The Importance of Having Good Management Accounts

In this day and age, most small and medium sized businesses (SMEs) use computerised accounting systems; and suppliers of accounting software, such as Sage, have made the bookkeeping process very straightforward, irrespective of whether your annual sales are £100k or £50m. As a result most SMEs now maintain a reasonable quality of bookkeeping that accurately records their financial transactions. However, many limit the regular use of their accounts systems to the processing and control of sales and purchase invoices, debtors & creditors, wages & salaries, the bank, VAT etc. And this means that they are missing out on one of the most important tools that is available to help them manage their businesses more effectively and more profitably. I’m talking about the production of monthly management accounts.

From the work that I do with SMEs, there seem to be two distinct issues. The first is businesses that don’t produce monthly management accounts at all. The second is businesses that do produce monthly management accounts but structure them in such a way that, at best, they are not particularly helpful and, at worst, are seriously misleading.

Let’s look, firstly, at those businesses that don’t produce monthly management accounts at all. Generally these are at the smaller end of the SME scale. They often don’t see management accounts as a priority; perhaps have some difficulty understanding and interpreting them; and may struggle to produce them. Realistically, if yours is a one person business with no employees and a very small number of transactions, monthly management accounts are probably not going to add much value because they won’t really tell you anything, you don’t already know or can’t work out in five minutes with a calculator or spreadsheet.

However, the business doesn’t have to grow too much, before the number of transactions increases to the point, where you lose track of them. At this point, many businesses then keep a close eye on the bank account and assume that, if there’s cash in it, they’re OK. And that’s the first big mistake because cash is not profit. A business can be making losses, whilst still having a healthy cash flow. It can also be making healthy profits, whilst having a cash flow problem (I’ve written another article about this, which you can access at Cash v Profit). You need a profit and loss account at the end of each month to tell you whether you’re making money or not and you need a balance sheet to show you whether you’re solvent and whether you have a liquidity problem or not.

Your management accounts should give you an accurate picture of where all your costs are and whether your margins are where they need to be. You can monitor where all your cash is tied up (stock, debtors etc.) and whether there is enough in the business to pay your wages and creditors. As the months go by, you begin to identify trends that may be developing; rising or falling costs; deteriorating or improving margins; increases or decreases in stocks, debtors and creditors; improving or deteriorating cash position etc. So you start to identify problems at an early stage and are able to take remedial action before those problems become acute. Similarly, you can see where you’re having increasing success; so you can then start developing strategies to build on that success. Finally, where you have a business plan with a detailed financial budget, you can compare your performance against the budget and take actions to get things back on track, when you’re falling behind plan; or build on your success, when you’re pulling ahead of plan.

Unless you have some form of accounting/bookkeeping experience, you may struggle to produce monthly management accounts yourself. Apart from ensuring that everything has been posted to the correct nominal account, a number of procedures such as stock adjustments, work in progress adjustments, dealing with prepayments and accruals are required. So you’re probably going to need someone to make all of these adjustments and to then produce the profit and loss account, balance sheet and any other reports that you may require. Obviously, some SMEs are big enough to employ a full time or part time bookkeeper and if so, the bookkeeper should be able to undertake all of these tasks. Some larger businesses will have accounts departments with a number of dedicated staff. These are likely to be producing monthly management accounts as a matter of routine. However, if your business is not producing management accounts each month, you’ll need to consider whether it’s possible to produce them, using existing resources or whether you need additional support. If you do need additional support, you may be able to employ a bookkeeper on a part time basis for a few hours a week; or there are many self-employed people and small companies offering bookkeeping services. Either way this doesn’t need to be a hugely expensive commitment and the benefits to your business are likely to be substantial.

The fact that you personally may struggle with accounts and may not have a very good understanding of them, doesn’t mean you shouldn’t have management accounts as part of your business processes. They’re just too important to ignore. In these circumstances, just be honest with yourself and your bookkeeper or prospective bookkeeper; admit it’s not your thing and ask your bookkeeper to go through the figures with you, line by line, explaining what each line is and what it’s telling you. You’ll need to invest some time in this; but, if you do, you’ll soon learn; and you’ll quickly discover it’s not rocket science.

I now want to move on to the second problem, I see all too frequently, and that is management accounts that are not appropriately structured and, as a result, don’t provide information that is helpful for the business.

Generally speaking, this problem comes about because the business owner/CEO doesn’t tell the person, responsible for producing the management accounts, what information is actually required. It’s just left to the accountant/bookkeeper, who may well understand the numbers but who, invariably, doesn’t understand the business.

The two most common problems are: –

1. A lack of sufficient breakdown between key business activities and/or product groups.
2. Classifying as overheads, entries that should be shown as direct costs.

Let’s look firstly at the breakdown between business activities or product groups.

If your business has more than one business activity, you need to understand the performance of each one. For example, let’s say you fabricate PVCu windows and doors; but you have two different market channels. The first is selling an installed service to homeowners; and the second is selling, on a supply only basis, to the trade.

Your production costs are likely to be more or less the same irrespective of the channel. However, the cost structures of the two channels are likely to be considerably different, as are the selling prices. Selling an installed service to homeowners is likely to involve sales commissions, advertising, survey costs, sub-contract installation costs, installation material costs and finance/credit card charges. Selling to a trade customer, is likely to involve different sales and advertising costs and may involve delivery or possibly trade counter costs; but it’s unlikely to involve survey and installation costs. Your management accounts need to pick all this up and provide a margin analysis for both market channels. If everything is lumped together, you just don’t know where you’re making money and where you’re not. So how do you know what strategies to apply to each channel? The answer is, “you don’t”!

A similar issue arises between different product groups. Let’s now say that you’re still a PVCu fabricator but all of your sales are based on selling an installed service to homeowners. However, this time you also sell conservatories. Your sales and advertising costs may be similar for both products; but conservatories require a roof, and also involve a significant amount of building works. So the cost structure of supplying and installing a conservatory is entirely different from that of windows and doors. Once again, if you lump these two product groups together, how do you know where you’re making money and where you’re not? And once again, you don’t.

Your accounts must be structured to provide a margin breakdown for all your key product groups and market channels so you have an accurate understanding of the true margin made by each one.

Moat accounting software can handle this type of analysis as a matter of routine; but it does have to be set up correctly to do so; and that’s where the main problem lies.

I’ll now move on to the second problem I encounter, which is all about whether costs are classified as direct costs or as overheads. Direct costs refer to materials, labour and expenses, related to the production or supply of a product or service. Other costs, such as depreciation or administrative expenses, are more difficult to assign to a specific product or service, and are, therefore, considered as overheads.

Many SMEs classify materials and direct labour as direct costs but almost everything else as overheads. And this can be very misleading. Let’s go back to the business selling windows and conservatories on a supply and install basis to the homeowner. Not only does this business have materials and direct labour as direct costs, but it has installation labour and materials, disposal of site debris, survey costs, sales commissions, lead generation/advertising, finance/credit card costs, warranty/guarantee insurance. All of these are directly related to the sale, production and supply of the product and its installation. So all should be classified as direct costs.

If you decide to classify only some of these costs as direct, you’ll end up exaggerating your gross profit, which is normally calculated by deducting your direct costs from your sales revenue. You’ll also overstate your overheads because some of your direct costs will be absorbed as overheads. The consequences of this could be quite profound.

Let’s say that the business is barely profitable and that you have to take action to improve profitability. One way of doing this would be to increase sales; you, therefore, put a sales plan together. You think you’re making some good margins so you decide to offer some additional discounts. You also need to spend some more money on advertising and, of course, extra sales mean extra commissions installation costs etc. Everything seems to hang together and off you go. You’re initially pleased with the increase in sales, but when you run your management accounts, the effect on the bottom line is shown to be marginal. You’ve added some volume but for little or no extra profit. So what’s happened?

The problem is that your accounts have mislead you about your margin. Because you’ve only included materials and direct labour as direct costs, you’ve been duped into believing that you’ve been making healthy margins. However, if you’d included all of the other direct costs as direct costs, you’d have found that your margins were in fact very poor; and, once you’d accounted for the additional discounts you offered, it would have been clear that there wasn’t much left.

If you’d known this at the outset, it would have been very apparent that additional volume wasn’t going to provide a solution. The only effective options open to you were (a) drive down your direct costs as a proportion of your sales, (b) increase your selling prices, or (c) a combination of both.

Let’s now look at another problem that can occur as a result of confusing direct costs and fixed costs. Many businesses seeking to improve their profitability, embark on a cost cutting exercise; but they cut the wrong costs.

If many of your direct costs are treated as overheads and you need to make cuts, staffing, process costs, administration, maintenance & renewals etc. are often the soft options that you go for rather than address the more challenging issue of high costs in sales and marketing, installation etc. However, the outcome of this can be catastrophic because, in reality, you still have a margin problem but you’ve cut the basic infrastructure that would have enabled you to address that margin problem by driving down your direct costs.

In the home improvement sector, which is where I focus most of my time, one of the most common problems I see is SMEs that under resource their processes, controls and administration and, as a result, suffer from direct costs that are out of control. Genuine overheads are relatively easy to control because you can make definitive decisions as to whether you proceed with something and spend the money or whether you don’t. Direct costs are much more difficult because they depend on operational efficiency, effective processes, quality control etc. In many SMEs, total direct costs are much higher than total overheads. So controlling direct costs provides far greater potential to improve the bottom line than controlling overheads. In fact, quite often, an increase in overheads is needed in order to provide the resources that are required to bring direct costs under effective control. In this situation, the bottom line may get worse, for a short time, before it starts to recover to the levels, at which it should be.

Once you have your accounts structured to give you really good information about your direct costs and overheads, you can start making these sorts of decisions with confidence.
Many owners and directors of SMEs find interpreting their management accounts quite challenging; so, if that describes you, don’t think that you’re on your own because you’re not. It’s, therefore, very important to have good accounting and bookkeeping support, the scale and structure of which will depend on the size and complexity of your business. It could range from a part-time bookkeeper or bookkeeping service to a significant sized accounts department. But wherever your business is on that scale, what you can’t do, is just let them get on with it, as they see fit, because they won’t understand your business as well as you do. You need to work with them to get the structure of your management accounts right and to ensure that it provides you with the right information in the right way at the right time. If you invest some time and effort in this, it will repay you handsomely.

If you’d like to discuss any of the issues raised in this article, in more detail, please feel free to contact me.

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The UK Window Industry: Balance Sheets & Quicksand

Whilst there are some very successful businesses within the UK window industry, unfortunately, too many are seriously challenged due to their weak balance sheets. This may not have mattered so much during the long years of growth and comparative prosperity but, in today’s saturated market, it’s a crippling disease that the industry ignores at it peril.

Let me support this statement with some facts.

The Plimsoll Report analyses the financial performance of the 1,000 largest businesses in the industry. The table below shows some interesting data from their latest report, published in April 2014.Figure 1

Only 368 of the 1,000 largest companies saw their net worth increase during the previous year and 160 saw theirs remain static. So less than 50% actually increased their net worth. The report also shows that the average net profit for this group of businesses, during the last year was 2.3% of sales, which is a very low average indeed and suggests that there are a significant number of serious loss makers, balancing out a few star performers.

The pie chart below shows Plimsoll’s categorisation of these 1,000 businesses in terms of their strength and sustainability. 227 are classified as being “in danger” and another 90 categorised as “caution”.Figure 2

So, although 578 are either strong or good, a very large proportion of these businesses are relatively weak and, as we see from the above table, are either stagnant or declining.

The report also points to increasing polarisation between some highly successful businesses, building on their success and, at the other extreme, a very significant number of businesses in decline, to the extent that, without some form of intervention, they are at an increasing risk of failure.

Remember, we’re talking about the top 1,000 businesses in the industry, which according to Insight Data has around 14,000 businesses active within it. So, if this is the picture painted of the top 1,000, it’s fair to assume that the collective position of the smaller businesses is even worse.

To test this hypothesis, I undertook a small experiment.

From the GGF website I selected 10 businesses that were GGF members. I disregarded the larger names that would have been part of Plimsoll’s top 1,000 and I also disregarded all smaller businesses, of which I had any prior knowledge. So all ten that I selected were completely unknown to me; but to try and provide some regional balance, I ensured that my selection was distributed around the country. Having made my selection – and it’s important to note that I selected the companies, without any prior knowledge of their financial status – I then obtained their latest accounts from Companies House. For all but one company, the accounts were abbreviated, in line with small company rules.

The table below shows, in an anonymised format, some key balance sheet figures for all ten companies.Figure 3

Of the ten, there are two really good businesses (Company A & Company B) with strong or fairly strong fixed asset bases, good liquidity, represented by high net current assets, and significant shareholders’ funds (net assets). What isn’t shown, in the table, is the fact that Company A substantially increased its net worth over the previous year. So here we see two businesses in comparatively strong positions.

By contrast, Company J is balance sheet insolvent, having net liabilities of circa £20k. It’s difficult to tell from abbreviated accounts how the business is able to continue trading. It has net current liabilities of £30k, indicating a significant liquidity problem; and it has minimal fixed assets of £12k. So it’s either hanging on by the skin of its teeth, lurching form crisis to crisis, or it’s being supported by a kindly creditor or shareholder. Realistically, this business needs to embark on a major transformation strategy, which, in the absence of any significant cash, may be very difficult. But without this, the prognosis is unlikely to be very good.

The remaining seven businesses are all solvent, from a balance sheet perspective; but their nets assets (shareholders’ funds) range from virtually nothing to not a great deal; so none of them is in a strong financial position and two of them, Companies G and I, have net current liabilities, suggesting a very tight liquidity issue. Of the seven, only Company G has significant fixed assets; but that’s offset by its net current liabilities.

Based on this analysis, I’ve classified 20% as stars or stronger performers, 40% as chugging along but quite vulnerable, 30% as more seriously challenged and 10% as insolvent. This is a significantly worse position than that shown by Plimsoll for the top 1,000 companies. But if the systems companies and some of the large trade fabricators were to analyse the balance sheets of the companies, making up their customer networks, I have little doubt that they would find a very similar pattern. And this is the nub of the industry’s problem. We have a comparatively small number of larger capital intensive players, at the core, dependent on supply chains that are built on quicksand.

Roughly, 80% of the industry’s output to the final customer is via these small businesses, 80% of which range between vulnerable or insolvent; and that isn’t a foundation for a successful long term future.

So what can we do about it?

In my view we need to consider this very serious challenge on two distinct levels, namely strategic and cultural.

At the strategic level we need to move away from the current laissez-faire supplier-customer relationships, with each level of the supply chain and each business, within the supply chain, doing its own thing, in its own way, and often not very well. And we need to move towards strategic alliances that enable entire supply chains to act in a co-ordinated way, based on common standards, systems and processes and under the umbrella of a single brand.

A homeowner in Newcastle upon Tyne, buying from a fabricator/installer of Systems Company X should receive the same product, quality and service levels as a homeowner in Truro, buying from the Systems Company X fabricator/installer in Cornwall. The processes and systems deployed should be identical throughout; and the total brand experience should be exactly the same, just as it would be if these two customers were buying from a large national brand such as Everest or Anglian.

I’ve waxed lyrical, in previous articles, about the issue of small businesses in our industry having no brand, on which to base their business/marketing strategies. The systems companies and large trade fabricators have commoditised the product to an unprecedented extent; and to an extent that does not exist in other building product or home improvement markets. Other than the 20%, or so, held by the large national brands, most of the market is price driven, with an unrealistic belief that good selling can deliver premium prices in the absence of a brand. Good sales reps can undoubtedly achieve higher prices than poorer sales reps; but there aren’t enough of them; training is a never ending journey because of the high turnover rate, within sales forces; and, in any case, the higher rates that the good reps do achieve are relative to the levels of their own sales forces not to the levels of a premium brand.

It’s no wonder that we have so many unprofitable or marginally profitable small businesses within the industry. On their own, they’re not big enough to develop strong brand positions. They rely on local reputation, which is very difficult when, at best, their product is only purchased, by the end user, a few times in a lifetime. Some do break through to become significant local or regional brands; but these are a small minority and, even then, their own perceptions of their brand strength can sometimes be considerably greater than an independent brand recognition survey would assess them to be. Many of these small businesses are left, by the systems companies and large fabricators, to fend for themselves, often without the management and business skills that they need to run a successful, profitable business.

There can be several different ways of creating more cohesive networks under a single brand; and the precise structure is not the key issue. However, there are four important requirements.

The first is that there is a core organisation, at the heart of the network, that implements and monitors performance standards over the product range, productivity, operational efficiency, quality, systems, process and service levels. This could be a systems company, a large fabricator or some other third party; but all businesses, within the network, must be contractually bound to adhere to those standards.

The second is that each business, within the network, must have real and meaningful business support available to it. This doesn’t just mean marketing support of one sort or another. It means that they need support that will enable them to manage their businesses better, achieve high levels of operational performance, make good profits and build strong balance sheets. Everything from HR to PR; from production to installation; from financial control to administration; from IT to process and systems; from management to organisation structure. Support in all of these areas needs to be available to help the businesses, within the network, build on their strengths and really get to grips with their weaknesses.

The third is that the whole organisation must go to market under a single brand, with co-ordinated advertising, PR and lead generation strategies; albeit tailored to suit local circumstances. This could mean a franchise type arrangement, where the franchisees only use the core brand e.g. McDonalds or Body Shop; or it could be a dual brand with an identifiable independent business selling a branded product range – System X from ABC Windows. Either way, there should be a single, state of the art website, enabling the brand to be properly managed, developed and controlled, rather than many small, often not very good, websites with a wide range of uncoordinated brand messages, giving rise to hopelessly confused brand values.

The fourth is that all this has to be paid for; and each level of the supply chain – systems company, trade fabricator and retailer/installer – must accept their share of the cost. Again, there are many different ways of achieving this; but one thing is for sure, neither the systems companies nor the large trade fabricators can fund it on their own; so it must be a cost to the entire network, but proportional to each layer of the supply chain and to each business within it.

Developing a network with a good, well managed product range, supplied through a group of disciplined businesses, all optimising their operational performance and service levels, will bring significant financial rewards at all levels of the supply chain. And if this happens under a strong brand, the network, as a whole, can determine where it wants to position itself in the market and the price levels appropriate to that position.

This last point is incredibly important. Not every network can be a premium brand, going to market with a premium price. Some will need to be value brands and some will need to be budget brands. The cost structures, within the networks, will need to differ accordingly, as will the brand values that are developed and promoted.

That’s enough about the strategic level. So let’s now consider the cultural challenge.

To achieve the change, from where we are to where we need to be, a significant cultural shift is required.

I’ve talked to many senior people, from within the industry, about the need for the sort of changes that I’ve described. And there seems to be an acknowledgement that the products have been commoditised and that this has given rise to some serious difficulties. There’s also an acknowledgement that, if the industry is going to thrive once again, substantial change is required. But when it comes to the specifics of what that change should be, the barriers often go up and the reasons why things can’t be changed seem to overwhelm the reasons why things can and must be changed. The result, not surprisingly, is inertia and a retreat to comfort levels, which is likely to lead to continued decline.

Somehow, the bigger players must start thinking outside their traditional boxes. So much of our thinking is still influenced by the sales driven philosophies of the 1980s and 90s; but those days are over and the industry needs to move on. The face of retail and direct sales has changed beyond recognition, due to the on-line revolution; and we need to look closely at what happens in other more progressive markets and at the cutting edge of both B2C and B2B developments. There’s so much to learn and we’ve been so slow to learn it. Perhaps we need to bring in more people from more dynamic retail environments; not just to teach us but to lead us and to give us the confidence we seem to lack. One way or another the major players must initiate the changes that the industry needs because it can’t continue to exist on a foundation of quicksand.

But a different culture is not just needed amongst the larger players, it’s needed within many smaller businesses as well. Many of them really must raise their games; and this is something, with which some will struggle to come to terms. But they need to manage their businesses better so they can generate more profit, strengthen their balance sheets and create greater long term sustainability. But without help and support, of the type I’ve described, this is often very difficult for them to achieve; and sometimes impossible. So whilst I’m urging the systems companies and larger fabricators to develop more controlled networks, with far more support for the businesses in their supply chains, the smaller players need to accept that they may need some help and that they will lose some independence, as the price they pay for support from the network, of which they become part. At the moment the supplier/customer relationships, within the various supply chains, are a free for all that are, in practice, damaging many more businesses than they are helping. The network approach is that each business, within the supply chain, is part of and contributing to a larger team. But the strength of the larger team, within the market, is greater than the sum of the strengths of the individual businesses.

If we can start to address these cultural issues, the changes that are needed will start to flow.

On a final note, there are actually some encouraging signs that movements in the right direction are beginning to happen, albeit very slowly.

The US building products giant Masco is now well established in the UK window industry; and, whilst it’s still a bit of a sleeping giant, it’s hard to believe that it won’t want to develop a more dominant position over here. When it does, it will start to put some real pressure on the indigenous industry to change.

Similarly, Internorm, the leading European window brand, seems to be showing some increased interest in the UK market and this may also add to the potential pressure from Masco.

On the home front, Epwin’s recent news that it’s floating on the AIM market and appointing a new Chairman is very interesting. Peter Mottershead was a previous CEO of Anglian and brings some serious retail experience to Epwin. So we could see some interesting developments and perhaps a much greater emphasis on the Swish brand, which although a household brand name, remains only a small part of Epwin’s business. Perhaps it’s another sleeping giant that is starting to stir.

Network Veka is currently by far the most advanced network in the UK window market and has created a very successful organisation focused on first class service levels and operational performance. It’s associate Veka UK, now owns the Halo brand, which was originally designed as, and intended to be, a consumer brand (As the first CEO of Bowater Halo, I wrote the original business plan!). It’s not hard to imagine a “Halo” branded product supplied through Network Veka; that could be very powerful, so who knows.

The Conservatory Outlet is almost the opposite of Network Veka. It’s a fast developing network of independent businesses, all going to market under a single brand, based on a modern, on-line marketing strategy, using a single website. It seems to have some strong legs and, whilst still comparatively small, may be showing the way to some of its larger rivals.

Imagine combining the operational disciplines of a Network Veka type organisation with the brand management and marketing strategy of a Conservatory Outlet type organisation. Eureka! We’re getting there slowly; and someone is going to join the dots up before very long. And when it happens that organisation will be catapulted into a commanding position, within the market, with others being forced to play catch-up.

It will be interesting to see who gets there first. Epwin with Swish? Veka/Network Veka with Halo? The Conservatory Outlet by extending its business model? Or perhaps a current outsider? Polyframe, the Halifax based trade fabricator, has been taking market share very successfully, resulting in controlled and profitable growth. This has involved a number of strategic alliances with other fabricators/retailers; so perhaps its next move could be to extend its business model to incorporate a Conservatory Outlet type brand and marketing strategy. Who knows?

The changes that I’m advocating are starting to happen, albeit in a small way and perhaps without all the dots being joined up yet. But to return to my starting point about weak balance sheets and foundations of quicksand, things need to speed up. At the moment there is still too much resistance to change, a lack of vision, too little mould breaking strategic thinking and not enough energy and resources being applied to shaping the future. If we’re going to create a firm foundation for the future and address this debilitating balance sheet problem, this must change; not tomorrow or sometime/never; but today.

Better Times Ahead

Most economic indicators are now pointing to a recovery.

• The economy is growing
• Manufacturing and services are up
• Unemployment is continuing to fall
• Inflation is below 2%
• Living standards are beginning to recover, albeit slowly

Under these circumstances, business confidence is on the increase. However, over the last few years, small and medium sized businesses have had a tough time.

• Profits have been low
• Balance sheets have weakened
• Cash has been under pressure
• Investment in plant, equipment and infrastructure has been supressed.

So, it’s inevitable that many businesses remain very cautious. Nevertheless, as markets continue to recover, businesses do need to gear up; and being over cautious is likely to lead to lost opportunities and being left behind by your competitors.

So Think About Your Business

• Is your business model working effectively and still relevant to current and future market conditions; or does it need to adapt?
• Is your marketing strategy working; or have you been left behind by the fast moving on-line revolution?
• Are your products/services state of the art; or are they getting tired?
• Are your processes and systems as efficient as they need to be; or are they becoming cumbersome?
• Is your productivity as good as it should be; or are your direct costs too high?
• Are your quality standards under effective control; or are you getting too many complaints?
• Is your organisation structure fit for purpose; or has it become dysfunctional?
• Are you supporting your employees effectively; or are too many underperforming?
• Are your customers happy; or are they drifting to your competitors?

In all honesty, very few businesses can tick all of these boxes. Sadly, some can tick very few, whilst the majority fall somewhere between these two extremes and, therefore, have the opportunity to raise their game.

How Can You Raise Your Game?

As an owner, director or senior manager of a small or medium sized business, the first thing you need to do, is to be honest with yourself about the state of your business; good or bad. Then remember that you don’t necessarily have all the skills and experience needed to address the weaknesses your business might have, or exploit the opportunities that the market might present. Recognising that you aren’t superman or superwoman is a strength in itself.

Next, think about how you can spend more time working “on the business” and less time working “in the business”. That probably means more delegation of responsibilities; and remember that a failure to delegate is often more about your own inclination to micromanage, rather than the lack of competency of the people, to whom you should be delegating.

At this point, you can start to take a more considered view about the strengths and weaknesses that your business has, and you can be more objective about the opportunities and threats that exist. So you can now start to plan. Look at where you want to take the business and assess the resources you’ll need. Compare these with the resources you have. Then consider how, and over what time frame, you can acquire the resources you need but don’t have, as well as offload the resources you have but don’t need. This is all about developing a properly focussed strategy; and, once you have this, you can start to work on a more detailed business plan.

Now back to the point about your own skills and experience. For many owners, directors and senior managers of small and medium sized businesses, strategic planning and change management isn’t familiar territory; and if that is true for you, you have three options.

The first is do nothing, carry on as before and chance that everything will turn out alright in the end. It’s high risk but it might just work.

The second is to go it alone and to try and find your way through. If you do that, you may get there eventually, but the chances are you’ll take some wrong turns, get lost, have to retrace your tracks and end up taking much longer to reach your destination, whilst incurring substantially higher costs on the way.

The third is to hire a guide; a business advisor, familiar with the territory, who can steer you to your destination via the shortest and least costly route. Business advisors cost money; but the right business advisor will cost you a fraction of what it would otherwise cost, by the time you’ve taken several wrong turns en-route.

The changing economic climate means that small and medium sized businesses, which have battened down the hatches for the last few years, can increasingly start to take a more proactive position. But most markets are likely to remain highly competitive; so focused strategies, well developed business plans and ever increasing levels of operational excellence are essential to long term sustainability.

Cash v Profit

The UK economy is coming out of recession; that now seems to be the general view of economists, politicians and business. In fact growth in the July to September quarter was 0.8%, which equates to an annual rate of around 3.2% and is the fastest growth rate of all the G7 countries, over the last quarter. Even better is the fact that all sectors of the economy – services, construction and manufacturing – are growing.

This is all great news and let’s be thankful that, at long last, there’s some light at the end of the tunnel. However for small and medium sized businesses, it presents some new challenges and I’d like to highlight some of the more significant ones.

The last recession was longer and deeper than any other recession since the Second World War. But it has shown some very different and perhaps unexpected characteristics.

Consider employment and unemployment. The following tables show changes in employment statistics between August 2011 and August 2013. I’ve extracted all of the data from official figures prepared by the Office for National Statistics.

People in Employment

People in Employment

The number of people, aged 16 – 64, who in theory could have been working has risen by 101,000 (0.3%). But the numbers in employment will always be much lower than the total number in the 16 – 64 age group, which includes students, people who have retired early, people of independent means, people who are sick, disabled etc. However, the really significant factor is that the number of people, in employment, has increased by nearly 600,000, which means that many jobs have been created or existing vacancies filled; and there are proportionately fewer people, under the age of 65, who are economically inactive.

Economically Active & Unemployed

Economically Active & Unemployed

My second table shows that the number of people, between the ages of 16 and 64, who are economically active, has increased by 700,000 over the two year period; and yet, the number of people, who are unemployed, has fallen by 90,000. These first two sets of figures seem to disprove the suggestion that the unemployment figures have fallen, due to people being reclassified as economically inactive and in receipt of other benefits. The new jobs do seem to be real and the fall in unemployment does appear to have happened.

Full Time v Part Time Employment

Full Time v Part Time Employment

My third table shows that the number of people, working part time, has gone up by 269,000; so some of the new jobs have been part time. However, the number, working full time, has increased by 519,000. The notion that most of the new jobs are part time is, therefore, a myth. Most of the new jobs are, in fact, full time.

All of this has been happening at a time when public sector jobs have been cut by 437,000. So the private sector has actively created over a million new jobs, most of which are full time. And this has happened, during a recession, which is unprecedented. It also means that the wealth creating part of the economy has increased its capacity, which is now likely to be underutilised. But that, in turn, means the private sector should be able to support significant growth, as the upturn gathers momentum.

However, there is considerable evidence that salaries and wages have fallen and that living standards have been supressed. Furthermore, despite the loss of nearly 450,000 public sector jobs, over the last two years, public sector jobs now command a 6% premium over private sector equivalents, according to the “Policy Exchange” think tank. This all points to many private sector employees having had no pay rises for some considerable time and to people leaving public sector jobs and taking lower paid jobs in the private sector.

Understandably, the political focus is now moving from economic growth and unemployment to the cost of living. In reality, it is quite normal for real wages to continue falling during the early stages of a recovery. But it’s also normal to see pressure building up for wage increases; and realistically, there is likely to be a period of catch-up over the next two or three years. The challenge for business is to ensure that the higher wages that ensue, are paid for through productivity improvements and don’t just inflate costs. However, that should be possible due to the extra private sector jobs and capacity that have been created.

Another factor to consider is that the rate of business insolvencies has been considerably less, during this recession, than during previous recessions. And much of this is due to the banks, which have tended to leave struggling businesses to continue struggling, rather than calling in loans and appointing administrators. But the downside is that there are now a huge number of zombie companies that can barely generate enough cash to service the interest on their debts and keep their creditors at bay. The UK’s largest insolvency practitioner, Begbies Traynor has calculated that there could be as many as 432,000 businesses in this category.

If we now start to join up all the dots, a picture is emerging of a whole raft of businesses, particularly small and medium sized ones, which have weak balance sheets, high wage costs, upward pressure on wages, suppressed profits and cash flow difficulties. Add to this, a lack of investment in infrastructure, IT, R&D, plant & machinery and training and it’s clear that many of these businesses will struggle to invest and grow as the economic recovery gains momentum. Indeed, there is a developing school of thought that, because they will act as a brake on the recovery, it may be preferable to steer many of them towards administration, thereby releasing their employees to work for stronger businesses that can fully exploit the recovery.

I don’t want to get into the political arguments of whether this is right or wrong but I do want to emphasise, to owners of small and medium sized businesses, the importance of developing robust business strategies that take account of these very real challenges. I’ve written a series of articles about many aspects of planning and managing small businesses but, on this occasion, I want to focus on the difference between cash and profit because having a clear understanding of those differences is an essential part of developing a realistic and achievable growth strategy that is able to capitalise on the current recovery.

Depending on your type of business, it is perfectly possible to run a significantly loss making business, whilst generating a substantial cash surplus; at least for a time. It is also perfectly possible to run a profitable business and have a serious cash shortfall. So let’s look at this in more detail.

First of all consider a Business to Consumer (B2C)/retail business. It receives payment for its goods/services at the point of sale. In some cases it may have even taken a deposit prior to the point of sale. So it’s generating its cash very quickly. However, it may be paying its suppliers and employees a month in arrears. The following table is a very simple profit and loss account and cash flow statement for a £1m turnover business doing precisely as I’ve described.

B2C Business £1m Sales

B2C Business £1m Sales

This business has sold goods or services to the value of £1m and has collected all of the cash from those sales during the year; but it has made a loss of £50k because its total costs have exceeded its sales revenue. However because it is paying its suppliers on net monthly terms and its wages a month in arrears, it has only paid for 11/12ths of its costs; so its cash outflow has been less than its total costs. As a result it has generated £37,500 of cash, albeit, it still owes its creditors £87,500.

If the sales and expenditure figures, in the P&L, remain the same in the second year, the cash gain, in the first year, will have been a one off because the business will pay out 11/12ths of its costs for year two plus the final 1/12th for the first year. As result, it will have a net cash outflow equal to its loss i.e. £50k.

But now see what happens if, instead of remaining static in the second year, the business increases its sales by 20%, whilst maintaining its overheads at the previous level.

B2C Business £1.2m Sales

B2C Business £1.2m Sales

It still makes a loss, this time £10k. But it benefits from collecting all £200,000 from the additional sales but only makes payments for 11/12th of the additional cost of sales. As a result it generates £3,333 of cash. So over the two year period, it has made cumulative losses of £60,000, whilst generating £40,833 of cash

If, on the other hand, the business reduces its sales, in the second year, by 10%, whilst still maintaining its overheads at the previous level, a very different picture emerges; and this is shown in the next table: –

B2C Business £900k Sales

B2C Business £900k Sales

Not only do the losses increase due to the lower sales volume, but the cash drain is even greater. Cash in is reduced by £100,000 due to sales also being £100,000 lower, resulting in a loss of £70,000. However, payments related to the cost of sales, drop proportionately less because they include 1/12th of the cost of sales from the previous year, which were 10% higher. So the cash outflow is £76,667 i.e. £6,667 more than the actual loss. Over the two year period, this means that the cumulative losses would have been £120,000 and the net cash out £39,167.

This is a classic problem for many B2C/retail businesses. They embark on a growth strategy funded out of cash flow rather than profit. Providing they don’t let their overheads expand at a faster rate than their sales, they can keep growing and maintain a positive cash flow, often for several years, whilst continuing to generate losses. However, at some point, the crunch inevitably comes. Growth grinds to a halt; sales decline for a period; the cash disappears and bang! the business goes bust. The home improvement market is an example of a sector that has a large graveyard of companies that collapsed in this way; and some of those failures were quite spectacular.

Now let’s consider the reverse problem.

Take our £1m turnover business but, this time, let’s assume it’s trading Business to Business (B2B); that it’s profitable but gives its customers ninety day terms, whilst paying its suppliers in thirty days. The next table shows simple profit & loss and cash flow statements.

B2B Business £1m Sales

B2B Business £1m Sales

Here’s a nice little business making a modest profit of £25,000 but, because it has only collected 9/12th of the cash from its sales and has had to pay out for 11/12th of its costs, it has had a net cash outflow of £143,750, which it has had to fund.

If its P&L was to remain unchanged during its second year, then it would collect £1m of cash from its sales (3/12th coming from the first year’s sales); and it would pay out twelve months’ costs (1/12th from the first year’s costs). It would, therefore, generate £25,000 of cash.

As with our retail business, the second year’s cash flow would match the profit or loss generated, providing sales and costs remained the same. But let’s see what happens to this business if it grows by 20%, whilst holding its overheads at the same level as in year one.

B2B Business £1.2m Sales

B2B Business £1.2m Sales

A sales increase of 20% would result in a profit of £65k (+160%). Cash flow would benefit from collecting three months’ cash from the previous year, as well as nine months from the second year. But cash from three months of the incremental sales, in the second year, would not have been collected by the year end, so the cash generated would only be £41,667.

The cumulative profit for the two years would be £90,000 but the cumulative cash position would show a net cash outflow of £102,083. It would, therefore, take several years of this type of expansion to recoup the initial cash outflow from the first year. And this assumes that overheads could be maintained at year one levels, which may be unrealistic.

Now let’s see what would happen if we go for a 50% increase in sales. In this case we’ll also assume that overheads would increase proportionately.

B2B Business £1.5m Sales

B2B Business £1.5m Sales

The net profit of £37,500 would be higher than in year one but would be suppressed by the additional overheads. But there would have been a net cash outflow of £6,250 because the cash from three months’ worth of incremental sales would not have been collected. So, in this scenario, there would have been two years of cash outflow, totaling £150,000 despite profits of £62,500, during the same period.

For businesses of this type, growth can be quite tricky. It needs to be planned and it needs to be controlled because, even though the business may be profitable, it may not have the working capital it needs to fund the growth it would ideally like to achieve. In a worst case scenario, it could fail due to over trading.

There are, of course, ways of funding the working capital needed to support growth; invoice discounting being one option. But however it is done, it involves a cost, which impacts on both profit and the amount of cash required. So there is a balance to be struck that keeps the costs manageable, the bottom line sufficiently profitable and the level of growth supportable.

For most small and medium sized businesses, the recovery shouldn’t be a signal for a mad dash for growth because rapid growth has its risks. For B2C/retail businesses, the risks tend to revolve around throwing money at growth because the cash is available in the bank. But costs then tend to get out of control, which hits profitability and ultimately leads to a crisis. For B2B businesses the risks tend to be around over trading, the inability to fund growth and the risk of running out of cash, which also ends up in a crisis.

Stronger businesses will obviously want to capitalise on the recovery and should of course do so; but it’s important that their growth strategies are properly planned, resourced and controlled. It’s also vital that funding is in place to support the growth plan and that the incremental sales make a real contribution to the bottom line. Whether you run a B2C or B2B business, both cash and profit need to be properly managed; and focusing on cash at the expense of profit or profit at the expense of cash is a road that invariably leads to a crisis. Get all this right and the business should grow and prosper; get it wrong and the business could be in trouble.

But what about the many zombie companies that now exist? Well, I’m afraid that some harsh truths may need to be faced. The first is that most of them are where they are due to bad management not bad luck. The second is that some of them are probably past the point of no return and just don’t have a viable future. For those that do have a chance of recovery, they really must address the underlying strategic, operational and management deficiencies that are responsible for their current predicament. Only when they’ve done this and can demonstrate a turnaround are they likely to get the support that they need, from suppliers, customers, banks and finance houses, to put in place even a modest growth strategy. But with the right approach and the right help, I’m sure that many of these zombie companies could be brought back to life.