Accessing debt to finance your business growth opportunities is a critically important requirement to achieve business success. All lenders place a heavy reliance on the financial reports provided by applicants. Lenders are very sophisticated businesses and they will have experienced people scrutinising the applicants for finance. If you assume their default position is that the application should be denied – and that their job is to find the reasons why it should be denied – you can also assume they will take a sceptical approach to assessing the reliability of financial reports.
So, to ensure that you can verify that your business is creditworthy and that the lender should approve your funding application, you will need to ensure you can confirm the following:
- the finance and accounting controls are sufficient to ensure the accounts are a true and fair representation of the performance and position of the company
- they demonstrate the ability to comfortably make the repayments and remain within the lending covenants during the term of the loan, and
- management has the tools to manage a range of business outcomes
Finance and accounting controls
As all finance professionals know, financial reports can be misleading. This is particularly the case within individual reporting periods. Many businesses have this problem. It is generally caused by insufficient focus on the following three issues:
Consistent accounting policies
To achieve consistent and meaningful reporting, all businesses need accounting policies. Often, businesses do not have formal policies. This leads to inconsistent treatment of transactions with a lack of clarity around which general ledger accounts transactions should be applied to, whether to capitalise or expense costs, how to treat work in progress, what accruals to recognise, and how to treat customer deposits amongst many issues.
Setting up formal accounting policies does not need to be a major hurdle. Establishing an accounting policy framework will allow a business to more formally develop their policies as they go. Accounting policies should be reviewed regularly as well.
The policies will provide the reference sources for all those involved in the finance function including employees & consultants to ensure there is a consistent approach.
Timing of recognition of revenues and expenses
Recognising revenue and expenses in the periods they are earned or incurred is fundamental to understanding the performance of the business. Understanding gross profit performance is at the heart of managing performance. If revenues and expenses are not recognised in the correct periods, gross profit margins will be inaccurate.
A simple example would be where, at current revenue levels, the business needs to achieve a 30% gross profit margin to meet its profit targets. If the business reports a 25% margin, how should management react? Unfortunately, it is all too common that the response is to make excuses due to timing issues related to pay cycles, customer deposits, one-off costs, or other similar causes when proper accounting treatment would have eliminated these to reflect the true gross profit margin, explained by operating issues rather than accounting technicalities.
Over recent years, many businesses have been taking advantage of the instant asset write-off. This is a great incentive for reducing tax liabilities. However, it can obscure the true performance of the business. Along with a range of other prepayments, expensing costs in a single period, whilst enjoying the economic benefit of the asset over many periods, just further obscures the true performance of the business.
Businesses will often neglect the appropriate accounting treatments because it is “easier” to do so. However, lenders will struggle to gain faith in the accounts if this is an ongoing problem. And – in the absence of appropriate accounting policies – it usually is.
Balance sheet reconciliations
This is another important process that is often neglected in businesses that do not yet have a well-developed finance department. When these are neglected, businesses can have a cancer-like problem which can cause major changes to the reported profit outcome when it finally makes itself obvious.
An example of this could be where multiple related accounts exist that need to be cleared on a regular basis, but the clearing process is not undertaken. This can happen with the BAS lodgement process. Some accounting packages will have separate accounts for GST collected, GST paid, PAYG withholdings, and an Integrated Client Account to apply the payments to when they are made. Over time, if these are not reconciled on a regular basis, sizeable discrepancies can accrue, and the business eventually needs to true up these accounts. This can often result in a costly process to get them to the correct position. Fixed asset accounts are another common area that can become misleading over time.
Even key control accounts can become misleading over time. General journals should never be applied to control accounts, but it does happen. Particularly where accounting policies are unclear or non-existent.
Undertaking regular balance sheet reconciliations ensures that the balance sheet accounts are accurate. Unless it can be established that the balance sheet accounts are accurate, it cannot be relied upon that the profit and loss accounts are accurate.
Meet repayment commitments
This is obvious. But how does a provider of finance establish the applicant’s ability to meet repayments, and their ability maintain this capability under a range of potential changes to their operating environment?
Forecasts
At the very least, businesses need to have an annual budget. However, this does not provide a forecast of the cash reserves of the business over the outlook period. Lenders are now asking for 3-way forecasts to support lending decisions. This means having a balance sheet forecast as well as a profit and loss forecast. This is the only way to be able to predict what level of cash that the business will have available at any time.
Constructing a meaningful 3-way forecast will require management to have a strong understanding of three key elements:
- the drivers of revenue & cost
- the historical performance of the accounts
- the strategic plan
The drivers of revenue and cost can vary significantly from one business to another. The drivers of revenue can include the number of customers, customer sales, products/services, pricing structures, and capacity constraints. Cost of sales will be driven by product/service costs but also, product mix, customer mix, channel mix, and a range of other factors such as productivity, FX rates, transport costs, and waste.
The historical performance of the accounts is a strong determinant of the future performance of the accounts. Clearly, where new plans are being implemented, or where circumstances have changed, there will be significant changes to accounts. However, the historical performance provides important context for the forecast period.
For the historical accounts to provide valid support to the forecasting process, they need to be accurate. This means that revenues and costs must be recognised in the periods they were earned/incurred. It is also important that the transactional treatment of the accounts is consistent across the entire period.
The strategic plan will enable forecasts to include a range of items that have very significant impacts on cash. These can include investment plans (capex), loan commitments, and financing plans. It will also include plans for managing working capital and the outlook for withholdings accounts such as GST, income tax, and superannuation. There are also several areas related to employees which need to be considered. Are there plans for new hires? Are there plans for redundancies? Will employees be taking long service leave? Will annual leave accruals grow or reduce over the outlook period?
There also may be other factors to be considered such as related party loans, shareholder loans, and dividend policies. The list of balance sheet factors that can pull cash out of the business can be extensive and all need to be considered in the forecasting process.
Scenario analysis
Constructing a 3-way forecast based on the business’ expectations for the outlook period provides management with a good understanding of the issues that need to be managed to achieve the goals of the business. But management also needs to understand how a range of other outcomes might impact the business’ key resource, cash.
The relationship between sales volumes and costs is the biggest issue. Costs fall into two key buckets: fixed costs, and variable costs. Some businesses have high levels of fixed costs and low levels of variable costs. These businesses are more exposed to the impact of falling revenues. They need to have modelled the impact of reduced revenues and have strategies for responding to this situation.
The nature of costs is that some variable costs are fixed in the short term, and many fixed costs are variable in the long term. What constitutes short-term and long-term in these cases depends on a range of factors from contractual commitments through to employment law requirements. The important thing is for the business to have reviewed those circumstances and understand their options for responding to changed circumstances.
The ideal situation is where management has analysed these impacts and has contingency plans in place should they be needed.
Covenants
When lenders make loans of a significant magnitude, they will often include loan covenants in the loan agreement. The purpose of these covenants is to provide the lender with some assurance that the debtor will remain solvent and able to meet their commitments whilst they comply with the covenants.
Lenders will require financial reports including the covenant measures generally on a quarterly or half-yearly basis. And they will need to be confident that the reports are reliable. Inconsistent financial performance is a key warning sign for lenders. Inconsistency in financial performance could be demonstrated by variable gross profit margins, variable sales volumes, and variable overhead expenditure. It can also be demonstrated by growing liability accounts such as withholdings accounts and employee entitlement accounts.
This, once again, highlights the need for strong financial controls to be in place in the business to ensure that reports present a true and fair account of business activities to lenders.
Management tools
Having strong financial controls also underpins the usefulness of a range of performance management tools that are critical to the success of the business. Management decisions will be heavily influenced by the analytics and key metrics produced. Without strong financial controls, this information could be as likely to mislead as to inform.
Performance review
A key part of reviewing performance is to understand the variances between expected performance and actual performance. It is important to be confident that the reported variances are accurate. It is also important that management understands the causes of the variances.
Businesses operate in a changing environment. Nothing highlights this more than the recent pandemic. This has had a detrimental impact on many businesses while having a beneficial impact on some. Businesses also face losing key customers, changing FX rates, changing input prices, new technologies, changing legislation and many others.
Management needs the tools to analyse the impact of these changes. Whether producing key metrics or other analytics, the quality of source data will be a critical factor. However, these must be built on a solid foundation. That solid foundation is the financial controls that the business has in place.
Business intelligence (BI) analytics
There are many business intelligence applications available on the market. Applications such as Microsoft PowerBI do a great job. These enable large amounts of data to be analysed, enabling management to drill down to the causes of variances.
Microsoft Excel also has a very important role in analysing data and modelling strategic initiatives. Its power, flexibility and wide acceptance means it will be used in almost all businesses.
But, as with all the previous activities, the reliability of the accounts is an essential element for a true understanding of what is driving business performance and generating responses to enable the business to achieve targeted objectives.
Financial modelling
Management needs to have the capacity to properly assess options to improve performance. This could be investment in new equipment, developing and launching new products or services, undertaking a new marketing strategy, or adding to the current sales team. Whatever the plan is, management needs to understand what impact it will have on profit and cash reserves.
Investment in new plant and equipment may be the very reason why the business is seeking a loan. In this case, the business will need to show what impact the investment will have on business profitability. Even prior to seeking finance, the business would be running the financial modelling on the merits of investing in the plant and equipment. To do this, management will be relying on the existing financial data and their understanding of how the investment will impact on profitability.
Decisions will be made based on the return on investment and pay back periods calculated by the finance department. Management’s understanding of how the investment will impact on these is critical. That understanding will be driven by the knowledge gained from analysing the historical performance. This knowledge, in turn, will depend on how reliable management thinks the data is that is provided to it. If the reporting is inconsistent, and those inconsistencies are not readily explainable, management will not have confidence to support the necessary assumptions.
It will be very similar for other strategic initiatives that the business will need to make. For any business that does not have strong financial controls, its capacity to successfully borrow money and meet the ongoing conditions of those loans, will be highly compromised.
The theme is consistent: strong financial controls support a better understanding of the business.
The Virtual CFO Group Australia has well-developed financial control processes that it uses with a range of clients. These have been developed for a range of business types with operations that include manufacturing, service delivery, 3PL, and wholesale/retail – both within Australia and internationally.
These processes have helped many finance teams to establish more reliable reporting and review environments that support productive decision-making.
