KŌNAE AKO 4
Seminar: Business Financial Planning
HE PAEMAHI KŌWHIRINGA THE ELECTIVE PROJECT
Introduction
Growing your business and implementing projects usually involves a financial cost. You may have heard the expression ‘you need to spend money to make money’, and there are some aspects to that which are true. However, you need to have money in order to spend it. Focussing on the potential income of a business strategy, without looking at the costs involved and the timing of the costs, is a common way for people to find themselves in financial difficulty. So is being very optimistic about expected income, and not giving enough attention to the most realistic and worst case scenarios.
Forecasting your financial situation is important even for businesses which want to focus on ‘business as usual’. One reason for this is it encourages you to analyse past performance, which makes it much more likely you will identify trends in costs and income. For example, it could help you to notice a fall in demand for a particular line of your product range in time for you to modify the product so that you are not left with excess stock on hand. If you identify a problem early enough, sometimes all it takes is a minor change to keep the business on track.
Long-term business success rests heavily on the idea that a thriving business is one where the business owner:
• has the discipline to keep a close eye on the financial indicators of their business, and then
• does something when the warning signs appear, rather than ignoring them and letting the business suffer.
Therefore, in this seminar we cover both the forecasting and analysis aspects of financial planning. We start by looking at how to forecast profits, then look at the cashflow implications of our forecasts. Also covered is the projected balance sheet of the business (that is, the Statement of Financial Position), so you can see if, overall, your asset base and equity is expected to increase over time. Finally, some of the main ratios you can use to evaluate the performance of your business and set targets for improvement are introduced.
Contents
This seminar will cover the following topics:
Case Study: Fruit and Vegetables Import Ltd (FVI Ltd)
Part A: Profit Planning (Projected Financial Performance)
• Assumptions
• Sales Forecasting
• Estimation of COGS and Evaluation of Gross Profit Margin
• Operating Expenses Forecasting
• Break-even Analysis
• Sensitivity Analysis
Part B: Cashflow Forecasting
• Cash Control
• Timing of Cashflows
• Debtors Collection
• Growing a Business
Part C: Balance Sheet Planning (The Forecasted Statement of Financial Position)
Part D: Ratio Analysis and Improvement Strategies
• Profitability Ratios
• Risk Analysis Ratios
• Liquidity Ratios
• Activity Ratios
Appendices: The Forecasted Financial Statements for FVI Ltd
• Appendix A: Sales Forecasts for FVI Ltd
• Appendix B1: Forecasted Statement of Financial Performance for FVI Ltd
• Appendix B2: Forecasted Statement of Financial Performance for FVI Ltd - Alternative
• Appendix C: Forecasted Cashflow Statement for FVI Ltd
• Appendix D: Forecasted Statement of Financial Position for FVI Ltd
Case Study – Fruit and Vegetables Import Ltd (FVI Ltd)
The following case study applies to the calculations used in Parts A, B, and C of this seminar. Due to the limited time for this seminar, the case study facts have been kept to a minimum with the purpose of not making the calculations complicated or difficult to follow. However, it is important that you take the time to understand how and why these calculations are used.
The business financial planning demonstrated in this seminar can be used whether you are just starting out in business or if you have been in business for a number of years already. However, for your particular business, there will be specific income, expense, asset, and liability items that do not apply (or are not shown) in this case study and which may not apply in another business.
Introduction to the Case Study: FVI Ltd
Three friends, Api, Harkness, and Silei, decide to start a business importing a variety of fruit and vegetables from Samoa (where their families are from). Their intention is to grow the business slowly, as all of them will be keeping their current jobs at least for the first 6 months of the business starting up. They will therefore start by only importing containers of taro for the first year of trading, but have set themselves goals which include adding at least two more fruits and / or vegetables to their product range in their second year of trading.
Api, Harkness, and Silei form a company, Fruit and Vegetables Import Ltd (FVI Ltd), and put a business plan in place. Each person will contribute $5,000 as start-up capital, with a further $10,000 each contributed once the business begins importing. Initially, FVI Ltd will have their office at Silei’s home, however, they plan to move to separate premises at the end of their second year of trading. They will rent a warehouse to briefly store their produce before being distributed to retailers for sale.
As part of their business plan, FVI Ltd prepare projected financial statements for their first year of trading: 1 June 2023 to 31 May 2024 (note this is not the same as the income year – which for most businesses is 1st April to 31st March; that is, a 31 March balance date). Throughout this seminar, reference will be made to these forecasted financial statements, which are given in the appendices.
FVI Ltd will import their first container of taro from Samoa in August 2023. Thus, in the first two months of trading (June and July) there will be no sales income. The taxes payable are calculated at 28% of the net profit before tax. GST is paid monthly.
Part A: Profit Planning (Projected Financial Performance)
“Ki te kore ngā pūtake e mākukungia e kore te rākau e tupu.”1
- Māori Proverb
Profit planning takes the form of a forecasted Statement of Financial Performance (also known as an Income Statement, or a Profit and Loss Statement). This document includes your sales expectations and budgeted costs, and results in the calculation of your expected profit. Preparing a forecast of your income and expenses will enable you to:
• Identify resource requirements (for example, you may need more staff in order to reach your sales targets).
• Evaluate your business operations (for example, identify if there are costs that could be reduced).
• Determine whether the venture will be profitable, and therefore worth pursuing.
After preparing a forecast, your aim is to reach the sales targets and keep costs within those which are projected. That is, it acts as your budget to guide spending and monitor performance. However, reality is often different from our plans – there are likely to be some additional costs that the business must face, and hopefully some costs that are lower than budgeted.
It is normal for what you expected to happen to not be a perfect match with what actually happens. Instead of discarding your plan, you should compare these ‘actuals’ (the actual events that occurred) with the budget on a regular basis (e.g. monthly or at least quarterly). The comparison process highlights variances from the budget and allows you to identify appropriate action to be taken. For example, if you know that sales have been 20% lower than projected for the past two months, you could develop a new marketing initiative, instead of waiting until the end of the year and finding that sales were down for 10 out of 12 months.
Sometimes the appropriate action to take may even involve revising your budget. Referring to the previous example in which sales are lower than expected, it is likely that you would want to revise the budget to allow extra for marketing in order to boost sales. It may be more costly (in terms of lost sales and thus lower profits) to try to keep to the current marketing budget than it is to spend a little extra and get more sales.
In essence, income and expense budgeting is a pro-active form of managing your business finances. Part of this planning process requires you to establish a profit target for your business – remember the saying that ‘if you aim for nothing then that is what you are likely to get’!
Profit planning includes the following steps:
• Sales Forecasting
• Estimation of Cost of Goods Sold and Evaluation of Gross Profit Margin
• Operating Expenses Forecasting
• Break-even Analysis
Before looking at each of these steps, it is important to first understand the role of assumptions in profit planning.
1 If the roots of the tree are not watered, the tree will never grow.
Assumptions
Writing assumptions is an excellent way to help ensure your financial plans are as accurate as possible. Assumptions are the explanations of how you worked out the figures which appear in your budgets. The process of writing these assumptions requires you to think logically, and in depth, about how to forecast sales and about the various expenses in your business. This reduces the likelihood of expenses being overlooked, and encourages you to be more realistic when projecting sales.
Having written assumptions also help you when it is time to update your plan. It is much easier to adjust details in your assumptions and then calculate the new figures, than it is to try to remember how you worked out your original figures and then calculate figures for the upcoming period.
Written assumptions should outline details such as:
• How GST is accounted for – e.g. Is the business registered for GST? Is GST shown within the figures in the assumptions or is it in addition to them? A point to note is that, if you are registered for GST, the figures in your forecast need to be GST exclusive. This is because GST received on sales does not belong to you, and does not increase your profit.
• Why there may be variations in figures from one month to the next. For example, it may be forecasted that sales (and expenses) will be much higher in February than at other times of the year due to a ‘Back to School’ promotion that the business always runs.
• What costs are included in a particular figure. For example, if you have a category of expenses called ‘technology expenses’, you should specify what type of expenses are included within this (such as internet, website hosting, software subscriptions, and so on).
• How those figures are calculated.
• How expenses are apportioned. E.g. are they spread evenly over the year or only shown in particular months? Why?
You also need to ensure that the assumptions you use in the financial planning for your business are realistic for your business’s industry and the market conditions.
Sales Forecasting
Start developing your budget by forecasting your sales for the coming period. Rather than focusing on the dollar value of sales, it is better to begin with unit sales or ‘activity levels’; it is much easier (and more accurate) to estimate sales levels in terms of the number of:
• customers served,
• units / products sold,
• services performed,
• service hours worked,
• contracts completed,
• beds occupied (for a hotel, etc.), and / or
• students enrolled (for a course).
You can then apply your pricing schedule to the forecasted unit sales. For example, let us assume you are a boutique motel owner who has 12 beds available. You may forecast that, in the summer months of 1 December to 28 February (12 weeks), your motel will average 10 beds occupied on at least 6 nights of the week, at an average of $150 per person. This means your forecasted sales for the summer period can be calculated as follows: 10 beds × 6 nights per week × 12 weeks × $150 per person = $108,000.
A sales forecast must be realistic. This may require you to take a ‘reality check’ on how many units you think you may sell or how many billable hours you will undertake for the service that you provide. You need to constantly look at the market potential for your product / service and the ability of your business to win its share of the market. You also need to ‘keep an eye out’ for a downturn in the economy or a fall in demand for your product or service, so that you can adjust your sales forecasts if needed.
If you are just starting out in business, or adding a new product or service to the range, you need to think carefully about how long it will take to build up your customer base – in most cases it would be unrealistic to expect to be operating at full capacity straight away.
USEFUL WEBSITES:
There are a number of sources for current economic information such as quarterly economic forecasts. Refer to the following bank websites:
• BNZ, Markets Outlook – https://www.bnz.co.nz/institutional-banking/research/publications/ markets-outlook
• Westpac, Economic and Financial Forecasts – https://www.westpac.co.nz/business/economic-updates/ economic-and-financial-forecasts/
It is recommended that your sales forecasts take into account the checklist of sales considerations shown in Figure 1.
Figure 1: Checklist of Sales Considerations
Sales Considerations
Past sales volume
Production capacity
Number of hours you and your staff are able to work
Pricing policies
Any sales or discounts planned
The profitability of your various products and services (providing that there is demand for them, focus on those products that are more profitable)
Results of market research
General economic and industry conditions
Advertising and other promotions (and the timing of these)
Quality of sales staff
Competition
Seasonal variations – recognise the seasonal and month-to-month variations in the level of sales
Long-term trends for products / services
Forecasts should also take into account variations in the number of sales days or hours available per month. That is, even when there is very little seasonal effect on sales, the number of days each month will vary from 18 to 23 days (based on a 5-day week) due to weekends, public holidays, and the actual number of days in the month. This influences such matters as the ability to dispatch orders, the number of clients your sales staff can visit, the number of hours available to charge out, and the number of retail days.
The variation in the days available in the month will also influence the budgeting of a number of operating expenses, such as the wages for your sales staff.
TĪWHIRI:
It is important when you are starting up a business to review your forecasts more frequently. Before starting a business, it is much harder to forecast as you do not have past sales data to act as a guide. However, once you begin operating, you will be in a much better position to assess the situation and take action if needed.
Other factors that are dependent on the sales forecast include:
` Variable Costs:
These are the costs that change in direct proportion to the changes in sales. These could include expenses such as the cost of goods sold (the cost of stock sold, and of materials purchased to make the goods that are forecast to be sold), commissions paid on sales made, credit card processing fees, online auction success fees, etc.
` Fixed Operating Costs:
These are costs that do not vary as the level of sales changes. While these costs are termed ‘fixed’, at some point extra sales volume may have an impact. This means that although costs do not vary in direct proportion to sales, once a certain sales / production level is achieved, they may change.
For example, a business’s lease on a warehouse may cost $5,000 a month, regardless of whether the business stocks 10 items of their product or 600 items of their product in that warehouse. However, it may be that the maximum capacity of the warehouse is 1,000 items – if sales increase enough, the business will need a larger warehouse.
` Resource Plans and the Associated Costs:
Think about what resources you will need and what they will cost. For example, how many staff do you need to meet sales targets? What about assets? E.g. do you need another delivery van, more storage space, or additional computers? All of these factors usually involve extra costs.
` Working Capital Requirements:
If sales forecasts project an increase in sales, there is likely to be a need for additional cash to invest in increased stock or to provide for debtors (customers / clients whom you supply products and services to, but who do not pay you straight away) to match the increase in sales.
As you can see, accurate sales forecasting is vital. Do not rush this part of the forecasting process – this is an area where you should take great care. You need to remember that your sales forecast becomes the basis for important decisions such as those relating to the need for extra personnel, new finance arrangements, or larger facilities. If decisions such as these are based on overstated sales expectations, then the additional resources obtained will be wasted and your profit outcomes and cashflow balances will also be affected.
The sales forecast for FVI Ltd is shown in Appendix A. The assumptions that explain how these sales forecast figures were derived are as follows:
Case Study Example: FVI Ltd – Sales Forecast (refer Appendix A)
Sales revenue is based on each container of taro carrying 400 bags of taro, each weighing 30kg, to be sold at an average wholesale price of $3.00 per kg (GST included) – i.e. $90 a bag (equal to $78.26 + GST). Retailers will then on-sell this at $6.00 per kg (GST included). Therefore, sales revenues are as follows:
• 1 container: 400 bags × 30kg each × $3.00 = $36,000 inc. GST
• 2 containers: 800 bags × 30kg each × $3.00 = $72,000 inc. GST, etc.
However, because the forecasted Statement of Financial Performance (Appendix B) shows figures exclusive of GST, the total sales revenues for each container would be $31,304.35 (calculated as $36,000 ÷ 1.15).
FVI Ltd forecasts that sales will be sufficient to provide for several containers per month on average in the first trading year. The exact number is shown in Figure 2. It is also assumed that all stock will be sold in the month that it was ordered, meaning that the business will sell the full contents of all 26 containers during the first year of trading.
Figure 2: Containers in First Trading Year
Estimation of Cost of Goods Sold and Evaluation of Gross Profit Margin
Work out how much the goods or services that you have forecast to sell / provide each month will cost you. Be careful not to mistake this figure as simply the value of products / materials that you will buy each month – you need to take into account opening and closing stock values.
For example, in the month of September, a shoe retailer may spend $10,400 on buying shoes from one particular supplier – buying enough to cover sales for the spring and summer months of September through to February. The cost of goods sold for the month of September will not be $10,400 – it may be that only 10% of these shoes ($1,040 worth) are expected to be sold that month. Furthermore, the shoe retailer is likely to sell some of the shoes left in stock from other suppliers (ordered in previous months). Thus, the value of cost of goods sold for a month is represented as follows:
In order to calculate this, you need to know the value of what you expect to sell each month – you cannot know the expected value of your closing stock if you have not figured out the value of what you will be selling! If you have prepared a detailed sales estimate, this will help determine the cost of the goods you sell. This is because you will have estimated how many of each type of product you expect to sell each month.
Example: Cost of Goods Sold
If you estimated that you would sell 40 units of Product A in January (at a retail price of $30, but at a cost of $13 per unit) and 20 units of Product B through the month (at a retail price of $100, but at a cost of $45 per unit), you can work out the cost of goods sold as $1,420 (calculated as 40 × $13 plus 20 × $45), for an expected sales value of $3,200.
Once you know the cost of goods sold, you can calculate the gross profit and the gross profit margin. The gross profit is simply the sales revenue less the cost of goods sold. Note that some businesses will not have any cost of goods sold, and thus their gross profit will be the same as their sales.
The gross profit margin (also called the gross profit percentage) is an important financial ratio. The formula to calculate the gross profit margin is as follows:
A gross profit margin is a good indicator of the business’s pricing policy and can help highlight the extent to which you are keeping to your intended policy. For example, if you plan to have a mark-up of 100% on items sold, you would expect a gross profit margin of 50% (that is, you expect costs of goods sold to be half of the final sales price). If you then found your gross profit margin was significantly lower, this may alert you to the fact that any planned discounts and sales may account for a larger proportion of your total sales than you had realised. In this case, you could choose to discount less, or alter the mark-up on your products so that, overall, you still get a 50% gross margin, even after some items have been sold at a discount.
Cost of Goods Sold = Value of Opening Stock + Purchases − Value of Closing Stock
HEI TAUIRA:
The gross profit margin also gives an indication of how well direct expenses are managed over time. If costs have been creeping upwards but you have not increased your prices, your gross profit margin will be diminishing. This could be because actual purchase costs are rising, or because you are not using materials purchased as efficiently as you previously did.
HEI TAUIRA:
Example: Ben the Butcher
Ben is surprised to see his gross profit margin has reduced in the past year, even though the cost of purchasing animals to slaughter did not increase. Upon investigation, Ben found it was due to a high amount of wastage – more meat was being dropped on the floor than usual, and fewer parts of an animal were being used to make products. The cost of goods in his business had therefore risen in proportion to sales (more animals were needed in order to achieve the sales level) causing gross profit margins to fall. Upon talking to his staff, he identified that his newest member of staff needed further training and better supervision.
It is useful to evaluate a business’s forecasted current gross profit margin performance against the following factors:
` Business Goals and Objectives:
Based on the forecast, how well do you expect the business to perform compared to the original aims and expectations?
` Industry Averages:
Based on the forecast, how well do you expect the business to perform compared to similar businesses in the same industry? This type of comparison is referred to as ‘benchmarking’ and was discussed in Kōnae Ako 1 of this programme.
Recall that the IRD has some benchmarking information available online for a number of industries (refer to https://www.ird.govt.nz/topics/industry-benchmarks). Chartered Accountants should also be able to provide information on what margins are appropriate (particularly if they specialise in a specific industry, e.g. the rural farming sector).
If benchmarking shows a significant difference between your expected margins and those of other businesses, try to find out why that difference exists. For example, if the industry’s margin is lower, are there additional direct costs that you have not thought of? If the industry margin is higher, do other businesses in the industry get cheaper materials?
` Past Performance:
Based on the forecast, how well do you expect the business to perform compared to how well it has performed in the past? If you are projecting a gross profit margin that is notably different from past margins, make sure you understand why there is a difference. Do you expect costs to increase / decrease? Will you change your pricing strategy? Are you going to be able to make better use of your materials (thus producing more sales)? If you do not understand the reason for the difference, check your calculations and the assumptions you have based your forecasts on to make sure you have not made a mistake.
It is also beneficial to compare your actual gross margins in the same way – that is, against objectives, industry averages and past performance. An example of how to format the evaluation of profit margins is shown in Figure 3.
HEI TAUIRA: Analysis of Gross Profit Margins2
Analysis of the gross profit margin against objectives, industry averages, and current operations may reveal specific problems within the business or indicate opportunities for cost savings. For example, it raises questions regarding pricing (for instance, is the mark up on goods high enough?) and purchasing (for instance, can a more costeffective supplier of a particular product be found?).
It is also beneficial to look at the gross profit margin (both forecasted and actual) for each of your particular product lines or types of services. For example, as a dressmaker you may find your gross profit margin on wedding dresses is much higher than your gross profit margin on clothes repairs – even though, overall, your margins may be in line with industry averages. This analysis would indicate that you would perhaps be better to focus on the wedding dress segment of your business than on clothing repairs. However, you would also want to consider other factors such as seasonality of income – i.e. more weddings take place in the summer than in the winter.
The gross margin (gross profit) forecast for FVI Ltd is shown as part of Appendix B1. The assumptions that explain how figures were derived are as follows:
2 This example shows that the 2021 actual gross profit margin is lower than the 2020 result, the budgeted objective, and the industry average.
Figure 3: Example Analysis of Gross Profit Margins
Case Study Example: FVI Ltd – Cost of Goods Sold
Each container of taro bags costs NZ$25,000 (inc. GST) from the supplier in Samoa (i.e. $21,739.13 + GST). This compares to how much each container will sell for, which was calculated previously as $36,000 (inc. GST) or $31,304.35 + GST. From the Sales Forecast (Appendix A) it was estimated that 26 containers will be imported throughout the year. As it is assumed that all stock will be sold in the month that it was ordered (as per the sales forecast assumptions), the business is not expected to have opening and closing stock to account for. Thus, the total amount of purchases is included within the cost of goods sold.
Other direct costs associated with purchasing stock to sell include the costs associated with getting the vegetables to New Zealand. These are shown in Appendix B and include:
• Insurance in transit (Samoa to New Zealand): $500 inc. GST per container
• Customs Entry Fee: $2,280 per container, $4,560 for 2 containers, etc. (inclusive of GST)
• Wharf fee: $250 inc. GST per container
• Ministry for Primary Industries (MPI) costs: $650 inc. GST per container
• Renting of truck for delivery from wharf: $800 for one container, $1,300 for two containers, $1,800 for three containers, $2,400 for four containers (inclusive of GST)
Gross profit for the year is then calculated as follows:
Sales (26 containers × $31,304.35)
$813,913.04
Less: Cost of Goods Sold – $662,504.35
Equals: Gross Profit $151,408.70
Gross Profit Margin: ($151,408.70 ÷ $813,913.04) × 100 = 18.6%
Operating Expenses Forecasting
Most operating expenses will, in the short or long term, vary with the forecasted sales level – this is where it can become difficult to forecast! You could categorise your expenses into variable, semi-fixed, and fixed to try to draw attention to expenses which will, at some point, increase. As mentioned earlier in the seminar, variable expenses change in direct proportion to a change in the level of sales, whereas fixed costs are those that do not vary as the level of activity / sales volume changes.
However, as also mentioned earlier in this seminar, fixed operating costs may only be ‘fixed’ up to a certain level of sales. Once this level is reached, costs change. For example, every time a consultancy acquires another 20 regular clients, they may need to employ another consultant on a fixed salary, and once the company has more than five consultants, it may need to move into larger office premises (and pay higher monthly rent).
You need to then determine what degree of change in the actual level of activity will trigger changes in costs. Once you know this, you can look at the forecasted sales amounts and work out the costs involved in meeting those sales. Do not make the mistake of forecasting an increase in sales while basing expenses on your current / past expense levels.
You will also need to consider the timing of expenditure. Operating expenses (for example, power, phone, lease on premises) and non-operating expenses (for example, donation to charity) are incurred on a number of timing intervals such as:
• A regular monthly or bi-monthly basis (for example, GST and PAYE).
• An irregular basis such as once every 3, 6, or 12 months (for example insurance, holiday pay, local council rates).
• On the happening of a particular event such as a sales promotion or a particular time of the year, such as Christmas.
Factors to Consider:
Seasonal or event-related expenses need to be linked to the months in which they are expected to be incurred (as opposed to when they would be paid for, or as opposed to spreading them out over the year). In contrast, expenses that are paid irregularly, but which actually relate equally to all times of the year, should be spread across the 12 months.
While you may choose to pay your insurance premiums annually in January, this does not mean that January is the only month to which insurance relates – if you cancel a policy a few months later, it is possible that you will get a refund for the remaining months you have paid for. If you do not spread the payment out across the full year, it will result in monthly profit variations that do not reflect the actual operation of the business.
If you have a 31st March balance date (i.e. your financial year runs from 1 April to 31 March), and in January you decide to take out a new insurance policy and pay an annual premium of $1,800, you would record $150 per month in the months of January, February, and March, but nothing in the previous months. The remaining $1,350 would be shown elsewhere in your financial plans (to be specific, it would be shown as a ‘prepaid expense’ in your Statement of Financial Position – this is covered in Part C of this seminar).
In contrast, when you do your cashflow forecast (which is covered in Part B of this seminar), you will record amounts in the months that they were paid. Thus, using the example of the $900 annual insurance premium, the full $900 will be recorded in the cashflow forecast in the month of January.
When forecasting your expenses, you will need to distinguish between revenue expenditure (which are your dayto-day variable, semi-fixed, and fixed expenses) and capital expenditure (the purchase of assets worth more than $500 and the repayment of liabilities such as a loan principal). Revenue expenses are shown in the forecasted
Statement of Financial Performance (GST exclusive except where GST does not apply, for example, wages) and in the cashflow forecast (GST inclusive). In comparison, capital expenses are shown in the cashflow forecast (GST inclusive) and in the forecast of the Statement of Financial Position (GST exclusive). Only depreciation amounts associated with capital expenditure are shown in the Statement of Financial Performance.
The assumptions for the operating expenses of the case study business are given on the following pages.
Case Study Example: Operating Expenses for FVI Ltd (refer Appendix B1)
The assumptions regarding operating expenses for FVI Ltd are outlined below. All of these expenses are GST inclusive, unless specified otherwise.
Wages – Operations Manager: rate of $44 per hour, includes PAYE and employer KiwiSaver contributions (variable expense)
• August: 20 hours @ $44 = $880
• September, October, November: 40 hours each month @ $44 = $1,760/month
• December: 60 hours @ $44 = $2,640
• January: 40 hours @ $44 = $1,760
• February, March: 60 hours each month @ $44 = $2,640/month
• April, May: 70 hours each month @ $44 = $3,080/month
Wages – Warehouse Assistant: rate of $25 per hour, includes PAYE and employer KiwiSaver contributions (variable expense)
• August: 15 hours @ $25 = $375
• September, October, November: 30 hours each month @ $25 = $750/month
• December: 40 hours @ $25 = $1,000
• January: 30 hours @ $25 = $750
• February, March: 40 hours each month @ $25 = $1,000/month
• April, May: 50 hours each month @ $25 = $1,250/month
Petrol for produce delivery: $750 per container (variable expense)
Branding / promotional material: (semi-fixed expense)
• Branding / logo design plus small print of business cards: $800 (June)
• Further printing of promotional material as needed: $270 per month
Samoa airfares – supplier arrangements, July 2019: $650 per person for two directors. No GST applicable (fixed expense)
Home office rent and power: $356.37 excl. GST per month (fixed expense)
• The FVI Ltd office takes up 13% of the house floor space
• Monthly Rent for the house is $2,150 and monthly power bill averages $680
• Business portion of rent = $2,150 × 13% = $279.50 per month
• Business portion of power = $680 × 13% = $88.40 per month ($76.87 ex. GST)
• Note: GST can be claimed on power, but not on domestic rent. Total Rent and Power per month (ex. GST) is therefore $356.37 ($279.50 + $76.87)
Continues on next page...
Case Study Example: Operating Expenses for FVI Ltd (refer Appendix B) Continued...
Warehouse lease: $3,500 per month (fixed expense)
Depreciation on capital expenditure: (fixed expense)
• Purchase tablet computer for warehouse (June) for $994.75
• To be depreciated at IRD rate of 67% ($579.55 per year, $48.30 per month) – note depreciation amounts do not include GST
Employee training: (semi-fixed expense)
• MPI Training Course – Operations Manager: $400 (June)
• Other training courses: 11 months @ $120 = $1,320
Mobile phone charges: $173 per month (fixed expense)
• Mobile phone business plan: $138 per month
• Toll calls to Samoa for supplier arrangements: $35 per month
Internet charges: $99 per month (fixed expense)
Website-related charges: $40 per month (fixed expense)
• Domain names for business website is $60 per annum per domain name = $15 per month (for three domain name extensions)
• Website Hosting is $25 per month
Software subscriptions: $93.15 per month (fixed expense)
• Accounting software plus payroll: $75.90 per month
• Cloud storage: $17.25 per month
Office supplies: $80 per month (fixed expense)
Professional fees: (semi-fixed expense)
• Initial Professional Fees – (Operations, Accounting, Legal): $1,000 (June)
• Accountant: 10 months (July 2019 to April 2020) @ $200 per month = $2,000 plus $250 in May for extra end of year advice.
Bank charges: $20 per month (fixed expense)
Break-even Analysis
The term ‘break-even’ refers to the point at which a business neither makes a profit nor sustains a loss. It represents the sales level that must be achieved before any contribution to profit starts to occur. Being aware of the break-even point may help you to:
• Determine whether to accept special orders (which may be time-consuming, but could take you above your break-even point and thus be worthwhile).
• Determine whether to make items or buy them in (if you are not going to be able to break even on the manufacture of a particular item, you may be better off to buy it in).
• Analyse the profitability of using resources differently.
The calculation for the break-even point is illustrated below and on the following pages for the FVI Ltd case study. These figures have been obtained from the Statement of Financial Performance (GST exclusive figures, Appendix B1).
Case Study Example: Break-even Analysis for FVI Ltd
Having determined the fixed and variable costs, the break-even point is calculated by first expressing the variable costs as a percentage of sales. Recall that sales are $813,913.04.
Variable costs of $710,335.87 include:
• Cost of Goods Sold
• Wages – Operations Manager
• Wages – Warehouse Assistant
• Petrol for produce delivery
$662,504.35
$22,000
$8,875
$16,956.52
Variable costs as a percentage of sales are $710,335.87 ÷ $813,913.04 × 100 = 87.27%
This means that 87.27 cents of every dollar of sales is required to cover the variable costs. The remainder, 12.73 cents of every dollar of sales, is available to make a contribution toward paying the fixed costs and eventually to make a profit. The 12.73 cents is called the ‘contribution margin’. If all variable costs are included in the Cost of Goods Sold, the contribution margin is the same as the gross profit margin.
One way to make this calculation easier would be to classify the wages and petrol as being part of the Cost of Goods Sold. This is appropriate if these costs are directly related to sales. In reality, the wages (especially those for the Operations Manager) are likely to include some administration time. There is not any strict rule as to whether it should be part of the cost of goods sold or within the operating expenses, however, when it comes to conducting a break-even analysis, wages which change depending on sales levels should be counted in amongst the variable expenses.
Break-even is then calculated by dividing the fixed expenses (and semi-fixed expenses) by the contribution margin. In this case, the fixed expenses can be calculated as the total expenses of $108,472.61 less the wages and petrol expenses shown above as variable costs. That is:
Fixed (and semi-fixed) expenses = $108,472.61 - $22,000 - $8,875 - $16,956.52 = $60,641.09
Sales at break-even = Fixed Costs ÷ Contribution Margin = $60,641.09 ÷ 0.1273 = $476,363.63
The following calculations can be used to work out how many containers FVI Ltd would need to sell in order to break even:
• Sales at break-even point ÷ price (excl. GST) per bag = Number of bags which need to be sold
• $476,363.63 ÷ $78.26 per unit (bag of taro) = 6,087 bags
• 6,087 ÷ 400 bags per container = 15.22 containers
In the example of FVI Ltd, the breakeven analysis shows that when the business makes sales of $476,363.63 + GST, there will neither be a profit nor a loss. If it makes sales of less than this amount, it will not cover the fixed costs and will thus make a loss. However, in reality, as the plan is to import entire containers of taro (and not partly filled containers) it will need to import and sell 16 containers of taro.
Given that the business expects to sell 26 containers, the fact that they expect to break even with 16 containers sounds reasonable. However, you probably would have noticed that the gross profit margin and contribution margin are very low (18.6% and 12.73%). If the business sells taro at a lower price than the budgeted price of $3 per kg, this could have a significant impact on the viability of the business.
Sensitivity Analysis
Once you have prepared a forecast of profits and worked out your break-even point, it is recommended that you check how sensitive your forecast is to changes in your assumptions. Especially consider your ‘worst case scenario’. In other words, if the sales value is lower than you have forecast, and / or the expenses higher, what impact will this have on your profit? How much of a drop in sales can your business handle before making a loss?
Let’s look back at the example of FVI Ltd, which will be selling perishable goods. If they do not sell everything they import, these goods cannot sit in storage for long periods of time to be sold at a later date. The owners may therefore need to consider discounting stock. Consider the scenario where FVI Ltd is able to sell most of its stock at $3 per kg, but has to significantly discount some. As a result, the overall average price on all produce sold is $2.40 per kg (a 20% discount on the original price). This scenario is shown in Appendix B2.
Appendix B2 shows that, if FVI Ltd had to discount prices by 20%, it would not be able to cover the cost of goods sold. This means, regardless of the volume of products it sold, it would never break even. This demonstrates the importance of carrying out a sensitivity analysis, and of the need to maximise the contribution margin – a low margin may mean that discounting is not an option at all.
The analysis for FVI Ltd indicates the business is in a very risky position. To reduce risk, the owners definitely need to look at how they could increase their contribution margin, and should also consider whether reducing fixed costs is possible. The main options available to the owners are:
• Increase the wholesale price of $3 per kg. Therefore, even if some produce sometimes had to be sold at a discount, this could be offset by higher prices for the majority of the produce sold.
• Consider whether they could sell some stock direct to the final consumer at $6 per kg.
• Find a more competitive supplier price from Samoa to drive down their cost of goods sold (purchases).
You can see the value in doing a sensitivity analysis for your business when it provides you with such vital information, as it has done for FVI Ltd. With this information in mind, they can now do something to improve their profit position before they make a commitment to their suppliers or set a price for their customers.
Discussion Questions:
• What would you do to improve the profitability of FVI Ltd?
• When conducting a sensitivity analysis, how ‘bad’ should your worst-case scenario be?
NGOHE:
• Create a one-year Statement of Financial Performance forecast for the upcoming 12-month period (whether that is a trading year or an income year).
• Explain how you conducted your sales forecasting, what particular considerations you have taken into account, and any assumptions you have made. Include in your considerations a discussion of the general economic and specific industry conditions related to your business.
• Calculate the gross profit margin for your business and evaluate it against: business goals, industry averages, and performance in a similar period.
• Conduct an audit of your current operating expenses: establish the ‘drivers’ for each type of expense, and identify areas where savings may be possible.
• Complete the calculation for break-even analysis and then discuss what break-even position your business is in – how many sales do you need to make each week, and how realistic is this?
• Identify one key thing you could do in the next five business days to improve on the profitability of your business.
Part B: Cashflow Forecasting
“Entrepreneurs believe that profit is what matters most in a new enterprise. But profit is secondary. Cash flow matters
most.”
- Peter Drucker
A cashflow forecast, or cashflow statement, is a record of when you expect your business will receive money into, and make payments out of, your bank account. A cashflow forecast can be prepared for any period of time; however, it is beneficial to prepare one for the same period as your forecasted Statement of Financial Performance (i.e. usually a 12-month period) so you can determine the cash requirements for your budget.
Two of the key differences between the cashflow forecast and the forecasted Statement of Financial Performance are that:
• The cashflow forecast records all cash inflows and outflows when they occur. In comparison, the Statement of Financial Performance only includes figures which affect profit, which do not include ALL cash inflows and outflows (e.g. it does not include the purchase of assets worth over $500 or loan payments) and may include non-cash expenses such as depreciation.
• Figures in the cashflow forecast are GST inclusive, whereas (provided the business is registered for GST), figures in the Statement of Financial Performance are not.
Some of the benefits of cashflow planning are that it will help a business to:
• See when funds are likely to be available for purchases and discretionary expenditure.
• Identify in advance if extra funds are likely to be required, thus notifying the owner of the need to either arrange extra finance or alter their budget.
• Ensure that surplus funds are not left idle (that is, there could be a better use for them, even if that involves them being taken out of the business).
• Minimise interest payments if the business is in a deficit cash position.
As per the forecasted Statement of Financial Performance, when preparing your cashflow forecast, it is important to outline any assumptions made. However, you do not need to repeat details given in your assumptions for your forecasted Statement of Financial Performance; instead, focus on explaining the differences between these two forecasts. An example is given below for the case study business.
Case Study Example: Cashflow Forecast for FVI Ltd (refer Appendix C)
The assumptions for the cashflow forecast for FVI Ltd are as follows:
• FVI Ltd will be registered for GST on the cash basis, with payments being made bi-monthly. All figures in the cashflow forecast include GST, where applicable.
• Cash Sales and Accounts Receivable: Three quarters of taro will be sold to large, established retailers who expect to be able to pay the month following supply. The remaining quarter will be sold to smaller, newer retailers, whom FVI Ltd will require to pay on a cash basis. For example, of the $36,000 (inc. GST) of sales to be made in August only $9,000 in cash will be received that month, with the remaining $27,000 received the following month.
• Opening Bank Balance: Each of the three directors will contribute $5,000 cash prior to 1st June as start-up capital.
• Cash Equity In: When the first shipment is imported (in August), each director will contribute a further $10,000 to the business.
• The tablet computer for the warehouse will be paid for in June ($994.75).
• All expenses and purchases will be paid for in the months incurred, with the exceptions of mobile phone, internet and professional fees, which will be paid in the subsequent month.
• No income tax will be paid within the first year.
Based on these assumptions, the cashflow forecast predicts significant cash shortages. The expected bank balance is negative for eight of the twelve months, with the worst balance being -$24,870.72 in December 2019! At the end of the 12 month period it is expected to improve to -$4,527.56, although this is still negative.
The main reason for the cashflow shortage is that income for three quarters of the sales is expected to be received the month following the supply of taro. Thus, at the end of May, a total of $108,000 is expected to be owing from debtors (calculated as 75% of May Sales + GST = 0.75 × $144,000). With this knowledge in hand, the directors of FVI Ltd will need to work out how they will finance their business venture before they start importing their product.
TĪWHIRI:
When you are creating your own cashflow forecast, make it easy to understand. For example, you could highlight all GST-inclusive amounts in blue and those which do not attract GST in pink. This will make it easier for you to calculate expected GST payments. In the example in Appendix C, the GST-inclusive figures have been shown at the top of the list of disbursements.
A wall of numbers helps no one if you do not understand what it is you are looking at, so feel free to do what you need to in order to make sure you and others can understand what is in the forecast. There is no reason to not make this process as easy for yourself as you can.
Cash Control
The Cashflow Statement forecast is essential for exercising control over cash. For instance, a monthly cashflow budget will show in advance when a business is likely to be short of cash and require external funding (such as a bank overdraft) and when a business may have a cash surplus which can be profitably employed elsewhere (such as expanding the business premises to meet increased product demand).
Small businesses are especially vulnerable to cashflow problems because they tend to operate with small cash reserves. Furthermore, as they may have difficulty obtaining finance (particularly if it is a start-up business), owners need to be well prepared in advance as to how they will cover any cash shortages or avoid them altogether
Timing of Cashflows
The timing of cashflows can ‘make or break’ a business. Even if sales are expected to be high, the business may fail simply due to customers not paying accounts on time. Furthermore, in many industries, payments to suppliers are expected before customers pay. This is particularly true if you operate a retail shop – you generally need to have stock in your shop before the customer will buy it. However, in other businesses (or in certain situations – for instance, a special order), you may be able to arrange payment from customers before you order goods.
Seasonal fluctuations in a business or large orders (or large contracts) may also pose cashflow problems. Take the example of a catering business that secures a large one-off contract – if the business does not have access to enough cash to buy supplies and pay additional workers, it may not be able to take on the contract, regardless of how profitable it would be.
Cashflows also need to be considered within a forecast period, not just at the end of it. For example, if you prepare an annual cashflow forecast which shows cash inflows and outflows for each of the 12 months, you still need to make sure you can cover payments within the month. There will be certain outflows required at specific times of the month, such as payroll or rent of the premises, whereas customer payment terms may all be geared towards the 20th of the month. How will you meet payment obligations before this time?
The underlying point is this: if the business runs out of cash, this is fatal to the ongoing health of the business. Even if a business can borrow funds, sooner or later it has to match the timing of cash inflows and cash outflows if it is to remain in operation. That is, if you borrow money, you need to make sure you are going to be able to make the repayments at the required times whilst also covering other business costs.
Debtors Collection
Debtors are customers / clients who buy from you on credit. The cash inflow from your debtors is a major source of funds for repayment of creditors (your suppliers) and expenses. As such, it is an area in which you should focus your attention and efforts.
You need to take a professional stance and be clear about your payment terms right from the start. In addition to having them written down, discuss them with the customer until you are confident that they understand them. You then need to be consistent in following them up. If you say payment must be made within 10 working days, you need to be chasing unpaid bills on Day 11. It is a good idea to set reminders and alerts on your computer so you know when to start chasing a debtor (or use software which will alert you to overdue payments). From then on, set a time each week for following up with the remaining overdue accounts.
USEFUL WEBSITE:
The following webpage offers guidance on how to draft a terms of trade clause:
• How to Law, How to draft terms of trade – http://www.howtolaw.co/draft-terms-of-trade-392065
One idea is to set a ‘cash only’ policy. This does not mean that customers must pay in cash, but it does mean they must pay immediately (whether that be via internet banking, credit card, cash, or some other means). However, if you do this, remember that you need to take into consideration terms expected within the industry. If all of your competitors allow customers 30 days to make payment, enforcing a shorter payment period may be even more costly to your business in terms of lost sales. However, to reduce risk, you may also want to consider conducting credit checks before extending credit.
One of the biggest mistakes you can make is to wait until the end of the month to send out the invoice. Wherever possible, invoice instantly while the memory of how happy they are with their purchase is still fresh in the customer’s mind. Prompt invoicing also gives the impression to your customers that payment is expected quickly.
It creates a sense of urgency around payment, and often leads to customers paying as soon as the invoice is received, even if your terms of trade allow a number of days for payment. The longer you wait before invoicing, the less likely the customer will pay.
TĪWHIRI:
Email or address the invoice to the actual person who will be making payment. Someone is more likely to prioritise an invoice they are personally linked to. Furthermore, if the organisation is large, it may get to the right person quicker if it has their name on it, as opposed to only the business name.
If customers do not pay on time, do not be afraid to phone them to ask for payment. Remember, you should not feel bad about doing this – you have supplied them with a product or service and they owe you for it! You are not a charity ringing them to ask for donations. Whilst you may not feel comfortable doing this, you need to also think about the perception you are creating in your customers’ minds if you do not follow up. The more ‘relaxed’ you appear about payment, the less professional your business will look to customers. Customers will then feel there is less urgency and priority when it comes to paying you. Furthermore, this can restrict future purchases. If a customer is slow to pay, they may feel guilty about it and be less likely to buy from you in the future.
Neglecting the age and state of your debtors can lead to heavy losses both directly from bad debts and indirectly through working capital being tied up. That is, when customers have not paid you, you do not have the money that you could otherwise be spending on pursuing a profitable business strategy. In Part D of this seminar, we will look at two ratios that can be used to monitor the rate of collection from trade debtors.
USEFUL WEBSITE:
For more tips on invoicing and debtor control, refer to:
• Xero, Invoicing survival guide – https://www.xero.com/nz/resources/small-business-guides/invoicing/
Growing a Business
It is particularly important to be aware of the increased need for working capital when a business is experiencing rapid growth. For instance, if the business turnover (the amount of goods sold or billable service hours) has increased significantly over the period, it would be expected that the business will require increased working capital to fund the growth in debtors and stock (inventory).
However, what often happens is that a business expands without obtaining the necessary funding facilities. The business may then be forced to delay payment to their creditors which can have a detrimental effect on their trade relationships, their credit rating, and their ability to obtain discounts. Just as your business would not like to carry debtors who continually miss their payments, the same is true of creditors who supply to your business – they are not going to want to carry you as a customer if you do not pay your invoices.
For this reason, what can happen is that such businesses in a growth phase can find themselves in a situation where they are continually operating on, or over, their overdraft limits and still unable to pay their bills as they fall due. It is vital to remember that cash in the bank is not the same as profits earned and thus large forecasted profits from a growth strategy may not necessarily result in a healthy bank balance in the short term.
As you look at your assumptions for the cashflow forecast, keep in mind that every extra dollar of debtors or inventory as assets is a dollar that you do not have in your cash balance. On the other hand, every dollar in creditors is a dollar that you have in cash, too. Nonetheless, if you continually have a high amount of creditors that you never pay on time, you will eventually end up in a situation whereby no one wants to supply to your business and thus you will not have any supplies or resources to generate sales.
Another important point is that separating your personal finances from those of the business can have a very positive impact on your cash position! Some small businesses are run with the business bank account being treated as an ‘open tin’ for business owners and their families. In addition to this leading to higher accountancy costs (as the accountant tries to sort out which transactions are business related and which are not), it complicates budgeting and tends to deplete the cash balance. Instead, it is better to budget for a set amount of drawings (or wages) and pay these in lump sums as per the budget, instead of in multiple smaller transactions.
Discussion Questions:
• Think about times when, as a small business owner, you have had cashflow problems. How did those problems arise (for example, did you purchase too many fixed assets in your first three months of business?), and what did you do to resolve the cashflow shortage?
• Are there particular seasonal fluctuations in your business which pose cashflow problems (for example, does the bulk of your cash come in over the summer months and fall off in the winter and autumn months)?
• Do you have terms of trade? If so, do you think you communicate these effectively to customers?
Part C: Balance Sheet Planning (The Forecasted Statement of Financial Position)
“Debt is one person's liability, but another person's asset.”
- Paul Krugman
The balance sheet (also known as the Statement of Financial Position) shows the business’s assets and liabilities, along with the owners’ interest in the business (called ‘owners’ equity’) as at a given date. ‘Assets’ represent the resources owned by the business, whereas liabilities and owners’ equity indicates how those resources were financed. At all times, the value of total assets is equal to the value of total liabilities plus the owners’ equity.
Two other ways to view the components of the Balance Sheet are as follows:
Assets = Liabilities + Owners' Equity
What the Business Owns = What the Business Owes
That is, everything that the business owns is either owed in debts or owed to its owners.
Assets − Liabilities = Owners' Equity
That is, what the business owns, less what it owes in debts, belongs to its owners.
The figures in the forecasted balance sheet result from using figures in the forecasted Statement of Financial Performance and the forecasted cashflow statement together with the figures in the balance sheet from the previous period. For instance, the forecasted balance sheet will show the value of all assets, including the bank balance –this bank balance is taken from the forecasted cashflow statement.
This means you do not need to write assumptions to ‘guess’ what these figures may be. Whilst this can be quite complicated (especially in regard to working out figures such as GST payable), the example below explains how each of the figures in the case study example was derived.
Case Study Example: Forecasted Statement of Financial Position for FVI Ltd
(refer Appendix D)
• The Bank Account and Additional Equity figures in the first column reflect the $15,000 contributed by the three directors (i.e. $5,000 each) prior to 1st June 2019.
• Accounts Receivable of $108,000 represents three-quarters of sales from May for which payment is due to be received in June 2020.
• Computer Equipment of $865.00 represents the tablet computer to be purchased in June for $994.75 (as shown in the forecasted cashflow forecast) less GST.
• Accumulated Depreciation of $579.60 represents the depreciation on the tablet computer, accounted for in the forecasted Statement of Financial Performance.
• The Bank Overdraft of $4,527.56 is obtained from the Cashflow Forecast.
• GST Payable of $15,299.75 includes: (1) An amount of $1,280.88, which would be owing at the end of the year based on the April and May figures in the forecasted cashflow statement – refer to the last figure in Appendix C; plus (2) the GST component of accounts receivable – that is, of the $108,000 of accounts receivable, $14,086.96 is GST to be received and paid to the IRD; less (3) the GST that will be claimed back once the Accounts Payable are paid – that is, of the $522 of accounts payable, $68.09 is GST which will be claimed back.
• Income Tax of $12,022.11 is obtained from the forecasted Statement of Financial Performance in Appendix B1.
• Accounts Payable of $522.00 consists of the following bills due to be paid in June 2019: Mobile Phone ($173.00); Internet ($99); and Professional Fees ($250).
• The Opening Balance of Owners’ Equity is carried over from the closing balance the previous year (this is the $15,000 the directors contributed).
• Net Profit of $30,913.99 is obtained from the forecasted Statement of Financial Performance in Appendix B1.
Discussion Question:
• Why is it of value to forecast your balance sheet?
Key areas where cash ‘disappears’ can be identified from looking at certain figures in your balance sheet and comparing them to a previous period of the same length. Figures to look for include:
• an increase in stock on hand
• an increase in fixed assets
• an increase in debtors (accounts receivable)
• a decrease in creditors (accounts payable)
• a decrease in term loans
• a decrease in owner’s equity
If you have been in business for two years or more, refer to your past financial statements and analyse each of these six key factors. In doing so, consider the questions provided below. If you are new to business, just consider these questions in relation to your forecasted Statement of Financial Position:
• Extra stock might be good for your business – but do the higher inventory figures result because you have surplus stock which is difficult to sell?
• Spending money on buying assets might result in greater productivity in the business – but have they increased your profits as much as you expected?
• An increase in debtors might mean you are doing a lot more business and therefore you have to give credit to customers – but does it instead indicate you are not collecting the money owed to you as efficiently as you should?
• A decrease in creditors might be because you are paying your accounts more quickly, which is good –but what has been the effect on cashflow?
• A decrease in term loans usually shows that you have repaid some outstanding loans and commitments, which is good – but again, what has been the subsequent effect on cashflow? Have you repaid them faster than required and left the business without sufficient cashflow to operate?
• A decrease in owner’s equity may be because you have taken larger drawings or dividends from the business than usual. Is this because you have surplus money in the business which you would rather have in your own bank account, or did you need to withdraw money for personal reasons when the business actually needed that money?
Part D: Ratio Analysis and Improvement Strategies
“Mauri mahi, mauri ora; mauri noho, mauri mate.”3
- Māori Proverb
Ratio analysis involves using information within the financial statements to give an indication of the business’s current financial shape as well as provide information about trends in financial performance and position. Some examples of this analysis have already been shown in the preceding sections: the gross profit margin and the break-even analysis.
A critical assumption in the use of financial statements is that the past can predict at least part of the future. When it comes to long-term stable trends that have continued for many years, this will usually be true, at least for the near future – however, changes in the external environment will always need to be taken into consideration. Even if the business environment is rapidly changing, at the very least, it is beneficial to analyse past performance to identify areas for improvement and help set goals.
Ratio analysis can be used to monitor your business’s progress, to find out what you are doing well and, more importantly, to find out where you need to improve. By comparing this year’s numbers (or forecasted numbers) with those from previous years and industry norms, you can discover problems before they become too serious. If you wish to borrow money, the bank may insist that you keep certain ratios within specific limits. However, it is important to understand that ratios vary considerably from industry to industry. That is, what it a perfectly acceptable figure for one type of business may be totally unreasonable for another.
In the following sub-sections, a selection of key business ratios is shown.4 These ratios are grouped into four categories:
1. Profitability Ratios
2. Risk Analysis Ratios
3. Liquidity Ratios
4. Activity Ratios
1. Profitability Ratios
Profitability ratios assess the business’s ability to operate profitably.
a. Gross Profit Margin
Gross Profit Margin = Gross Profit Total Sales × 100
Where: Gross Profit = Sales – Cost of Goods Sold
The gross profit margin (introduced in Part A) is an important measure of profitability. It shows how much profit is earned per dollar of sales, before taking overheads such as selling and administration costs into account. For example, a margin of 82% shows that 82% of sales income is available to cover overhead expenses and profit.
3 Hard work begets prosperity, idleness begets poverty.
4 Content derived from: Aotahi Ltd. (2014).
You also need to ensure that the gross profit is positive for all your products, and is sufficient to cover all your other costs and allow for profit. The higher the gross profit margin, the more flexibility you have in regards to your pricing strategy. If your gross profit margin is low, offering a discount on a sale could mean the sale actually results in a loss.
The ‘optimal’ gross profit margin depends on the type of business you have. What is considered acceptable in some industries may be very poor in others. For example, in a retail clothing business, a gross profit margin of 50% may be acceptable. This would indicate that, on average, a mark-up of 100% is maintained on products.
b. Sales Growth Percentage
Sales Growth Percentage = Current Sales − Last Year's Sales Last Year's Sales × 100
This shows the percentage increase or decrease in sales between this year and last year. Instead of using ‘current sales’ and only analysing past performance, you can use your forecasted sales value in order to see whether your planned growth in sales is expected to meet your targets.
This type of analysis can also be done over a shorter time period if required. For example, it is common to also calculate sales growth monthly or quarterly. Ideally, there should be a steady increase in sales over each time period. This rate should be above the rate of inflation. If you are calculating monthly or quarterly sales growth, it can be a good idea to compare the resulting figures to the same period for the previous year, particularly if your sales tend to be seasonal. For example, if most of your sales occur in the summer months, it is likely that each year sales growth will substantially fall in the winter months.
c. Net Profit Margin
Net Profit Margin = Net Profit Sales × 100
This shows how much profit you make, after all expenses and tax, from each dollar of sales. For example, a ratio of 12% means that, for every $1 of sales, the business earns 12 cents of profit.
You should make comparisons with other similar businesses to see if your business is operating as profitably as it could be. Remember to look for trends. This ratio should preferably show a steady increase, or at the very least remain constant. If it is decreasing, check to see whether this is because sales are decreasing, the cost of goods sold are increasing, or other expenses are increasing.
This is important because increasing sales volumes will improve profitability if other expenses have increased, but will not necessarily increase profits if the cost of goods sold have increased. In this case, you would need to consider increasing prices and / or reducing the cost of goods sold first.
d. Return on Equity
This ratio shows the rate of return you, as the owner, are making from your business. You need to ensure that you are generating a return that is sufficiently high to compensate for the risks of being in business.
Compare your return on equity to other investment alternatives, such as savings accounts, large company shares, or government bonds, and also to other similar businesses. If this ratio is too low, take action to increase it. For example, you should make sure that your return on equity is at least higher than the rate of interest you would receive from putting your money in the bank.
e. Return on Assets
This is a measure of how effectively assets are used to generate profits. The Return on Assets ratio shows the amount of income for every dollar tied up in assets. If your business is in a situation where it needs to purchase assets but has a choice about which ones to buy, this ratio could help to guide the decision – you can forecast the net profit the business would generate for each of the options, and then work out the return on assets. The higher the return on assets, the more profitable the asset purchase is.
However, also take into consideration the net profit amount on its own. For example, if purchasing an asset results in an extra $50,000 of profit, but reduces the return on assets from 10% to 8%, it is likely the owner will consider the purchase to be worthwhile. If you choose to use this ratio in your business, you will need to decide what rate of return is acceptable.
Improving Profitability Ratios
The main ways to improve profitability ratios are to: increase sales values, reduce the cost of goods sold, and reduce other expenses. A set of questions is provided below which you may consider using when thinking about ways in which you can improve the profitability of your business.
Increase Sales Values
• Can you use a CRM (customer relationship management) system to help increase sales?
• What impact would increasing your prices have on your sales volumes?
• Can you charge for services currently being provided for free or offer any ‘add-ons’ which have high profit margins?
• Are your advertising choices and promotions effective?
• Can you increase your salesperson’s product knowledge and / or sales skills?
• Are customer claims and complaints investigated to avoid a recurrence?
• Do you need to conduct market research with consumers to find potential opportunities?
Reduce Cost of Sales
• Are all materials used efficiently? Can you use or sell scrap materials?
• Are your production batch sizes appropriate given the quantity and timing of sales?
• Are there cheaper suppliers available who can meet your quality requirements?
• Are some product lines unprofitable? If so, can you cut these from your range?
• How can you increase productivity? Do you perhaps need to service machines more regularly, or maybe review staff break schedules?
Reduce Other Expenses
• Is all expenditure necessary? Will reduction of expenditure in some areas affect sales?
• Is advertising and sale promotion expenditure optimised? Are you able to track the effectiveness of each form of promotion to determine which ones are worth doing?
• Are costs appropriate for the level of sales, or are you spending more than you need to? For example, does your broadband internet plan provide much more data usage than you need? Are you renting a larger storage unit than required? Are you insured for inventory figures much larger than you need to be given your stock on hand?
2. Risk Analysis Ratios
Risk analysis ratios measure the vulnerability of the business. They are often used by creditors to determine the business’s ability to repay loans.
a. Debt to Equity Ratio
This ratio shows how your business is financed. It is important to know how much of your business financing is derived from owners’ equity and how much from debt. For this calculation, loans from business owners are usually regarded as equity rather than debt.
The rule of thumb is that the higher the ratio, the greater the risk to creditors. Most lenders have strict limits on this ratio for lending purposes. A 2:1 ratio ($2 of debt for every $1 of equity) is a common limit for small business loans. Too much debt can put your business at risk, but if you do not have much equity to provide to the business, a low ratio may mean that you are restricting your business from reaching its full potential.
b.
Debt to Total Assets Ratio
This ratio is similar to the Debt to Equity ratio. However, instead of showing what proportion of debt the business has relative to how much equity, this ratio shows what proportion of the overall business is financed by debt. For example, a ratio of 0.6:1 means that for every $1 of assets there is 60 cents of debt. In other words, this means that 60% of your business is financed by debt, and only 40% is owners’ equity.
If you know the Debt to Equity ratio, you can determine the Debt to Total Assets ratio. For example, if a business has a Debt to Equity ratio of 2:1 (which, as noted previously, is often the maximum ratio acceptable to lenders), the Debt to Total Assets ratio must be 0.67:1, as two thirds of the business assets is financed by debt and one third is financed by equity.
c. Interest Cover Ratio
Interest Cover Ratio = Profit Before Interest and Tax Interest Expense
This ratio shows how many times your interest payments are covered by your pre-tax profits. Generally, a ratio of 5:1 is acceptable. Lenders may look at this ratio to assess your ability to repay loans.
Nevertheless, being debt-free is not necessarily a good thing. Borrowing can give you the money required to pursue an excellent business opportunity. However, if the business is highly geared (financed heavily with debt), you need to ensure that your ratios remain acceptable, including liquidity ratios. Should the business forecast predict problems with meeting interest payments, it is best to contact the lenders immediately to discuss refinancing arrangements.
3. Liquidity Ratios
Liquidity ratios measure your ability to pay your debts on time. They are particularly important because, as highlighted in Part B of this seminar, a lack of cash will often result in business failure, which means the business could end up insolvent (unable to pay debts).
a. Current Ratio
This ratio shows your ability to pay your bills under normal circumstances. A current ratio of 1:1 means that you have $1 of current assets for every $1 of current liabilities. Generally, a current ratio should be over 1:1 as this indicates you will have enough cash to pay for current liabilities. In fact, a ratio of at least 2:1 is considered to be appropriate for many business types. However, one problem with relying on the current ratio is that if all the current assets are stock, there are going to be difficulties paying bills due immediately.
b. Quick Ratio (also known as the Liquidity Ratio)
This ratio shows how feasible it is for you to pay your bills without relying on sales of stock to bring in cash. Generally, a ratio of 1:1 is good. Nevertheless, as the quick ratio still contains accounts receivable it ignores the timing of those receipts. Thus, if you have a high proportion of accounts receivable you may need to collect these before you are able to pay your bills.
4. Activity Ratios
These ratios show how well key parts of the business are managed – particularly accounts receivable, inventory, and accounts payable.
a. Accounts Receivable Turnover
Accounts Receivable Turnover = Sales Average AccountsReceivable
This number shows how many times per year, on average, you collect money owed from each customer. A higher number means that there is a shorter amount of time between the sale and the customer paying their account. Thus, the higher the number, the better. For example, if the accounts receivable turnover is calculated as 12:1, this means that, on average, accounts are paid 12 times per year (in other words, they are on average paid monthly).
When you are calculating this ratio, try to get an accurate idea of ‘average’ accounts receivable and use this figure instead of the accounts receivable figure on your balance sheet. This is because, as at your balance date (typically the 31st of March), you may have an unusually low number of accounts receivable. Using this low figure to represent ‘Average Accounts Receivable’ in your calculations would make the ratio appear more favourable than it usually is and, as a result, you may overlook this as an area in which you need to focus your efforts.
b. Days in Receivables
Days in Receivables = 365 Accounts Receivable Turnover
This number shows the average length (in days) of time taken to collect accounts receivable. The lower this number is, the better. For example, if your Accounts Receivable Turnover is 5, using the above formula, your Days in Receivables will be 73. This means that, on average, it takes customers 73 days (over 2 months!) to pay your invoices.
The Days in Receivables figure should be compared to the required payment timeframes stipulated in your terms of trade. For example, if your terms of trade specify customers need to pay within 7 days, yet the Days in Receivables figure is higher, customers are not adhering to your terms of trade.
Debtor Management Improvement Strategies
Some ways in which you may be able to improve your accounts receivable ratios include:
• Issuing invoices immediately – look for software which makes it easy for you to do this.
• Following up overdue accounts the day after they were due.
• Seeking advance payments or deposits.
• Charging penalty interest.
• Encouraging payment on invoice instead of on monthly statements.
Also consider whether it is worth offering discounts for prompt payment – if your gross profit margin is low, this may not be a good idea. If you do offer discounts, see if you can build this into the price of your products and services.
c. Inventory Turnover
Inventory Turnover =
Cost of Goods Sold
Average Inventory (of Finished Stock)
This ratio shows the number of times that you sell the total value of your inventory in a year. Inventory refers to trading stock. In general, a high inventory turnover is a good sign, but it can also mean that you have inadequate inventory. On the other hand, a low turnover may mean that you are keeping too much stock on hand and / or much of the inventory is obsolete.
The problem with holding large quantities of stock on hand is that it can put a strain on your cashflow. You could be using your cash better in other parts of your business. Recall the liquidity ratios – if much of your cash is tied up in stock, you may become insolvent (unable to pay bills on time). This figure is not of much relevance to service industries.
d. Days in Inventory
Days in Inventory = 365
Inventory Turnover
This figure shows the number of days, on average, that it takes you to sell your inventory (stock). Generally, a low number of days is good for your business. For example, if Inventory Turnover was 28, this would mean that, on average, you sell all of your products approximately every 13 days.
Inventory Management Improvement Strategies
Some ways in which you may be able to improve your inventory management ratios include:
• Ensuring you order appropriate quantities of inventory for your forecasted sales volume.
• Reviewing ordering policies – perhaps by ordering smaller quantities or only ordering when current inventory levels reduce to a certain level.
• Reducing the numbers of different types or lines of stock held.
• Rotating stock better to avoid stock becoming old and damaged.
• Offering special deals to move older stock which is unlikely to sell at full price.
• Finding alternative distribution methods for excess stock (e.g. selling on Trade Me).
e. Accounts Payable Turnover
Accounts Payable Turnover =
Cost of Goods Sold
Average Accounts Payable
This is the average number of times you pay your creditors or suppliers per year. From your point of view, a lower figure is better as it can help with management of cashflows. For example, if you are a new business, your suppliers may require you to pay within seven days. If you comply with this, your Accounts Payable Turnover will be 52 or more (as there are 52 weeks in a year). However, as you build a relationship with your suppliers, they may agree to you paying them within 30 days. This would involve a lower Accounts Payable Turnover. This is good for you as cash that would usually go directly to the suppliers can be used for other purposes for up to 30 days. Note that the Cost of Goods Sold figure generally represents the total amount that you spend on buying products from suppliers for resale. However, this is not the case if you also have direct labour costs included in your Cost of Goods Sold figure. In situations such as these, it is more appropriate to use ‘Total Purchases’ instead of ‘Cost of Goods Sold’ in this calculation.
f. Days in Accounts Payable
Days in Accounts Payable = Accounts Payable Turnover
This ratio shows in days the average length of time for which your trade payables remain outstanding. Generally, a high figure is better, as long as you are paying suppliers within the agreed timeframe. However, a high figure can also be a sign of inadequate administration systems. It is advantageous for you to negotiate extended credit terms wherever possible. Remember, the more days you have to pay your creditors, the better.
g. Cash Conversion Cycle
Cash Conversion Cycle = Days in Inventory + Days in Receivables - Days in Accounts Payable
This figure shows the average number of days that cash is tied up in making a sale. That is, it measures from the point at which stock is purchased to the time a customer settles their bill. A lower figure is generally better. The figure given by this calculation is very important.
For example, if your Days in Inventory figure is 120, your Days in Receivables figure is 30 and your Days in Accounts Payable is 0, this means that, on average, your cash is tied up in making a sale for 150 days (close to 4 months). In situations such as this, some solutions could include negotiating credit with suppliers so that you do not have to pay for products straight away, reducing the amount of stock you have on hand, being careful about the timing of your purchases (e.g. not buying summer stock until it is very close to the summer months), and restricting credit terms to your customers.
Discussion Questions:
• Consider the range of businesses in your class. Which ones do you think require the highest gross profit margins, and why?
• Are there any ratios which are more relevant to some business types than others?
• How can you determine if a ratio is ‘acceptable’?
NGOHE:
People who succeed in business have learnt the lesson that it is much easier to make good business decisions if you have some accurate facts and figures in front of you. A way in which you can do this is deciding on some key performance indicators (KPIs). You can set KPIs based on the ratios in this part of the seminar.
Create your own list of KPIs you will use in your business, and make it specific. For example, if you make ‘Gross Profit Percentage’ a KPI, exactly what percentage do you aim for or what trend are you looking for? Also consider how often you will check them. Try to limit your list to three to five KPIs – if you have too many, you are less likely to monitor them.
References
Aotahi Ltd. (2014). Taking Care of Business: A Guide to Entrepreneurship in Aotearoa (4th ed.). Te Kuiti, New Zealand: Author.
Xero. (2017). Small Business Guide: Invoicing and Payments https://www.xero.com/resources/small-businessguides/invoicing/
Statement of Financial Position (FVI Ltd)
Disclaimer
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This publication was revised in October 2021.
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