How many times have you thought to yourself:
“I’d love to know specifically the overall financial position of our business – to help with planning” or “I really hope that come next year, we’ll have enough money to pay for the school fees/buy new machinery etc?”
Consistently profitable businesses generally don’t get there (and stay there) because of luck, or chance.
These businesses plan ahead, measure and review their performance – and make adjustments to things that affect their performance and profitability.
How to start? Budgeting and Forecasting…
Successful businesses recognise the importance of understanding and utilising the basic financial information and statements – and using them to their advantage.
A 3-way Budget or Forecast is one of the most effective ways to use your available financial statements to help you plan ahead – and to review and measure your progress.
The 3x way Budget utilises the following financial statements as the basis for forecasting the financial performance and position of a business:
- Profit and Loss Statement – summarises a business’ revenue and expenses over a time period. Provides information about a business’ ability to generate profit by increasing revenue, reducing cost or both
- Cash Flow Statement – summarises how good a business is at producing cash based on its revenue and expenses (linked to the Profit and Loss Statement) and also takes into account other business expenditure (e.g. asset purchases such as machinery) or financing activities for the business (e.g receiving cash from the bank in the form of a loan)
- Balance Sheet – provides information about what a business owns (assets), what it owes (liabilities) and how much is left over for its shareholders (equity) as of a specific date
These 3 financial statements will show how a business has performed historically, however the real benefit can be when they are used as tools for financial forecasting.
Many businesses only consider one or two of these when forecasting or reviewing their position. However in doing so, you don’t get a complete picture of the position of the business.
A positive position on the Profit and Loss Statement is much less attractive if the position on the Balance Sheet shows that your Liabilities are not realistically able to be paid off, or the value of your assets are declining significantly over that period.
Similarly, a projected positive position in the Profit and Loss Statement in 6 months’ time is meaningless if the company is unable to convert that profit into positive cash flow due to delays in payments from customers, or the business has significant other purchases to make in that time, and is unable to remain solvent.
Preparing a detailed 3x way budget is often done at the beginning of the financial year (often requiring input and support from your accountant / financial planner), and should be done over a longer forecast period (typically 1-3 years). Progress against the budget should be assessed regularly throughout the year, and the budget updated where required.
Cash Flow Forecasting
In addition to the 3x way budget, it is critical that short-term cash flow monitoring is also undertaken, to stay on top of near-term fluctuations in cash within a business – to help plan accordingly. Remember, cash flow is the life blood of any business!
Benefits of a cash flow forecast
A cash flow forecast is one of the most important operational and management financial tools. While the Profit and Loss Statement and Balance Sheet are typically standard financial statements provided by your accountant or bookkeeper, a cash flow forecast is generally prepared separately, and requires operational knowledge about the regular cash movements within the company. Cash flow forecasts assist in forecasting cash movements in and out of the business over regular periods (often shorter periods such as monthly or weekly).
- Forecasts are used to help plan a more accurate budget– because they are generally built on historical data, and are broken down into smaller increments (monthly and sometimes weekly). A well-developed cash flow forecast can provide detailed information for next week, or for 3 or 6 months away.
- Can help you to avoid problems before they occur – a cash flow forecast allows you to plan ahead and avoid crises before they occur. This is particularly important for times of the year that you know are slow, or for times of the year when you have and make larger payments such as GST or buying new equipment.
- Is useful when seeking finance, or for a potential investor or purchaser – an up to date and accurate cash flow forecast is a critical element in reducing the perceived risk of your business, thereby often contributing to an increased value.
When preparing your cash flow forecast, you should take some time to consider and include all likely sources of cash inflows and outflows. It is important that when developing your cash flow forecast, enough detail is included to make the forecast useful, but not overly onerous.
It is also important that the time scales relevant to the different line items are captured appropriately. For examples, wages may be paid fortnightly, whereas electricity may be quarterly, and rent paid monthly. As a result, these different costs should be given separate line items to make sure they are captured in the relevant time period.
Want to know more?
Financial Fundamentals webinar – How to get back in control.
Find out more information in the recent webinar we ran on the “7x Financial Fundamentals” of a profitable and high performing agribusiness.