’ll have to cut.
Some areas to evaluate are:
- Accounts receivable management
- Inventory mix and management systems
- Fixed asset policies, equipment needs and maintenance requirements
- Bank relationships and financing needs
- Sales and marketing activities
- Pricing and margin management
- Staff utilization and compensation systems
- Production systems and processes
- Purchasing and supply chain efficiencies
- Travel and promotional activities
Market dynamics have been altered dramatically which will in turn put pressure on revenues and affect nearly every product or service you buy. The confluence of these events makes the current environment very fluid and eminently perilous. There are few businesses that will be unaffected. A “weather the storm” mentality will not work this time.
Subscribe to:
Posts (Atom)
