If you didn’t keep to your New Year’s resolutions last year, you’re not alone. A national survey conducted by finder.com.au found that 58% of Australians – an estimated 11 million people – broke their New Year’s resolutions in 2015 . But, the good thing about setting yourself New Year’s resolutions is that we all get the opportunity to have a fresh start each year and try again.
The survey also detailed that 21 percent of Australians failed because they made too many resolutions. Did you make any New Year’s resolutions for your business this time last year? Did you attain your financial goals, and ready yourself for the New Year? If not, incorporating a business goal into a resolution is a great way to maintain good financial health.
Despite the longstanding tradition of making New Year’s resolutions (born from Roman mythology and a god named Janus in 153 B.C), many fall off the radar after just two weeks. This year we’ve come up with five easy and effective New Year’s resolutions that every business owner should focus on for a prosperous 2017.

Resolution #1:

Realise that your business is just a pot of money – your money.

Fundamentally, every business is the same. They use capital to produce a profit. In our “pot” we usually put equity capital (money belonging to the owner and reinvested profits) and debt funding (obtained from the bank, leases, HPs, etc.) – the inputs of the business. Out the bottom of the “pot” drops sales, less expenses to leave a profit – or the outputs of the business. The key is to maximise outputs and minimise inputs.

Resolution #2:

Decide what rate of return you want from your business.

Think about how you have arrived at that rate. After all, you can get around 4% in ten year, risk-free government bonds. On a broad portfolio of publicity traded blue chip stocks you should expect a long term average of around 12 per cent. Therefore, you should generally expect a higher rate of return on the capital invested in your business, which is not publicly traded (i.e. easily sold) and usually in one industry, not a broad portfolio of companies. As a guide, we recommend you start with a minimum expected rate of return of 20 per cent, but this will vary depending on the riskiness of the business.

Resolution #3:

Get to know the financial “drivers” of your business.

Is your business volume driven? Is it margin driven? Is working capital a key driver or are you in a capital intensive industry with large investment in plant and equipment? It’s no use selling more if it is at the expense of margin and you end up making less profit. Either way, you need to know in what area, changes will give you more “bang for buck”.

Resolution #4:

Many small changes can make a big difference.

Some business owners think their panacea can be achieved by simply increasing prices or increasing sales. Based on my experiences, small changes made to a handful of areas can have a multiplied effect on return on capital employed (ROCE). Focus on the key driver for your business but also look at other areas including working capital management, under-utilised assets and margins.

Resolution #5:

Understand what your free cash flow is.

Finally, profit is opinion—cash is fact. You can still make a profit but have no (or negative) cash flow. This is because management decisions and accounting policies have an impact on how profit is reported. Assumptions are also made regarding depreciation rates for plant and equipment and these also impact on profit. Businesses are also growing, which means more and more cash is chewed up in more and more stock, debtors and plant. Many fast growing businesses have gone broke through lack of cash flow.

We hear a lot about corporate governance, particularly in the press when things go wrong at some of the country’s biggest companies. But what does corporate governance for SMEs mean in reality and how is it relevant to the vast majority of companies that class themselves as small or medium sized businesses?

When I talk to many people through my role as Audit Director at MGI, I often hear that “corporate governance is only for larger companies and besides, I’m too busy running the business.” There appears to be a high level of scepticism towards corporate governance as the view is that is another level of unnecessary compliance for no benefit.

However, corporate governance is not about compliance and hindering a business, it is about establishing a framework of processes and attitudes with a view to adding value to the business, helping build its reputation and ensuring its long term continuity and success. Good corporate governance generally delivers major advantages in circumstances such as when a business is looking to sell, raise funds or just improve its overall financial performance.

Unfortunately the vast majority of information available on corporate governance tends to be only relevant to large listed entities, which makes it very difficult for SME’s to understand what it all means and what the benefits are. However, I have assisted many clients to establish practical ways to adopt certain aspects of corporate governance for the overall improvement of their businesses. Some of these include:

  1. Family owned businesses should establish and document a clear definition of the role that each family member plays. If non-family members are part of management it becomes even more critical that the staff member is fully able to undertake the role without have conflicting views from a range of different family members.
  2. It is important to establish an effective board which meets regularly to discuss the operations and future strategic direction of the company.
  3. There should be a clear division of responsibilities at the head of the company between the running of the board and running of the company’s business. This allows accountability for the operations of the company which the board can critically review.
  4. The board should have mix of skills and experience which allows for more robust debate about the issues facing the business. Obviously the size of the board will be dependent upon the complexity and size of the company and may need to change over time as the business grows and expands.
  5. The board is responsible for managing risk and should maintain a sound system of internal control to ensure safeguarding of the company’s assets and the shareholders’ investment.
  6. The board should be supplied with appropriate information within a timely manner. The more timely the information, the higher chance the board can discuss and if need be, change the direction of the business to address the conditions that the business is facing.
  7. All directors should receive adequate and ongoing training to allow them to keep abreast of key issues of the day.
  8. The board should review its strategic direction on a regular basis.
  9. The board should undertake a regular appraisal of its own performance and that of each individual director.
  10. Levels of remuneration should be appropriate to attract, retain and motivate executives and non-executives of the quality required to run the company successfully.
  11. Establishing guidelines to ensure that private and non-business activities are not pushed through the business.

Many of the above points relate to the operation, size and structure of the board. This is relevant to almost every company in the country regardless of its size or complexity. However, once the company grows, particularly if it grows quickly or expands into different areas, there are additional considerations that directors should give consideration to, including:

  • Appointing an independent chair or director to the Board – this provides the board with an outsiders view of its operations and direction, allowing them to objectively analyse the business without being involved in its day-to-day running.
  • Establish sub-committees including an audit committee and a remuneration committee.
  • Consideration of remuneration should include key people within the business and cover incentive schemes and appropriate remuneration for board members.
  • Consider appointing an external auditor to obtain comfort around the financial results of the company, the effectiveness of the internal control environment and whether the company has established appropriate policies and procedures.
  • Be in regular communication with non-active shareholders of the business, by way of timely and regular updates on business operations.

Good corporate governance really is for everyone and not just for large listed companies. All businesses, regardless of their size or complexity, can benefit from improved corporate governance arrangements. The benefits can include increased accountability of performance, improving both the quality and timeliness of the company’s financial reporting and enabling a board to be united in focusing on the company’s overall strategic direction. The tone of good corporate governance is set from the top and should be filtered all the way down to the bottom ensuring that all staff members live and breathe the corporate culture.

If you feel like your small business would benefit from improved corporate governance processes, feel free to reach out to the Audit and Assurance team at MGI for an informal chat.

Are we using the wrong metrics to assess business success?

So often we hear or see something in the media about a particular business that has “made it”. Usually, it’s a fast growing start up business that has grown out of someone’s garage into a “multi-million dollar business”.

Sorry to be the bearer of bad news – but it is usually NOT a “multi-million dollar business”.

As a society, we seem to have this obsession that the business value is somehow the same as its sales volume. In other words, a business turning over $3m is somehow a $3m business, implying that it is worth $3m. This is rarely, if ever, the case.

In my opinion, this focus on sales (and not true business value) is one of the factors influencing many business owners to chase volume (or sales) at the expense of building a sound, sustainable business over time and why we continue to see business failures reported on an almost daily basis.

It will therefore come as no surprise that my key measure of business success is business value, not sales volume. It therefore follows that every decision a business owner makes should be predicated on building long term business value. Sometimes this may be contrary to sales growth. For example, it is easier to build sales if you simply discount your prices. You’ll have higher and higher sales, but less and less profit. In my experience, this is a downward spiral to the bottom.

On the other hand, adopting a premium pricing strategy and differentiating your product may actually result in slower sales growth. This is not a bad thing. Your sales growth needs to be sustainable. However, if your cost of product remains unchanged then clearly you will make more profit under a premium pricing strategy than a price discounting strategy.

This raises an interesting point. How many business owners actually measure and manage their business value on a regular basis – say yearly? How many actually develop strategy based on whether those strategies will increase the business’ value? How many know whether a particular strategy will increase or decrease its value?

From my 30-odd years of experience, the answer is very, very few. Everyone measures sales and everything else in the financial statements but very few measure their business value and whether they have added or destroyed value in their business.

How to determine my business value?

In its simplest form, business value is added when the business makes a return (on capital employed) greater than the cost of the capital invested in that business.

The capital invested in any business has an opportunity cost. If that capital wasn’t invested in that business it could be invested in another business, in publicly listed shares or in interest bearing deposits in the bank. Either way, that capital would get a return relative to the risk taken with the various investment classes. When you choose to invest your capital into a business you need to ensure that you’re getting an appropriate rate of return reflecting the risk taken. If your rate of return is less than the rate you need to compensate you for the risk on investing in that business, then you’re destroying value, not building value.

So why the predisposition with sales turnover?

In my view, it’s simple – sales feed the ego of the owner or CEO and it’s an easy metric to pick. It is also implicit that if sales are growing, the business must be doing well. Wrong! Look at the corporate collapses in recent months and you’ll see quite a number that have been “fast growing”. I would say, growing too fast.

So, before you get excited (and envious) about some fast growing business you may see reported in the media, ask a simple question – what was their return on capital employed? This is the true measure of business success.

Business owners need to constantly ask themselves the question: “Is my business decision adding value or am I destroying value?”

MGI works with our clients to help them regularly measure the value of their business and strategies to improve this.

The information contained in this article is general in nature and readers should seek their own professional advice in relation to these areas. MGI refers to one or more of the independent member firms of the MGI international alliance of independent auditing, accounting and consulting firms. Each MGI firm in Australasia is a separate legal entity and has no liability for another Australasian or international member’s acts or omissions. MGI is a brand name for the MGI Australasian network and for each of the MGI member firms worldwide. Liability limited by a scheme approved under Professional Standards Legislation.

The economic challenges of the last few years have brought with it a never-ending number of corporate collapses. I was recently asked why businesses fail. Is it the time of year? Is it that businesses are growing too fast and did this come down to the ego of the owner or chief executive? Or is it that management just doesn’t get it? My answer was, yes to all of the above. Let me deal with each of these.

Time of year?

I think it can be the case that for some businesses the run-up to Christmas is their best time for sales. This brings with it the wish or hope that “if we can just get through Christmas everything will be OK”. Unfortunately, unless the fundamentals of the business are sound, the festive season’s trading doesn’t end up being the panacea that may have been hoped for.

If a business looks like a dog, behaves like a dog and barks like a dog – then it’s probably a dog, no matter what time of the year.

Ego – is it a dirty word?

As the saying goes – turnover (sales) is vanity, profit is sanity and cash flow is reality.

Unfortunately, based on my 30 years’ experience, sales growth can often be driven by the ego of the owner or chief executive. Here’s how – “look how good I am”, “we’ve doubled sales in three years”, “business is booming” – all mindsets that feed the ego. And this is fed by the media, with a growing stream of stories about this month’s fast-growing business, only to be next month’s corporate collapse.

What many of these businesses fail to realise is that a fast-growing business is in dangerous territory. There is often a focus on growing the top line (sales). There is less focus on whether the business is profitable and even less focus on how the growth is going to be funded – the cash flow.

Fundamentally, there is only one reason businesses fail – they run out of cash. You can have all the sales you like, but if you don’t have cash you’re out of business. There seems to be this mistaken belief that sales growth will magically fund itself.

Or is it just plain ignorance?

A business owner said to me recently: “You know, we don’t know what we don’t know.” What he meant was that he was blissfully unaware of the key things he needed to know in order to run a successful business.

He had no idea whether his business was performing well. He had no key business performance metrics on which to assess performance. Clearly not all businesses are like this but it begs the question whether failed businesses are measuring and managing the key aspects of their business.

As mentioned previously, there is only one reason businesses fail – they run out of cash. There are three reasons they run out of cash – they grow too fast, they use operating working capital to buy long-term assets (e.g. plant) or they simply aren’t profitable. The key is to ensure you don’t fall into one of these three categories by undertaking good business hygiene.

The sad part is that in the vast majority of cases, business failure can be prevented if owners and chief executives focus on a few key parameters. Here are my key parameters to prevent your business becoming a statistic:

  • Leave your ego at the door. Growth is important, but unless you have the cash to fund that growth you’ll go broke.
  • Know your Return on Capital Employed (ROCE). You’ve got money invested in your business that needs to generate a return. Know how much you’ve got invested and what ROCE you’re achieving and what the drivers are to improve your ROCE.
  • Every business has a Sustainable Growth Rate – know yours. This is the rate at which your business can grow without adversely affecting your debt/equity ratio.
  • Watch your Free Cash Flow like a hawk. Free Cash Flow is simply the amount of cash you have left over out of your profit after funding growth. Many failed fast-growing businesses have negative free cash flow and that is why they fail. If you’re a fast-growing business and you’re not measuring and managing this you could be headed for disaster.
  • Know your Working Capital Burn Rate. Sales growth generally doesn’t fund itself. Know how much additional working capital you need for a given increase in sales. Don’t budget for sales growth in the next year unless you also know this key metric.

If you aren’t being provided with this information and managing it properly, you’re flying blind.

Grant Field works as a business advisor with a number of high growth companies assisting them to achieve a sustainable high growth performance. For more information on our business advisory or accounting services please contact us.

This article has been modified from the original in August 2023 and originally appeared in The Sydney Morning Herald, The Age, WA Today, Canberra times and Brisbane Times.

“If you don’t know where you’re going, any road will get you there”

In my view there are two major problems facing small business when it comes to strategic planning. The first is not knowing where they’re going. This means not taking the time out from “doing it, doing it, doing it” to strategically look at the direction they want their business to head in.

The second, having identified where they are going, is a failure to implement. That is, the things that need to get done, don’t. This is usually because there is a lack of follow up, largely because in small business, the owners are so busy ‘doing it’ that priority is not given to ensuring action plans are implemented.


Now, Where, How

Invariably, I find that one of the biggest issues facing small businesses is simply getting started or not knowing where or how to start. This is completely understandable if the business has not undergone a process like this before.
In my view, the keys to successful strategic planning are:

  • Having a process to work through which helps in formulating the vision for the business.
  • An action plan (i.e. who has to do what, by when).
  • A follow-up program to ensure the action plans are implemented.

The Process

Typically, this involves preliminary discussions with key stakeholders plus a one or two day workshop. The content of the workshop clearly needs to be tailored to the particular needs of the business and the issues they currently face. However, as a guide (and for businesses who may not have been through the process before) I find that including the following items in the workshop content is a good starting point:

  • A strategic SWOT Analysis: I find that most business undertake a SWOT Analysis but miss its real value. I recommend using the SWOT to actually develop strategy. That is, having identified the strengths, weaknesses, opportunities and threats, I then ask the following questions:
    • How do we use our strengths to capitalise on our opportunities?
    • How do we prevent our weaknesses limiting our opportunities?
    • How do we use our strengths to overcome the threats?
    • How do we prevent our weaknesses from compounding with our threats?
  • Create the vision: Do you have a clear vision as to where you want to take the business going forward, and do all the key stakeholders share that vision? My experience is that some work may be required in this area for most businesses. When a business can’t create the vision of where it wants to go, the development of action plans is useless. Again, it is often useful to use a process to help in formulating a clear vision for the business and obtaining “buy in” from all stakeholders.
  • Identify your Sustainable Competitive Advantage (SCA) i.e. why should your customers buy from you rather than your competitors? Sometimes there is also a lack of clarity as to what this is for a business and how you can market to it effectively. Having a clear process is often a useful way to work through this.
  • Categorise your products according to which ones are adding value and which ones are destroying it. I use the BCG matrix. Some businesses manufacture a product that has no future (what we call ‘dogs’) while others may have great market appeal and high profitability (we call these ‘stars’). Each has different characteristics and life spans. It is important to understand your ‘dogs’ from your ‘cash cows’ and ‘wildcats’. Many businesses don’t do this.

The Action Plan

I believe that a crucial part of the process is developing and documenting a “one page plan”. This is a living breathing document detailing who has to do what, by when. If your business plan doesn’t have this then the chances are that very little is being implemented. The one page plan clearly sets out where the business is NOW, WHERE the business is headed and HOW the business will get there.


The Follow-Up

This can be a real trap for some businesses. They go away with a clearly defined vision and action plan stating who has to do what, but nothing happens. We call this FTI or Failure to Implement.

My experience is that just holding a workshop will not get you where you want to go. It is imperative that afterwards you have someone, usually sitting in on your monthly management meetings, to guide, monitor and hold you accountable to ensure that the action plans are being implemented.

An external facilitator can “turn up the heat” when the hard decisions have to be made, but also act as an impartial party to provide an external focus for the business.

All content provided on this blog is for informational purposes only. While every caution has been taken to provide readers with most accurate information and honest analysis, please use your discretion before taking any decisions based on the information in this blog. Author will not compensate you in any way whatsoever if you ever happen to suffer a loss/inconvenience/damage because of/while making use of information in this blog. For more personal advice, contact one of the team who will be happy to discuss relevant issues specific to your personal circumstances.

As business owners we all want to create a growing and thriving business.

However the reality is that some of us manage to achieve this while others seem to potter on in a hard-earned but stagnant existence.

I recently ran a workshop with 15 high growth businesses and we discussed just this. After much debate it became clear that every successful organisation we could name had a very certain and passionate purpose and a clear vision.

I don’t mean the text book statement of purpose that we all learn about in our university days either.


Let me explain.

Each great business understood exactly why they existed and could articulate what it was that made their teams turn up to work each morning.

For example:

Oxfam exists to create a just world without poverty.

Multiple Sclerosis Foundation exists to create a world free of MS.

Temple and Webster exists to be Australia’s most beautiful shopping experience for the home.

These statements aren’t the voluminous, meaningless waffle that we were traditionally taught a statement of purpose should contain or that you so often see hanging on a company’s wall.

They are a clear one sentence statement that describes what it is that is driving the business.


Understanding the why factor

I watched a TED talk by expert Simon Sinek which explains this further. Click here to view this talk.

Sinek argued that people don’t buy what you do; they buy why you do it. Meaning they buy on emotion and then rationalise it with logic.

And yet most businesses focus their marketing communication on non-emotional things like facts and features.

This is because most businesses know what they do but very few know why they do it.

So where does this leave you if you are like many of the business owners I meet and haven’t thought about the very reason your business exists?


As the year draws to a close take the time to reflect on your purpose and vision

  1. Start by reviewing your ‘why’/purpose
    Your why is the inherent driver for you and your business. It is not to make a profit. That is the outcome of doing what you do but it is not why you do what you do. If you are struggling with clarifying ‘why’ your business exists consider using a mind mapping process to expand your mind and provide focus and clarity.
  2. Use your purpose to help define your vision.
    The next step is to develop your vision. If your purpose talks to your heart, your vision talks to your brain. It describes the long-term desired change that results from your organisation’s work and provides a mandate that all work can be measured against. This is your inspiration for rallying your troops. In other words it captures exactly where you are heading to achieve your purpose.
  3. Use both your purpose and vision to guide everything you do
    Your vision should set the direction for how you interact with staff, market to your customers and the criteria you use to make decisions.

Fine-tuning your vision into something that is inspirational can be a real challenge. But with so few businesses really understanding why they exist – this is an opportunity to stand out from the crowd and is the first step in building a growing business.

Of course developing your vision is just the first step to creating a high growth business. In our next newsletter we will discuss how to turn your vision into action.

The Federal Government has indicated that they are very keen to support innovative businesses. There are a number of funding options available by way of government grants for businesses that can meet the Government qualification requirements.

If your company has been “experimenting” to try and solve a problem in your business for which there was previously no useable solution you may be eligible to claim those activities under the Research & Development (“ R &D”) Tax Incentive. If you believe your company may qualify you need to register with AusIndustry. That body will determine if your process meets their innovation requirements and, if you are successful, will provide you with a registration number that is then incorporated into your company’s income tax return where you make your claim for the Tax Incentive. There is a separate round of incentives each financial year. Registration is undertaken in the months following the end of the year during which you incurred the costs. Therefore you need to first incur the costs and then seek the incentive after the end of the financial year.

For the 2017 financial year the rates of assistance under the R&D Tax Incentive are 43.5 per cent for eligible entities with a turnover under $20 million per annum and not controlled by a tax exempt entity and 38.5 per cent for all other eligible entities.

The incentive is obtained either as a refund of cash in circumstances where the company has no taxable income or as a rebate of tax where the company does have taxable income.

The R & D Incentive is complex and you should seek advice to assist you to make the appropriate claim. You should be particularly aware that the applicant for grants must be a company.

The Federal Government also operates an Entrepreneurs Programme that provides assistance to innovative businesses. Of particular interest is the Accelerating Commercialisation Grants, which is a merit based programme that encourages and assists small and medium businesses, entrepreneurs and researchers to commercialise novel products, processes and services.

This grant provides up to 50% of expenditure to a maximum of $1 million and includes access to an expert network as well as access to promotional opportunities. More details can be found at https://www.business.gov.au/assistance/accelerating-commercialisation.

A recent addition to assistance available is taxation incentives for investment Innovation Companies. Unlike the R & D Tax Incentives, this scheme is available to persons who invest in companies that qualify. The system is designed to encourage high net worth taxpayers who qualify as “sophisticated investors” to investment in innovative businesses.

The incentives include a 20% non-refundable carry-forward tax offset on investment in eligible companies, capped at $200,000 per investor, per year and a 10 year capital gains tax exemption for qualifying investments held for at least twelve months. For further details of this scheme refer to http://www.innovation.gov.au/page/tax-incentives-investors

You should also be aware that there is also a raft of incentives and assistance available from the various State Governments around Australia. Your local MGI firm will be able to provide you with more specific details.

In a recent article, Planning to Take Control of the Family Business, I talked about the reluctance of family and privately owned business to plan. I opined that “time pressures” and “not knowing where to start” were two of the main reasons for this reluctance.

However, I believe there is another, very important, reason for not planning – basically, a lack of desire. Or, in other words, not enough discontent with the status quo. If the business owner is “content” with the way things are, why plan, why change?

So, how do you assess whether the business owner is “content” and therefore whether there is a desire to plan and a desire for change?

I use a simple model to assess the change potential of any business using the formula:

D x V x P = Change Potential

So, what do D, V and P stand for?

The “D” stands for dissatisfaction or the extent to which you are unhappy with the current position of the business. It is the “why” – why change?

The “V” stands for Vision and represents the extent to which the business has a clear, documented vision which is shared with the key stakeholders. The vision provides the direction. It is the “what” – change to what?

The “P” stands for Plan and represents the extent to which the business has a clear, documented and communicated plan with time and date actions (i.e. who has to do what by when). It is the “how” – how will we achieve our vision?

I then ask my clients to provide a score from 1 to 10 (with 1 being low and 10 being high) for each of D, V and P. What is interesting is that sometimes there is considerable variance in these scores between the various stakeholders, particularly between key employees and the owner of the business. This in itself opens up a worthwhile discussion.

So for example, if they have a documented plan but it is not communicated to key stakeholders and/or it doesn’t have time oriented actions attached to it, then you might rate the “P” as say a 4 or 5. Similarly, if the owner of the business has a vision for the business that is in their head and is not communicated to their team, then you might rate the “V” as say a 3 or 4.

However, in my view the level of the “D” is extremely important in determining the change potential of a business and therefore the likelihood of success in implementing the plan. This determines the level of motivation the stakeholders have to change and therefore the level of motivation to plan for something different – the “fire in the belly” if you like.

If there is a low “D” and all stakeholders are content with the way things are going, why would they be motivated to change? In addition, many people fear change particularly when it is imposed upon them.

Mathematically, then if the scores to the “D”, “V” and “P” are say:

5 x 4 x 3 then the product is 60. Given that the maximum possible score (10 x 10 x 10) is 1000, then to get a percentage simply divide the calculated number by 10. Therefore, in this example, the likelihood of the business implementing change and improving itself is only 6% – a very low likelihood.

However, if for example the scores were a high level of dissatisfaction with the status quo (say 9), the owner has a clear, documented and communicated vision (say 8) and there is a written action plan as to who has to do what by when (say 8), then the likelihood of the business implementing the plan and achieving the vision is much higher (9 x 8 x 8 = 57.6%).

As a final point, if the level of ‘Dissatisfaction’ of the owner is very low or does not exist, (e.g. zero), then any number multiplied by zero equals zero. Therefore, if “D” is zero so too is the change potential, or impetus to change, of the business even if there is a clear documented vision and a detailed action plan. There has to be a desire for change.

The challenge then is to convince the stakeholders of the need for change and that remaining as they are is not an option.

If you would like to find out more about applying this model in your own business or any other aspect of business planning, please feel free to contact me or take advantage of our free Business Development Consultation.

 

The recent collapse of the Dick Smith chain highlights the fact that no business is immune from potential catastrophe. But it begs the obvious question – how can a company as big as this and turning over $1.3 billion – a listed company – fail?

No doubt we’ll hear more in the months ahead as the receivers get to work. However, the lessons are the same for every business – from the corner store, to family businesses, to listed companies.

Fundamentally, there is only one reason that businesses go broke – they run out of cash. So how do businesses (even listed ones) run out of cash and what can you do to avoid it happening to your business?


There are basically three reasons businesses run out of cash.

  1. The first reason is they’re not profitable. They don’t have a cash flow problem; they’ve got a profitability problem. In other words, the lack of cash flow is a symptom of poor profitability (or even losses). Unless you fix your business model and restore profitability, you’ll never get cash flow under control.

I note from prior year annual reports of Dick Smith Holdings Limited that the company had after tax profits of about $19m and $37m in 2014 and 2015 respectively. I also note that an ASX announcement by Dick Smith’s on 28th October 2015 states that the company anticipates 2016 after tax profit being $5m to $8m below previous guidance of $45m to $48m. Whilst the profit outlook was reduced, the company still appears to be profitable.However, it has come to light that the company has significantly written down the value of its stockholding by $6m, effectively wiping out the prior year profits.

  1. The second reason businesses run out of cash is that they use short term working capital to fund the acquisition of long term assets. In other words, they use their working capital (short term funding) to purchase plant and equipment or property (long term assets). If your business is growing rapidly, this is a big no, no. You’ll need that working capital to fund your growth, particularly larger inventory holdings.

In most cases, this issue can be fixed by a sale and lease back of the assets (assuming funding is available). The key is never to use your working capital to acquire long term assets unless you’re absolutely sure you have significant excess and know that you won’t need it in the near future.Again, based on my assessment of the Dick Smith’s annual reports for the past three years, the value of plant and equipment appears to have grown by around $32m from the 2013 year end to the 2015 year end (after allowing for depreciation of about $28m).The cash flow statement indicates that the total amount paid for plant and equipment over the two years was closer to $60m.Bear in mind that after tax profit for 2014 and 2015 totaled around $56m and dividends paid in 2015 were around $35m, which is effectively funded by those accumulated profits. Once that is taken into account, available profit is $21m. If my figuring is correct, this would not be sufficient to fund the above increase in plant and equipment.

  1. The third reason that businesses run out of cash is that they grow too fast. Yes, businesses can grow too fast and it is a situation I see all too often.

Make no mistake, a fast growing business is potentially in danger territory, particularly if it doesn’t have access to an endless supply of funds – and which businesses have that luxury? For many fast growing businesses, this means holding more and more inventory. As the business (and sales) grows, more of the profits are required to be used to invest in more and more inventory to stock more and more stores. If you’re in a business where margins are tight – whammo! – you have lower profits to fund ever increasing inventory. If you also happen to have a business where you give credit terms to your customers, then not only do you have a build-up of inventory, but you also have a build-up of debtors. These have to be funded from somewhere. Unless the business is highly profitable, the profit alone may not be enough to fund that growth. This invariably means going to your friendly banker – and as appears to be the case with Dick Smith – there is a limit to which banks will be prepared to fund your growth.

Again, I note from the company’s past annual reports that inventory levels have increased by around $122m from 2013 to 2015 and debtors (accounts receivable) increased by around $43m, a total of around $165m. This has to be funded from somewhere and if profits aren’t sufficient, then usually the banks are the ones who fund it.Interestingly, the ASX Announcement by Dick Smith Holdings Limited on 18th August 2015 states that since the company’s Growth Strategy was implemented 30 months ago, the company has opened 70 new stores. The company’s 2015 annual report states that 25 new stores were opened in that year and that it intends to open a further 15-20 new stores in 2016.

In my view it is therefore not surprising that the company entered into a $135m syndicated lending facility on 22nd June 2015 (as per its annual report), of which $70m was drawn prior to the June 2015 year end.

No doubt there were other factors at play, however in my opinion the Dick Smith business failed due to a combination of all three of the above reasons. It grew too fast, used short term working capital to fund long term assets and (ultimately after stock write downs) wasn’t profitable. The bottom line is that there was insufficient profitability or insufficient access to funding for growth.

As the saying goes – turnover is vanity, profit is sanity but cash flow is reality.


So, what are the lessons for business owners and particularly fast growing business owners when it comes to managing cash?

In my view there are three key measures every business should be checking on a regular basis, but particularly fast growing businesses.

  • Your Free Cash Flow is a critical measure. Free Cash Flow (or available cash) is simply that. It is the amount of cash you have left out of profit after funding the increase in size of your business. If you’re not measuring and monitoring this then you’re flying blind.
  • Your Working Capital Burn Rate. This is simply the amount of working capital (debtors plus stock less creditors) as a percentage of sales. If this is (say) 25%, then you know that for every additional $1m in sales, you’re going to need $250k in working capital to fund that growth.
  • Your Sustainable Growth Rate. This is simply the rate of growth the company can sustain without adversely affecting its proportion of debt to equity funding. It’s called “sustainable growth rate” for a reason.

Vibrant, growing businesses have an important role to play in our economy. The key is to be able to sustain that growth and it is only by keeping a watchful eye on key financial parameters that this growth can be sustained.

If you are not measuring the three key ratios mentioned above then you are flying blind. 

It seems like every second day I read about another business going into liquidation.

This past year has seen a number in the transport and logistics industry, the most recent being Gregorys Transport. This begs the question – why?

Businesses in this industry operate on small margins and invariably have a lot of money tied up in their trucks. In many cases, these vehicles are owned or leased from a finance company. This means they are effectively a fixed cost and can’t be “turned off” if business drops. The newer the fleet, the greater the capital invested and therefore the greater the fixed cost.

In contrast, a business that contracts out part of its business to owner/drivers has much more flexibility. If business falls off, then it becomes the problem of the contracted owner driver and the business can continue to keep its own trucks busy.

The same principle can be applied to a number of businesses. I saw this when there was a hiccup in the mining boom a few years ago. During the boom some businesses in the resource industry supply chain geared up and bought more new equipment in the belief that this was the new “norm”. Others retained their existing equipment and hired in part of their equipment. When the bubble burst, the latter businesses simply handed the hired equipment back to the hirer. Some of the businesses that geared up with new equipment went to the wall.

Sure, the profit margin on the hired equipment wasn’t as high as on the owned gear (due to the cost of hiring), but it certainly reduced the risk of the business and as we know, higher risk and higher return generally go hand in hand.


So, what are the warning signs for your business?

There are two key warning signs that I look for in any business.

Firstly know the dollar value of the capital you have invested in your business. This includes your stock, your debtors and your capital equipment. Most business owners can tell you what profit they make, but they can’t tell you their capital employed. If this is (say) $10 million and your profit (EBIT) is (say) $1million, then that’s a 10% return on your capital employed (ROCE). For most privately owned businesses that’s not enough given the risk involved.

ROCE is made up of two components – profitability and asset turnover (or activity). Naturally, profitability is simply the percentage that your profit (EBIT) bears to your sales. So, EBIT of $1million on sales of $10million gives a profitability percentage of 10%. This is only half the picture.

Asset turnover (or activity) is the big sleeper that very few businesses have their head around. In other words, how many sales can you generate for the capital employed in the business? If you generate sales of $10million on capital employed of $10million then your activity ratio is 1. This is probably too low and may be a sign of a “lazy” balance sheet.
Depending on the industry, you should generally be above 3 unless you have very high profitability. The multiple of your profitability percentage (in this case 10%) and your activity ratio (in this case 1) is your ROCE (i.e. 10%).

In the transport industry (or other capital intensive industries), your activity ratio will generally be low. That means your profitability ratio needs to be higher to compensate. When profitability is also low (as can be the case in road transport) then you are stuck between a rock and a hard place. Getting the mix right between your profitability and your activity ratio is key.
The second main point to understand is to know your free cash flow (FCF). As the name suggests, free cash flow means “available” cash flow – cash that is available for use in the business. If you don’t have free cash flow you’ll eventually go broke (that is, you have negative free cash flow). There are only three reasons why businesses don’t have cash (i.e. free cash flow).

  1. They’re growing too fast. That is, the dollar increase in working capital and equipment is greater than the profit the business generates.
  2. They’ve used short term working capital to fund long term assets. This is relatively easily fixed through a sale and lease back arrangement.
  3. The business is not profitable. So you don’t have a cash flow problem, you have a profitability problem (which goes back to point 1 above).

If you don’t have your finger on these two key business parameters you’re flying blind. If your business also has a lot of money invested in capital equipment then you’re really in danger territory.

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