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?
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.
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.
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.