Financial Guide for SMEs

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1 Financial Guide for SMEs

2 SME Corporation Malaysia Level 6, SME 1, Block B, Lot E, Jalan Stesen Sentral 2, Kuala Lumpur Sentral Kuala Lumpur General Line : Fax Line : Info Line: Website : First published in 2011 Printed by Percetakan Jiwabaru Sdn Bhd Lot 14, No 2, Jalan P/8 Kawasan MIEL FASA 2, Bandar Baru Bangi, Bangi Selangor Darul Ehsan

3 About the Guide This Guide has been adopted from the Australian version entitled Achieving Financial Success (formerly known as the Financial Survival Guide) prepared by Jan Barned (CPA, FFTP), with the assistance of CPA Australia and Small Business Victoria. Ms. Barned who is the principal of Financial Management Trainer ( has worked in the fi nance industry internationally and in Australia for over twenty years. SME Corporation Malaysia and CPA Australia have been granted the copyright to reproduce the Guide and to modify the content to suit the Malaysian context. The Guide will be a useful reference for entrepreneurs on fi nancial management which is a key success factor to any SME business, particularly for new entrepreneurs with little fi nancial background. Copyright Notice Copyright 2011 SME Corporation Malaysia and CPA Australia. All rights reserved. Subject to Copyright Act 1987 (Malaysia) and Copyright Act 1968 (Australia). No part of this publication, including the contents, trademarks and trade names may be reproduced, stored in a retrieval system or transmitted in any form by any means including in websites, for commercial or non-commercial means without prior written permission of SME Corporation Malaysia and CPA Australia. Application for these uses shall be made directly to the Chief Executive Offi cer of SME Corporation Malaysia. In reproducing or quoting the contents, acknowledgement of source is required. Disclaimer Whilst every effort has been made to ensure the accuracy of the information contained in this book, both SME Corporation Malaysia and CPA Australia accept no responsibility for any errors and / or inaccuracies it may contain, or for any loss, fi nancial or otherwise sustained by any person using information extracted from this book. All information and specifi cation are current at the time of preparation and are subject to change as may be required. No part of this Product is intended to be treated as advice, whether legal or professional. You should not act solely on the basis of the information contained in the Product as parts may be generalised and may apply differently to different people and circumstances. Furthermore, as laws change frequently, all users are advised to undertake their own research or to seek professional advice to keep abreast of any reforms and developments in the law. 1 chapter Eng.indd 1 8/27/11 11:15:00 AM

4 Table of Contents Introduction...5 Glossary of Terms...6 Section I : Business Finance Basics...9 Chapter 1: Understanding Financial Statements...11 Income Statement...12 Balance Sheet...16 Statement of Cash Flows...19 Chapter 2: Assessing the Financial Health of Your Business...23 Liquidity Ratios...23 Solvency Ratios...25 Profi tability Ratios...26 Management Ratios...27 Balance Sheet Ratios...28 Chapter 3: Budgeting...31 Profi t and Loss Budget...32 Assumptions...33 Monitoring and Managing Your Profi t and Loss Budget...36 Section II : Improving Business Finances...37 Chapter 4: Maintaining Profitability...39 Profi tability Measures...39 Discounting Sales...43 Expense Management...45 Chapter 5: Improving Cash Flow...47 Managing Inventory...49 Managing Payments to Suppliers...54 Managing Work-in-progress...58 Managing Receivables...60 Working Capital Cycle Cash Conversion Rate chapter Eng.indd 2 8/15/11 5:01:21 PM

5 Chapter 6 : Managing Cash Flow...67 Cash and Profi t...67 Cash Flow Drivers in Your Business...69 Cash Flow Forecasting...71 Section III Chapter Chapter Chapter : Financing Your Business : Debt, Equity or Internal Funds?...81 Comparing Debt Finance, Equity Investment and Internal Funds...81 Deciding Between Debt and Equity...91 Understanding the Debt Financing Options : Long-term versus Short-term : Transactional Banking to Suit Business Needs..103 Transactional Banking Products Merchant Facilities Transactional Fees : Trade Financing Foreign Currency Payments Alternative Methods to Manage Foreign Currency Payments International Trade Finance Section IV : Managing Lenders Chapter 10 : Applying For a Loan Preparing for a Loan Application Details of the Loan Required Presentation of the Loan Application The Role of Advisers Conclusion chapter Eng.indd 3 8/15/11 5:01:22 PM

6 Chapter 11 : Refinancing Your Debt How Refi nancing Works? Benefi ts of Refi nancing Common Dangers in Refi nancing Switching Banks Chapter 12 : Managing Your Banking Relationships Annual Review Continuing Relationships Managing Diffi culties Section V : Better Business Financial Management Chapter 13 : Financial Controls Benefi ts of Financial Controls Financial Controls Checklist Appendix Acknowledgement chapter Eng.indd 4 8/15/11 5:01:22 PM

7 Introduction Small and medium enterprises (SMEs) are often driven by the passion to achieve the owners desired outcomes. They may want to see a business grow from the start, be keen to enter into an industry that provides great challenge, or be motivated by personal reasons such as wanting to turn a hobby into a business or develop a long-term retirement plan. Whatever their reasons, many SME owners do not have formal fi nancial management training (that is they are not an accountant or bookkeeper) and usually have limited resources to pay for such services. For the success of any business, good fi nancial management is necessary. Good fi nancial management will go a long way to ensure that all the available business resources are used effi ciently and effectively to provide optimum return. This Guide has been designed to help SMEs to develop the fi nancial management skills that are essential for business success. Presented in easyto-understand language, this Guide discusses the key fi nancial aspects that SMEs should focus on to ensure that good fi nancial management is in place. The areas discussed in the Guide address the fi nancial aspects that a business should consider and understand as part of good fi nancial management. If these practices are implemented early, the business would benefi t from strong fi nancial management and the owner would be equipped with the fi nancial tools to operate and grow a successful business. It should be noted that some of the areas may not be relevant for all businesses. For instance, if you are providing a service, discussion on inventory management will not be relevant. Also, you have to keep in mind the type of industry that you are in when considering good fi nancial management. For example, if you run a café, you would probably be reviewing inventory levels every week; however, a small retail toy shop may only do an inventory count once a year. This Guide has fi ve sections, each with a number of chapters to further elaborate on the key topics. There are hints and tips along the way to help you focus on the important messages and these are summarised in the Appendix for easy reference. 5 chapter Eng.indd 5 8/15/11 5:01:22 PM

8 Glossary of Terms As with any topic, there is a wealth of jargon and terminology associated with fi nancial management. It is helpful for you to understand these terms when reading fi nancial statements or when talking to fi nance professionals such as bank managers. This will make you feel more confi dent and comfortable. The most basic and useful of these terms are set out below. Accrual Accounting Accounting Entry Accounting Period Asset Break-even Budget Capital Expenditure Cash Accounting Cash Conversion Rate Cash Flow Cost of Goods Sold (COGS) Recognising income and expenses when they occur rather than when they are received or paid for Basic recording of business transactions as debits and credits A period for which fi nancial statements are prepared (normally monthly and then annually) Anything having a commercial value that is owned by the business Amount (in either units or value), that the business needs to achieve before a profi t is generated A fi nancial plan for a business (allocating money that the business forecasts it will receive and spend); typically done once a year Amount of money that is allocated or spent on assets Accounting for transactions as they are received or paid Overall number of days to convert a trade from the cash outfl ow at the beginning of the working capital cycle to cash received at the end of the cycle Flow of cash into and out of the business Total cost of all goods sold during the period 6 chapter Eng.indd 6 8/15/11 5:01:22 PM

9 Creditors Current Assets Current Liabilities Depreciation Drawings Equity Expenses Financial Ratio Financial Statements Forecasting Inventory Intangibles Liability Gross Margin Mark-up Amount of money that the business owes the suppliers Assets that are likely to be turned into cash within a 12-month period Liabilities that are due within a 12-month period Writing-off of a portion of a fi xed asset s value in a fi nancial period Where the owner of the business takes something of monetary value permanently out of the business (can be in the form of cash or other assets) Amount that the business owes the owner Costs associated with earning the business income Method by which the business can measure the fi nancial health and compare their business operations to similar businesses in the same industry Record of the financial performance and health of a business for a given period Process of predicting the future financial performance of a business Stock that a business holds to sell Assets that do not have a physical form e.g. patents, goodwill etc. Amount of money that the business owes its external stakeholders Profi t from sales before deducting overheads Percentage by which the sales price exceeds the cost 7 chapter Eng.indd 7 8/15/11 5:01:22 PM

10 Owners Equity Overheads Profit Purchase Order Receivables Revenue Retained Profit Reserves Working Capital Work-in-progress Amount of capital contributed to form the business or added later Costs that are not directly associated with the products or services sold by the business Income minus expenses A commercial document issued by a buyer to a seller, indicating the type, quantity and agreed prices for products or services the seller will provide to the buyer Amount that are owed to a business (sometimes referred to as debtors) Income that the business earns from its operations Profi ts that have not been distributed to the owners Retained profi ts that are held for a specifi c purpose or the result of revaluation of assets Excess of current assets over current liabilities Where an order has been taken from the customer and the business is in the process of working to complete the order 8 chapter Eng.indd 8 8/15/11 5:01:22 PM

11 Section I : Business Finance Basics Keeping the book for your business can provide valuable information to enable you not only to prepare the fi nancial statements, but also to gain a better understanding on the financial position of your business and have insights into how to improve business operations. Good fi nancial systems will assist in monitoring the fi nancial situation, managing the fi nancial position and measuring the success of your business. In this fi rst section, we will look at the three key fi nancial statements and discuss on how you can use this information to improve business operations through ratio analysis and to prepare an operating budget. Financial Guide for SMEs Implementing good fi nancial practices in your business will provide sound fi nancial information that can identify current issues and be used to plan for the successful fi nancial future of your business 9 chapter Eng.indd 9 8/15/11 5:01:23 PM

12 Chapter 1 Understanding Financial Statements 10 chapter Eng.indd 10 8/15/11 5:01:23 PM

13 Understanding Financial Statements Please note that this chapter is not designed to assist you with the preparation of fi nancial statements but to familiarise you with what they look like and how they can be used to benefi t your business. Every business requires some assets to be able to run the operations and ultimately make a profi t. This could be as simple as having cash in the bank, but is more likely to be a number of assets, such as inventory (only unsold inventory is an asset), offi ce equipment and perhaps even commercial premises. Since all of these items need to be paid for when starting up a business, the owners will need to invest their own money or borrow from a lender (e.g. bank) or investor. Financial statements provide information on how the business is operating financially and why. Ensuring that these statements are produced regularly will provide financial information for continuous improvement of business operations There are three fi nancial statements that record fi nancial information of a business, which are: Income Statement; Balance Sheet; and Statement of Cash Flows. The fi nancial statements record the performance of your business and allow you and others to diagnose the strengths and weaknesses of your business by providing a written summary of the fi nancial activities for a given period. To proactively manage your business, you should plan to generate these fi nancial statements on a monthly basis, review the results and analyse for improvement. Let s look at the financial statements and see how they can assist in monitoring your businesses fi nancial performance. 11 chapter Eng.indd 11 8/15/11 5:01:23 PM

14 Income Statement The income statement is a summary of income and expenses for a business over a specific period. It should be prepared at regular intervals (usually monthly and at fi nancial year-end) to show the results of operations for a given period. Profi t or loss is calculated in the following way: Sales Less Sales Discounts / Sales Commissions Equals Net Sales Less Cost of Goods Sold Equals Gross Profit Less Expenses (Fixed & Variable) Net Profit Only those businesses that have goods (products) to sell will use the calculation of cost of goods sold Equals HINT Opening Inventory Plus Inventory Purchase Equals Inventory available for sale Less Closing Inventory Calculating the cost of goods sold varies depending on whether the business is retail, whole sale, manufacturing or a service business. In retail and wholesale business, computing the cost of goods sold during the reporting period involves beginning and ending inventories including purchases made during the period. In manufacturing, it involves fi nished goods inventories, plus raw materials inventories, work-in-progress inventories, direct labour, and direct factory overhead costs. In the case of a service business, the revenue is being derived from the activities of individuals rather than the sale of a product. Hence, the calculation of cost of goods sold is a smaller task due to the low level of materials used to earn the income. 12 chapter Eng.indd 12 8/15/11 5:01:23 PM

15 Case Study Adam s Computer Bags Adam has decided to start his own business and has been doing some research. He will sell computer bag to computer manufacturers. He is going to leave his job and has saved some money to help him go through the start-up phase. He has decided that in the fi rst year, he is going to focus on getting the business established, so he believes that a small profi t (before interest and tax) of RM5,000 should be achievable. His research has shown that the expenses to set up and operate the business will be approximately RM15,600 for the year. Profi t RM5,000 plus operating expenses RM15,600 Total cash needed RM20,600 From this information, Adam can see that he will need at least RM20,600 to cover the operating expenses and achieve his profit goal. Adam s research has also highlighted that it is reasonable to expect to sell at least 1,000 bags in the first year. Adam has negotiated with a supplier to provide the bags for the cost price of RM31.20 each. Now we can work out according to Adam s estimates, how much sales need to be made to reach the profit goal. Profi t RM5,000 plus operating expenses RM15,600 Plus cost of 1,000 bags RM31,200 (cost of goods sold) Adam will need a total of RM51,800 to achieve his targeted profi t Minimum selling price (RM51,800 divided by the1,000 bags that he will sell) equals to RM51.80 per bag. Adam thinks that he will be able to sell the bag for RM52.00 each. So, at the end of the fi rst year, if all goes according to the plan, his income statement would look like this: 13 chapter Eng.indd 13 8/15/11 5:01:23 PM

16 Adam s Computer Bags Income Statement For the Year Ending Year One Revenue Sales Total Sales RM RM 52,000 52,000 (1,000 RM52 each) Cost of Goods Sold (COGS) Opening Inventory Inventory Purchases Less Closing Inventory RM RM RM - 34,320 3,120 Total Cost of Goods Sold RM 31,200 (See details on the next page) Gross Profit RM 20,800 Expenses Advertising Bank Service Charges Insurance Payroll Professional Fees (Legal, Accounting) Utilities & Telephone Others: Computer Software Total Expenses RM RM RM RM RM RM RM RM , ,600 Net Profit Before Tax RM 5, chapter Eng.indd 14 8/15/11 5:01:24 PM

17 Towards the end of the year, Adam managed to purchase 100 more bags on credit from his supplier for an order in the new year. This leaves him with RM3,120 of inventory on hand at the end of the year. Calculation for Adam s Cost of Goods Sold Opening inventory Nil Plus inventory purchased during the year RM34,320 (1,100 RM each) Equals inventory available for sale RM34,320 Less inventory on hand at the end of RM 3,120 the year (100 RM each) Cost of goods sold RM31,200 For a service business, the income statement will usually not have a calculation of cost of goods sold. In some instances, where labour costs can be directly attributed to sales, you may consider including these costs as the cost of goods (services) sold. TIP Regularly (monthly) produce profi t and loss information and compare against activities in the previous months to ensure that your profi t expectations are being met 15 chapter Eng.indd 15 8/15/11 5:01:24 PM

18 Balance Sheet The balance sheet refl ects the fi nancial health of a business at a given time (usually the end of a month or fi nancial year). It lists in detail the various assets that the business owns, the liabilities and the value of the shareholders equity or net worth of the business: Assets are the items of value owned by the business; Liabilities are the amount of money owed to external stakeholders of the business; and Shareholders equity or shareholders fund is the amount that the business owes the owner. HINT Assets RM 54,820 Funded through: Liabilities RM 9,620 Shareholders Equity RM 45,200 This diagramme shows how the balance sheet works. The business requires assets to operate and these assets will be funded from the equity in the business, the profit from the operations of the business or by borrowing money from external parties. The balance sheet can also be illustrated as: Assets RM 54,820 Minus Liabilities RM 9,620 Equals Shareholders Equity RM 45,200 The diagramme above shows that the value of all assets owned by the business less the value owed to external stakeholders (liabilities) will equal the shareholders fund of the business that is, the value of the business after all debts have been paid. 16 chapter Eng.indd 16 8/15/11 5:01:24 PM

19 Balance Sheet Categories Assets may include cash, inventories, land, buildings, equipment, machinery, furniture, patents and trademarks, as well as money due from individuals or other businesses (known as debtors or receivables). Liabilities may include funds made available to the business from external stakeholders by way of loans, overdrafts and other credit used to fund the activities of the business including the purchase of capital assets and inventory and for the payment of general business expenses. Shareholders equity (or net worth or capital) is the money put into a business by its owners for use by the business in acquiring assets and paying for the cash requirements of the business. Balance Sheet Classifications For assets and liabilities, a further classification is made to assist in monitoring the fi nancial position of a business. These classifi cations are referred to as current and non-current. Current refers to a period of less than 12 months and noncurrent is any period greater than 12 months. The balance sheet will list non-current assets followed by current assets. Noncurrent assets are assets that will continue to exist in their current form for more than 12 months. These can include furniture and fittings, office equipment, company vehicles etc. While current assets will include items that are likely to be turned into cash within a 12-month period such as cash in the bank, monies owed from customers (referred to as receivables), inventories and other assets. Similarly, the balance sheet will include non-current liabilities followed by current liabilities. Non-current liabilities are all the loans from external stakeholders that do not have to be repaid within the next 12 months. Meanwhile, current liabilities are those monies that must be repaid within 12 months and would typically include bank overdrafts, credit card debt and monies owed to suppliers (referred to as payables). These will be followed by shareholders fund or equity. TIP A prosperous business will have assets of the business funded by profi ts rather than being heavily dependent on funding from either external parties (liabilities) or continuous cash injections from the owner (equity) 17 chapter Eng.indd 17 8/15/11 5:01:24 PM

20 Based on the case study of Adam s Computer Bags, his balance sheet at the end of year one would look like as follows: Adam s Computer Bags Balance Sheet For the Year Ending Year One Total Non-Current Assets Total Current Assets 0 Total Non-Current Liabilities 0 TOTAL LIABILITIES AND EQUITY RM54, chapter Eng.indd 18 8/15/11 5:01:24 PM

21 Statement of Cash Flows The statement of cash fl ows is a summary of money coming into, and going out of, the business over a specifi c period. It is also prepared at regular intervals (usually monthly and at fi nancial year-end) to show the sources and utilisation of cash for a given period. The cash fl ows (in and out) are summarised on the statement into three categories: operating activities, investing activities and fi nancing activities. HINT Statement of cash fl ows only shows the historical data and differs from a cash fl ow forecast Operating activities: These are the day-to-day activities that arise from the selling of goods and services and usually include: Receipts from income; Payments for expenses and employees; Payments received from customers (receivables); Payments made to suppliers (payables); and Inventory movements. Investing activities: These are the investments in items that will support or promote the future activities of the business. They are the purchase and sale of fi xed assets, investments or other assets and can include items such as: Payment for purchase of property, plant and equipment; Proceeds from the sale of the property, plant and equipment; Payment for new investments, such as shares or fi xed deposits; and Proceeds from the sale of investments. Financing activities: These are the methods by which a business fi nances its operations through borrowings from external stakeholders and equity injections, the repayment of debt or equity, and the payment of dividends. Following are examples of the types of cash fl ow included in fi nancing activities: Proceeds from the additional injection of funds into the business from the owners; Money received from borrowings; Repayment of borrowings; and Payment of drawings (payments taken by the owners). 19 chapter Eng.indd 19 8/15/11 5:01:25 PM

22 As mentioned earlier, the statement of cash fl ows can be a useful tool to measure the fi nancial health of a business and can provide helpful warning signals. Three potential warning signs which, in combination, can indicate the potential for a business failure are: Cash receipts are less than cash payments (i.e. you are running out of money); Net operating cash flow is an outflow i.e. it is negative; and Net operating cash flow is less than profit after tax (i.e. you are spending more than you earn). TIP Use the Cash Flow Statement to analyse if you are spending more than you are earning or drawing out too much cash from the business 20 chapter Eng.indd 20 8/15/11 5:01:25 PM

23 Here is an example of Adam s Statement of Cash Flows, showing the relationship between the Income Statement and the Balance Sheet. Adam s Computer Bag Income Statement As At End of Year One Adam s Computer Bag Statement of Cash Flows For the Year One Adam s Computer Bag Balance Sheet For the Year Ending Year One Cash flows from operating activities Income RM 52,000 RM 52,000 Sales RM 52,000 RM 5,500 RM 8,100 RM15,000 Non-Current Assets Computer Store Firnishing Office Equipment RM 15,600 RM 18,000 RM 34,320 RM 4,120 Receipts from income Payments of expenses Funding to Debtors RM 28, 6 00 Total Sales Inventory Movements Cost of Goods Sold Funding from Creditors 0 RM 34,320 RM 3,120 Opening Inventory RM 11,800 Net cash from operating activities RM 26,220 Stock Purchases RM 54,820 Total Non-Current Assets Current Assets Cash RM 5,100 Debtors RM18,000 Inventory RM 3,120 Total Current Assets TOTAL ASSETS Less Closing Inventory Cash flows from investing activities 0 Non-current Liabilities RM 28,600 Payments for property, plant and equipment Financial Guide for SMEs RM 31,200 Total Cost of Goods Sold (COGS) 0 Total-Non current Liabilities RM 28,600 Net cash from investing activities Current Liabilities RM 20,800 Cash flows from financing activities RM5,500 RM4,120 Gross Profit Credit Card Creditors RM 5,500 Increase in Short Term Debt Increase in Long Term Debt Total Current Liabilities RM 9,620 RM 9,620 TOTAL LIABILITIES RM 15,600 Expenses Total RM 40,000 RM 45,500 Proceeds from owners (equity) Net cash from financing activities RM 45,200 NET ASSETS Shareholder s Equity RM 5,200 Net Profit before Tax RM 5,100 0 Net increase in cash Cash balance as at start of year RM 40,000 RM 5,200 Owners Funds Current Year Profit RM 45,200 Total Shareholders Equity RM 5,100 Cash balance as at end of year RM 54,820 TOTAL LIABILITIES AND EQUITY chapter Eng.indd 21 8/27/11 11:15:40 AM

24 Chapter 2 Assessing the Financial Health of Your Business 22 Chapter 2-5 p22-65 Eng.indd 22 8/15/11 5:01:50 PM

25 Assessing the Financial Health of Your Business A helpful tool that can be used to predict the success, potential failure and progress of your business is fi nancial ratio analysis. By spending time doing fi nancial ratio analysis, you will be able to spot trends in your business and compare the fi nancial performance and condition with the average performance of similar businesses in the same industry. Although there are many fi nancial ratios that you can use to assess the health of your business, in this chapter we will focus on the main ones that can be easily used. The ratios are grouped together under the key areas that you should focus on. Liquidity Ratios These ratios will assess the ability of your business to pay its bills in due time. They indicate the ease of turning assets into cash and include the current ratio, quick ratio, and working capital (which are discussed in detail in Chapter 5). Financial ratio analysis will provide the important warning signs that could allow you to solve your business problems before they destroy your business HINT Use these ratios to assess if your business has adequate cash to pay debts in due time In general, it is better to have higher ratios in this category, that is, more current assets than current liabilities as an indication of sound business activities and an ability to withstand tight cash fl ow periods. Current ratio = Total current assets Total current liabilities One of the most common measures of fi nancial strength, this ratio measures whether the business has enough current assets to meet its debt obligations with a margin of safety. A generally acceptable current ratio is 2 to 1; however, this will depend on the nature of the industry and the form of its current assets and liabilities. For example, the business may have current assets made up predominantly of cash and would therefore survive with a relatively lower ratio. 23 Chapter 2-5 p22-65 Eng.indd 23 8/15/11 5:01:51 PM

26 Quick ratio = Current assets inventory Current liabilities overdraft Sometimes called the acid test ratio, this is one of the best measures of liquidity. By excluding inventories which could take some time to turn into cash unless the price is knocked down, it concentrates on real, liquid assets. It helps to answer the question: If the business does not receive income for a period, can it meet its current obligations with the readily convertible quick funds on hand? TIP The quick ratio will give you a good indication of the readily available cash to meet current debt obligations 24 Chapter 2-5 p22-65 Eng.indd 24 8/15/11 5:01:51 PM

27 Solvency Ratios These ratios indicate the extent to which the business is able to meet all its debt obligations from sources other than cash flow. In essence, it answers the question: If the business suffers from reduced cash flow, will it be able to continue to meet the debt and interest expense obligations from other sources? Commonly used solvency ratios are: HINT These ratios measure if your business has adequate long-term cash resources to cover all debt obligations Leverage ratio = Total liabilities Equity The leverage (or gearing) ratio indicates the extent to which the business is dependent on debt fi nancing versus equity to fund the assets of the business. Generally speaking, the higher the ratio, the more diffi cult it will be to obtain future borrowings. Debt to assets = Total liabilities Total assets This measures the percentage of assets being financed by liabilities. Generally speaking, this ratio should be less than 1, indicating adequacy of total assets to fi nance all debt. TIP These ratios indicate the extent to which the business is able to meet the debt obligations from all sources, other than just cash fl ow, as in the case with liquidity ratios 25 Chapter 2-5 p22-65 Eng.indd 25 8/15/11 5:01:51 PM

28 Profitability Ratios These ratios will measure your business performance and ultimately indicate the level of success of your operations. More discussion on these measures is included in Chapter 4. HINT Use gross and net margin calculations to measure and monitor the profitability of your business operations Gross margin ratio = Gross profit Revenue This measures the percentage of sales proceeds remaining (after obtaining or manufacturing the goods sold) to pay the overhead expenses of the business. Net margin ratio = Net profit Revenue This measures the percentage of sales proceeds left after all expenses (including inventories), except income taxes. It provides a good opportunity to compare the return on income of the business with the performance of similar businesses. TIP Comparing your net and gross margin calculations to businesses within the same industry will provide you with comparative information and may highlight possible scope for improvement in your margins 26 Chapter 2-5 p22-65 Eng.indd 26 8/15/11 5:01:51 PM

29 Management Ratios Management ratios monitor how effectively you are managing your working capital, that is, how quickly you are replacing your inventories, how often you are collecting debts outstanding from customers and how often you are paying your suppliers. These calculations provide an average that can be used to improve business performance and measure your business against the industry average (refer to Chapter 5 for more details). HINT Use the number of days for inventory, debtors and creditors to calculate the cash conversion rate for your trading activities Days inventory = Inventory x 365 Cost of goods sold This ratio reveals how well your inventory is being managed. It is important because it will indicate how fast inventory is being replaced. Usually, the higher number of times the inventory can be turned in a given operating cycle, the greater the profi t. Days debtors = Accounts receivable x 365 Net income This ratio indicates how well the cash from customers is being collected - referred to as accounts receivable. If accounts receivable are excessively slow in being converted to cash, the liquidity of your business will be severely affected (accounts receivable is the total outstanding amount owed to you by your customers). Days creditors = Accounts payable x 365 Cost of goods sold This ratio indicates how well accounts payable are being managed. If payables are being paid on average before agreed payment terms or before debts are being collected, cash fl ow will be affected. If payments to suppliers are excessively slow, there is a possibility that relationship with the supplier will be damaged. TIP Comparing your management ratio calculations to businesses within the same industry will provide you with comparative information that may highlight possible scope for improvement in your trading activities 27 Chapter 2-5 p22-65 Eng.indd 27 8/15/11 5:01:52 PM

30 Balance Sheet Ratios These ratios indicate how effi ciently your business is using assets and equity to make a profi t. HINT Use the return on assets and investment ratios to assess the effi ciency in the use of your business resources Return on assets = Net profit before tax x 100 Total assets This measures how effi ciently profi ts are being generated from the assets used in the business. The ratio will only have meaning when compared with the ratio of others in similar industry. A low ratio in comparison with the industry average indicates an ineffi cient use of business assets. Return on Investment = Net profit before tax x 100 Equity The return on investments (ROI) is perhaps the most important ratio of all as it tells you whether or not all the efforts put into the business is yielding an appropriate return on the equity generated, in addition to achieving the strategic objective. TIP These ratios will provide an indication of how effective is your investment in the business 28 Chapter 2-5 p22-65 Eng.indd 28 8/15/11 5:01:52 PM

31 29 Chapter 2-5 p22-65 Eng.indd 29 8/15/11 5:01:52 PM

32 Chapter 3 Budgeting 30 Chapter 2-5 p22-65 Eng.indd 30 8/15/11 5:01:52 PM

33 Budgeting Budgeting is the tool that develops the strategic plans of the business into a financial statement by setting out forecasted income, expenses and investments for a given period. The budget will enable you to evaluate and monitor the effectiveness of the strategic plans as they are implemented and to adjust the plan wherever necessary. Most SMEs operate without large cash reserves to draw on; therefore, budgeting will provide the financial information required to assess if the strategic plans will support the ongoing operations. In short, budgeting is the process Financial Guide for SMEs of planning your fi nances over a period. Budgeting can also provide an opportunity to plan for several years ahead in an effort to identify changing conditions that may affect the business operations and lead to fi nancial diffi culties. Good practice budgeting requires the following: A budget is the future fi nancial plan of the business. It is where the strategic plans are translated into fi nancial numbers to ensure that these plans are fi nancially viable Preparation of strategic goals; Budgeted timeline that is aligned to the preparation of financial statements; Regular comparison of budgets against actual financial results as disclosed in the financial statements; and Scope for amending activities and targets. In short, budgets are one of the most important fi nancial statements, as they provide information on the future fi nancial performance of the business. If the budgets are planned and managed well, they will be the central fi nancial statement that allows you to monitor the fi nancial outcome of the implementation of your strategic plans. 31 Chapter 2-5 p22-65 Eng.indd 31 8/15/11 5:01:52 PM

34 Profit and Loss Budget A profi t and loss budget is an important tool for all businesses because where activities can generate profi t, your business will be less dependent on external funding. The budget is a summary of expected income and expenses set against the strategic plans for the budget period. This is usually one year, although, in some cases, the period can be shorter or longer, depending on the purpose of the budget. Although your accountant can be of assistance in the preparation of this budget, it is important that you understand how it has been developed and know how to monitor the outcomes against the prepared budget to ensure that your business will achieve the required fi nancial outcomes. Hint By preparing a profi t and loss budget annually, you will be in a position to determine if your future business plans will support the ongoing activities of your business Preparing Profit and Loss Budget The key to successful preparation of a profi t and loss budget is to undertake the process in an orderly manner, involving all key staff and ensuring that the goals of the business are clearly understood prior to the preparation. There are two methods of preparing a profi t and loss budget: Incremental where the activities carried out in the previous year are used as the basis for budget preparation. Zero-based where the budget is prepared without consideration of past activities. For annual budgeting, the preferred method would be incremental, as zero-based budgeting would require an enormous amount of dedicated resources and time. In the case of project-based or activity-based budgets, zero-based may be more suitable, particularly for new projects where there is no previous fi nancial data. 32 Chapter 2-5 p22-65 Eng.indd 32 8/15/11 5:01:53 PM

35 An annual budget preparation policy should be documented and followed, and could include some or all of the following steps: Review the approved strategic plan and record all required activities for the budget period. Separate activities into existing and new for the new budget period. Identify and document all assumptions that have been made for the budget period. Review the income statement in the previous year by regular period (monthly, quarterly etc.). Prepare the profit and loss budget for the selected period using all the steps listed above. TIP An independent profi t and loss budget can be developed for separate projects to assess the fi nancial viability of each project Assumptions To ensure that your budget will be a useful tool, you need to spend some time planning on what you think is going to happen in your business in the future. As you are preparing your estimates on income and expenditure, you will be estimating how your business will operate in the future and these are referred to as assumptions. When determining your assumptions, it would be best to use realistic targets that you believe will be achievable. Using your historic fi nancial information and looking for any trends in this information is a good place to start. Also, any industry information provided by independent reputable companies will give your assumptions credibility. This HINT All assumptions made during the planning process of preparing budgets should be realistic and documented is particularly useful when you are going to provide your budget to a potential or current lender or investor. Make sure you write down all the assumptions and then establish a fi nancial number that reflects the event. Once you have completed the table of assumptions, attach them to the budget. This way, you will remember what you anticipated to happen and when reviewing your budget against the actual fi gures, this will help to determine why the actual results may not be the same as your budgeted numbers. 33 Chapter 2-5 p22-65 Eng.indd 33 8/15/11 5:01:53 PM

36 When listing your assumptions, if you believe there is some risk that the event may not occur, include this detail, together with any actions you could undertake if a particular assumption turns out to be incorrect so that you would already have an action plan in place. Let us return to Adam s Computer Bags and see how he is going to set his budget for year two of his business. Using his fi rst year income statement, Adam is now going to set some assumptions for the second year of his business. Assumption Table Assumption Sales Forecast Source Risk Action Increase by 50% Forward orders Sales remain constant or decrease Review inventory holdings and operating expenses Introduce marketing programme Cost of goods Remain at 60% of sales Current supplier contract Stock prices increase Source new supplier Salaries Increase to RM19,500 In line with industry standards Cash fl ow shortage Reduce salary expense Vehicle expense Purchase vehicle and include running expenses Required for sales and marketing Cash fl ow shortage Review operational activities to identify possible savings in expenditure 34 Chapter 2-5 p22-65 Eng.indd 34 8/15/11 5:01:53 PM

37 We can see Adam is now confident that, in the second year, he can increase his sales by 50%. Of course, with increased sales, comes an increase in expenditure to support the sales. Therefore, he has developed a plan of what the year two income statement will look like. Revenue Sales Total Sales Cost of Goods Sold (COGS) Opening inventory Inventory purchases Less closing inventory Total Cost of Goods Sold Gross Profit Expenses Advertising Bank service charges Insurance Payroll Professional fees (legal, accounting) Stationery Utilities & telephone Vehicle expenses Other: computer software Expenses total Adam s Computer Bags Income Statement As at end of Year One RM 52,000 RM 52,000 RM - RM 34,320 RM 3,120 RM 31,200 RM 20,800 RM 15,600 As at end of Year One RM 78,000 RM 78,000 RM 3,120 RM 49,920 RM 6,240 RM 46,800 RM 31,200 RM 500 RM 1,000 RM 120 RM 200 RM 500 RM 550 RM 13,000 RM 19,500 RM 200 RM RM 250 RM 800 RM RM 2,450 RM 480 RM 100 RM 25,350 Net Profit Before Tax RM 5,200 RM 5,850 Adam will need to monitor his actual results, checking them against this budget, to ensure that his plan will be achieved. TIP When documenting your assumptions, include both the risk assessment of each assumption and the anticipated action required to match the risk. By doing this, you will be well prepared and have an action plan already in place if the actual events do not match your assumptions 35 Chapter 2-5 p22-65 Eng.indd 35 8/15/11 5:01:53 PM

38 Monitoring and Managing Your Profit and Loss Budget There are a number of ways in which the profit and loss budget can be managed. As mentioned in Chapter 1, regular preparation of financial statements is important, particularly the income statements so that the actual activities can be compared against the budget. Standard practice would be to prepare monthly statements. However, for smaller businesses, quarterly preparation and comparison may be sufficient. Where the income statement is prepared on a monthly basis, the budget will need to be separated into months for the budget period. At the end of each HINT Remember, the more regular the reports, the faster operations can be reviewed for financial impact and action can be implemented immediately whenever required month, the actual results are compared with the budgeted results to analyse any variances. Such variances should be highlighted on the reports and explanations to be provided. All variances should be categorised as either a timing or permanent variance. A timing variance is where the estimated result did not occur but is still expected to happen at some point in the future. A permanent variance is where the expected event is not likely to occur at all. The power of this analysis is that each variance is documented for future reference, and whenever required, actions can be taken to counteract future variances or implement new or improved activities to ensure that the strategic goals underlying the budget can still be achieved. TIP Regular review of budget against actual results will provide information on whether your business is on track to achieve the plans formulated when you fi rst prepared your budget 36 Chapter 2-5 p22-65 Eng.indd 36 8/15/11 5:01:54 PM

39 Section II : Improving Business Finances Now that you have been introduced to the basics of business fi nance, you can use these tools to improve the fi nancial management of your business. Proactive management of the fi nancial position of your business would ensure that any issues encountered will be identifi ed early so that appropriate actions to rectify the situation can be taken in a timely manner. Through the use of the fi nancial information discussed in the fi rst section of the Guide, and by implementing the processes introduced in this section, you would be on the way to achieving good fi nancial management for your business. Improving business fi nances means you need to take a practical approach to implement new processes that allow you to monitor the key aspects of your business profi tability and cash fl ow Profi tability and cash fl ow are the key areas that should be monitored on an ongoing basis to help ensure that your business prospers. This section of the Guide presents a number of easy-to-understand procedures and tools that can assist you in maintaining profi tability and improving cash fl ow. Managing the business fi nances is all about taking a practical approach to maintaining profi tability and improving cash fl ow, together with having the discipline to continuously monitor and update the financial information as circumstances change. 37 Chapter 2-5 p22-65 Eng.indd 37 8/15/11 5:01:54 PM

40 Chapter 4 Maintaining Profitability 38 Chapter 2-5 p22-65 Eng.indd 38 8/15/11 5:01:54 PM

41 Maintaining Profitability One of the most important issues for any business is maintaining profitability. A profi table business will ensure that you can manage your business in line with your overall strategic objective, whether it is to grow the business, sell at a later date, or to achieve some other objective. In this chapter, we will be looking at three useful tools that will help you monitor the profi tability of your business. We will also discuss on how discounting can affect your profi t, and how to manage the expenses of the business to maintain profi tability. It is very easy for profi tability to be eroded if you do not measure and monitor on a regular basis. Therefore, it is important to understand how to use the tools available to continuously evaluate the profi tability of your business Profitability Measures Once you have an income statement, you can use the tools explained below to ensure that you know: Your profi ts are not being eroded by increasing prices in inventories or expenses Margin. How to set new selling price when inventory costs increase Mark-up. How much you need to sell before the business is making a profi t Break-even analysis. HINT Using the profi tability measures provided will ensure that you are aware of any reduction in profi t as it occurs and understand what level of sales is required for the business to generate profi t 39 Chapter 2-5 p22-65 Eng.indd 39 8/15/11 5:01:54 PM

42 Margin There are two margins that need to be considered when monitoring your profi tability: gross and net. For a service business, only net margin would be relevant, as it is unlikely that there would be a direct cost of service provided. Gross margin is the sales proceed left after subtracting the cost of goods sold from net sales. What does it mean by net sales? This is all the sales amount less any discounts that have been given to customers and commissions paid to sales representatives. By knowing what your gross margin is, you can be sure that the price set for your goods will be higher than the cost incurred to buy or manufacture the goods (gross margin is not commonly used for service businesses, as they often do not have cost of goods ) and you have enough money left to pay expenses and hopefully, make some profi t. Gross margin can be expressed either in value (gross profit) or in a percentage, that measures the percentage of sales proceed remaining (after obtaining or manufacturing the goods sold) to pay the overhead expenses of the company. The percentage value is particularly useful if you are comparing your business with other businesses in your industry or with past performance of your business. Gross profit (RM) = Net sales less cost of goods sold Gross profit value Gross margin (%) = Net sales value X 100 Net Margin is the sales amount left after subtracting both the cost of goods sold and the overhead expenses. The net margin will tell you what is your profi t before you pay any tax. Tax is not included because tax rates and tax liabilities vary from business to business for a wide variety of reasons, which means that making comparisons after taxes may not provide useful information. The margin can be expressed either in value (net profi t) or in percentage. The percentage value is particularly useful if you are comparing your business with other businesses in your industry or with past performance of your business. Net profit (RM) = Net sales less gross profit less overhead expenses Net profit value Net margin (%) = Net sales value X Chapter 2-5 p22-65 Eng.indd 40 8/15/11 5:01:55 PM

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