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Business basics: the finance fundamentals you need to master for growth

How to use business management information to drive and measure growth

Small to Medium Enterprises are quite exposed to the changes in the external environment. In the earlier phases of their business life cycle and before maturity, SMEs fight for their survivals; some little mistakes and wrong decisions can result in devastating consequences on their going concern.

In this scenario, during the growth stage even if the managers are experiencing profits and increasing sales, significant threats stand around the corner: everything in this phase happens very fast and any organisational weakness and a weak business model could turn an extraordinary moment into a nightmare. It is essential that the SME chases profitable growth and generates cash and profit.

Some of the critical questions that owners and managers need to answer are: Is the business profitable? Is the business generating cash? Is in the long term the financial structure (the gearing, the debt – equity mix) right balanced? In this context, a sound understanding of the financial statement plays a central role.

Cash is different from profit:

A capex investment is a cash out item and does not represent a cost , conversely, the depreciation is an non cash operational expense.

The need for financial understanding is critical and the business must be followed in at least three dimensions.

  • The profit and loss to track the profitability. Is the business is able to generate profits? I.E. revenue covers costs.

  • The financial statement to track the short term cash generation and to monitor the long term financial structure debt/equity mix.

  • The business generate cash and the financial structure, the gearing, is balanced.

The decision makers will face the need to precisely understand and answer to the previous questions, the abrupt change in the environment during the growing stage will add incertitude that must be assessed via financial report.

Effective ways to raise capital to fund business growth

There are some fundamental questions to answer before raising capital. Do I need external finance? Do I need debt or equity finance? Do I need short or long term finance? A general suggestion is to look for external financing when you are at the investor ready stage. Is the company business model efficient? By reworking on the actual term and condition with your customers/suppliers, you may reengineer the cash conversion cycle by reducing the financial needs and improving the DSO, DSI and DPO.

Has the business considered to reinvest the retained earnings? By increasing the profitability and changing the dividends policies you may generate one of the best long -term funding: the auto financing.

To challenge the business model is a necessary step, because the chances to obtain external financing, in case the company presents weaknesses, is remote and unprofitable: the bank will apply higher interest rates and the venture capitalist will require harder term sheets and more control on the business.

The typical medium long term debt finance solution is a loan. The institution, a bank or a private FCA registered company, asks to repay the loan at fixed intervals against a predefined interest rate. This instrument is generally secured by collaterals such as the company’s assets and by covenants, operational constraint, such as limitation to distribute dividends before the repayment of the debt.

On the other side, long term financing could be provided by equity. Equity must not be repaid but is expensive, the company must give away a percentage of its control so that the term sheet and the conditions applied by the private equity could be quite unaffordable.

My personal suggestion is to consider a debt solution if the company is profitable, alternatively a debt/equity mix within a reasonable gearing. If the control is given away, the company should expect to lose some strategical drive and conflicts could rise from the new investor. The venture capital firm could interfere in the company management, they could impose a heavy and bureaucratic reporting.

It is very important that the SME recognises the timing of the underlying asset that needs to be funded. The rule of thumb is that current asset must be covered by current and short term financing, while fix asset needs more medium and long term instruments.

The working capital could be typically covered by short term financing such as overdraft and factoring invoices. Fix asset is covered by long-term financial instruments.

How to fund overtrading

Overtrading often occurs when companies expand their own operations too aggressively with evident issues in term of working capital and financing. Hyper growth represents an opportunity and a threat in the SME business life cycle. This could be a unique opportunity to scale up in a very short time but the risk of over trading is high.

The momentum here is to transform overtrading in profitable growth, but what are the steps that could minimise the risks of overtrading and ride the unique opportunity to scale up quickly?

The first and basic need is to start this phase with a ready and consolidated business model. The company should have developed a consistent and coherent bottom up strategy. Is the market we are targeting in line with our strategy? Some trade off choices between profitability and term and conditions could be suitable: focus on less profitable customers in exchange of better payment terms.

Another tactical area to focus on is the cash conversion cycle. The company should have defined its Cash Conversion Cycle. For instance the company could choose to get on board customers that pay at 60 days instead of 90, even if less profitable. Another component is to control the DSI, days on inventory. The company should operate as lean as possible. The goal is to minimise the lead-time from the receipt of the raw material to the finished good. The DPO is related to the suppliers’ payment and in general the SME tends to match it with the DSO. My suggestion is to apply the norm because it would be risky to annoy the suppliers and lose their loyalty.

In case you still face financial gap in the hyper growth phase, it is possible to access to short term external financial instruments, such as factoring and overdraft. This is expensive, could reduce the operational freedom ie the need to balance the overdraft without notice and introduces some kind of accounting complexity.

Overtrading is risky but if the SME business model is strong and scalable, it is worth taking. It represents a unique opportunity to quickly scale up organically the company.

Financial decision making

Any business decisions will directly / indirectly impact on the financial statements. For sake of simplicity let’s simulate the impact of a strategic and an operational choice that typically decision makers are asked to take.

What is the financial impact of a recurrent strategic decision such as a new investment in a new technology or in a new product line? The effect of this decision will be in term of capex investments and financial returns. The cash out will impact in the financial statements and the returns will flow, hopefully, as additional profit in the P&L. What about product pricing increase? This will directly impact on company revenue, in their receivable and in the cash collection.

Operational day by day decisions such as changing the collection days, will impact immediately on the financial statement and in the generation of cash. All the managers and the decision makers need to have a sound financial knowledge to evaluate the consequences and effects of their choices. Additionally the financial reporting and planning culture should be promoted to all levels and functions, instead of being considered a statutory disclosing exercise, a waste of time keeping few qualified accountants busy.

The importance of business plans

Determine the financial impact of the business decision is important, but not sufficient. The backward looking approach is fine but it becomes effective only if, complemented by forward looking actions. The importance of a control system lies in the fact that it is able to outline what did go wrong and to identify the future corrective actions to bridge the gap.

The growing stage is a complex phase in the company business life cycle, the environment is difficult to predict, there is limited visibility and high uncertainty of the future outcome. In this context there is a prolific school of thought, that recons no utility in the planning and budgeting process especially in erratic periods. Provided that there is low likelihood to hit the projections, better not to produce the budget and save the time and costs. In my opinion the more the environment is unstable the more budgeting and planning becomes key to success. In an unstable environment the company certainly needs to draw a possible scenario, a reference to follow, to evaluate the deviations of the actual results over the projection (backward view) and take actions to recover (forward view). The scenario comes from the company strategy and it will be used as an operational control system to manage the company consistently.

The likelihood to hit the financials in term of profit and cash are low but the budget needs to be accurate not precise. It does not matter that you hit the sales figures and you generate profit in the exact way you expected, but it needs to generate sales and profit in the direction to what was planned.

Without a planning process the company is basically blind and do not have any reference to compare. The company is unable to answer to its basic questions: Are we following the right path ? Are we executing and generating the right level of cash and profit?

More over the budget must be exploded into relevant and operational KPI’s and cascaded through out the organisation to grant an integrated and coordinated system of control.

All the organisation will look at the financials that are more relevant for their functions. Sales and Marketing will look at the Sales and customer satisfaction. Operation to headcount productivity and finance will keep an eye to cash collection and disbursements.

Advice for planning and funding a growth period

Do we have a growth strategy ? Is the growth aligned to our strategy and mission? The company must follow a broad strategy, a SME simply has not enough resources, needs to be focused in some market / product. It could be that the strategy changes over time but this must be controlled , clearly communicated and cascaded thought out the organisation. At the strategic level the company should also determine different growth paths, such as should we grow organically or by external acquisitions? The latter is faster but expensive and very difficult to implement especially if there isn’t a consolidated strong business model.

Are we growth ready?

The company needs to have in place some kind of control system and some KPI’s to follow: A sound financial planning system enters in the equation in order to evaluate the profitable growth in term of profit and cash generation. If the company is not hitting the target it needs to understand why and detect the most appropriate corrective actions. Maybe the overall strategy should be revised, may be some processes must be reengineered.

Do we have the right talents in place?

Developing a strategy is a question of people. You need the right mix of talent and skills playing the same team. On one side the visionaries able to set up the path and on the other side individual able to implement , execute the strategy and reporting the results.


ABOUT Mario d'Aragona :

Mario is a seasoned finance executive, who served as CFO for fire & security, food, energy and clean-tech global companies. He has turn-around experience and managed to re-finance growing businesses.

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