Finance is one aspect of running a coaching business. In today’s guest post finance expert Hayley Chiba shares some of her expertise of working with small business and entrepreneurs.
Is Holding Three Months’ Worth of Overheads enough to Mitigate the Small Business from Risk?
By Hayley Chiba
Business coaches and consultants often advise a small business, to always aim to hold 3 months’ worth of their overhead costs. This is to mitigate the risk of some down turn in the business.
In fact, this could apply to any unforeseen event occurring, where this meant the business were unable to generate sufficient sales to cover their fixed costs.
As a business coach, overall this is a good metric to have, but I was recently asked this question by a business owner. He still didn’t feel assured and satisfied that he had risk covered. If a business coach is to provide a valuable metric to his business owner client maybe a fuller dialogue is needed. As we know, better discussions with our clients can often lead to longevity and trust from your clients, as it gives you the opportunity to demonstrate your deeper value to your clients.
The problem is, that using an arbitrary figure like this, does not really relate directly to the specific level of risk that the business is facing.
Using this measure is fine if it relates to a business with low growth. Also, if it has a foreseeable pipeline of sales and a good insight into future potential environmental factors which may affect the business.
Just concentrating on holding a reserve only buys time, actually 3 months in this case. You need to consider, if there were an unforeseen event, how would that impact on the business financially? An unforeseen event may be the loss of a major customer, change in law or perhaps the loss of a key employee. Having considered this, how long would the business need, to put in place an alternative plan? Furthermore, how long would it take for “business as usual” to resume? This then leads us to think that we may need a much longer period of time, perhaps more like 6 months. As well as thinking about the amount of time the business needs to recover, we also want to consider if the business owner is actually looking to change something about the business.
Specifically, if they are thinking about undertaking a significant investment to grow the business. In this case the potential risk will rise as the return from the investment into growth activity is still to be proven. Spending out on more investment for growth will, in the short term, lower the profit margins and available cash. This can feel daunting especially when the business owner realises their current healthy profit margin is going to be eroded and in fact with it, any cash reserves they have built up.
So, I always recommend that in this case, further projections should be made. This will give the business owner the peace of mind that eventually, he is going to see the results he is anticipating. More importantly though, having some sort of forecast of what he expects to happen and measuring against this, every month, will flag quickly to him, where the plans are not playing out the way he was expecting. This will give him sufficient time to look at this, think of the actions he needs to take and make the necessary adjustments to his action plans to try to bring his results back on track.
The key report required to help give visibility on whether the new investment is viable is the Cash Flow Forecast.
I always suggest starting with the current situation and financial shape. Hence at this point it is crucial you understand your current position in terms of some key components.
- What is the current Sales Projection based on hard data? We can all dream, but sales forecasts should be based on some credible extrapolation of the past or last year’s actual data achieved.
- What are the current profit margins and specifically what is the gross profit margin? Gross profit margin being sales less direct costs.
- What are the overheads and what is the average run rate for the overheads? Overheads will naturally fluctuate due to the timing of supplier invoices. Marketing, administration, repairs and travel are good examples of this type of spend. They reflect areas where the timing of spend is discretionary and not fixed as a monthly fee. Breaking out spend where there is some flexibility on when to spend, gives a view of what overheads are absolutely fixed and have to be covered month on month.
So, armed with these 3 areas of information, you should be fine now to create a time based cash flow forecast. Not you of course, the bookkeeper or the business owner himself!
This forecast should be drawn up as a monthly forecast, (or even weekly depending on the nature of the investment spend). Plot it forward until the point when you expect the business to be seeing the benefit from the investment. This is often longer than you realise. The cash flow forecast should show the benefits materialising, which take the business to the next level. Ensure that the forecast covers this full time span. Many business owners stop short of this point. They only project across the time of when the spend is actually taking place. You need to see what happens to the business shape post the spend. You want to see if and when the business shape returns or even improves versus its original shape. This will often result in a forecast for at least 1 to 2 years out.
Having created the forecast, the most crucial action is to measure against this monthly. Failure to do this, may mean that the forecast is not delivered. You will need a flag to alert where and when the business moves off-track. Ensure that there is a consistent and methodical tracking of the key components of this cash flow forecast.
Planning and then measuring, will help to confirm if the growth investment decision was the right decision. Where it is proving not to be, this early warning flag should give sufficient time to plan how to mitigate these costs by stopping the things that are not working and reinvesting in other areas.
Protecting the business pot of cash is as important as building that pot of cash, whether it relates to 3, 6 or 12 months’ worth of overheads. If you can advise him fully by including these additional necessary steps where appropriate, you will ensure that the business owners hard earned cash is not eroded.
That’s something I’m sure he will certainly thank you for!
About Hayley Chiba
Hayley Chiba is a qualified Financial Controller working with small businesses. She runs her own business, Better Numbers Limited, which provides one to one Financial consulting to £1m + growing businesses in the Bristol, UK area.
She also provides Financial coaching to Entrepreneurs, Home Business Owners and Start-ups via her Ecourses. She dedicated to helping small businesses grow through increasing their personal and business financial awareness.
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