Why a financially troubled business should create a three factor budget
A major contributor to financial distress for small to medium-sized enterprises (SMEs) in Australia is poor budgeting. Here we look at a useful budgeting technique — the ‘three factor’ budget/forecast, and how this can be used by distressed businesses to turn things around and avoid insolvency.
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Poor financial recordkeeping, forecasting and cash management are significant contributors to business insolvency in Australia. Here we look at how a ‘three factor budget’, also known as a ‘three factor forecast’, can provide useful insights to businesses that may otherwise face insolvency and the need to restructure.
Why is budgeting crucial in a financially troubled business?
ASIC data collated from external administrator reports over the years has consistently shown that poor cash management and financial recordkeeping are two of the biggest causes of insolvency in Australia. And, of course, the two are closely related: Without hard data, it is easy for business owners not to see critical cash shortages on the horizon.
Why does this occur? In our experience, cash management and bookkeeping deficiencies are not really root causes of insolvency in Australia — rather, they are a natural consequence of the time and financial pressures that small businesses in Australia are often under.
- Business owners/directors tend to prioritise working on the core function of the business, and see bookkeeping as something they will ‘get around to’ at some point in the future. This is particularly true in the construction and transport (trucking) industries which involve a punishing physical work schedule, and predominate in Australian insolvency statistics.
- Dealing with hard financial data can feel complicated and difficult, so it becomes attractive for some owners/directors to stick their heads in the sand.
- Optimism bias — many small business owners push forward with a belief that ‘she’ll be right’, and things will shortly turn around for the better. This means it can be easy to discount current cashflow problems as something that will resolve of their own accord.
For any business under distress, getting a budget in place is crucial in order to halt the slide into insolvency.
What is a three factor budget?
There are three related ways of thinking about the financial health of a business, each of which feeds into a particular financial statement:
- What it owns and what it owes — this is fed into the Balance Sheet (‘Statement of Financial Position’)
- What it receives and what it spends — this is fed into the Profit and Loss Statement (‘Statement of Financial Performance’)
- Whether it has the cash to pay its forecast outgoings — this is fed into the Cash Flow Statement (‘Statement of Cashflows’).
For distressed businesses in Australia, it is often the last consideration that is most important: No matter how healthy the owner’s equity is, or how significant the net profit is, if there isn’t cash available to pay outgoings on a timely basis, the business will likely be insolvent, and forced to go into an insolvency process: This will often mean bankruptcy for a sole proprietor and liquidation for a small company.
A three factor forecast/budget (also known as a ‘three way budget’) collates information from both the Balance Sheet and the Profit and Loss statement and feeds them into a Cashflow forecast. It mitigates some of the inherent limitations of accrual accounting — a Balance Sheet and Profit and Loss statement don’t provide useful ongoing information on cash-at-hand.
How to implement a three factor budget in a troubled business
In order to implement the three factor budget, a business should proceed as follows:
- Look at known cash events: Looking at the past, how often did customers pay within their 30-day terms of payment? Past payment should be the basis for forecasting future receipts. On the outgoings side, monthly payroll and contractor payments should be fairly predictable. Similarly, rental payments, subscriptions, interest payments on any loans and other payments that can be easily forecast should be taken into account. Cash needs to be on hand to pay for all these items.
- Factor in anticipated events. This includes sales revenue, minus the cost of goods. Obviously sales revenue can differ quite substantially from year to tear.
Doing this will provide a ‘road map’ for the company that allows it to see which times of year it may face a cash shortfall: For example, as GST, Superannuation and PAYG are due quarterly, the business will face cash pressures at those times. Or, if the company does a lot of sales in the time leading up to Christmas, but less in the middle of the year, they may have a cash shortage mid-year.
A 12-month period is useful (normally a financial year) as any longer than that and the numbers become less accurate. Changes in economic environment, company structure and trading will all have a significant impact on cash position.
Ideally, the three-factor budget should be informed by real-time accounting data taken from accounting software such as MYOB or Xero. There is also software, such as Spotlight Reporting, that can import data from MYOB and Xero to create a three way forecast and this could be the most efficient way to undertake this process.
If the three factor budget identifies an issue, what next?
The three factor budget will highlight if a cash shortage is expected, and when that is likely to occur. Where a cash shortage has been identified, what should a business do? We recommend:
- Look at the forecast to work out the cause: For example, what does Accounts Receivable Aging look like? It may be that clients/customers are getting later with payment.
- Assess whether anything can be done to resolve the issue. For example, with the cash shortage identified above, it could be that the business is not qualifying its leads appropriately and needs to tighten up client acquisition.
- See if there are any other ways of improving cashflow — this could include slashing unnecessary expenses.
- Where the cash shortage is imminent and there is no viable way of the business resolving the issue with its own resources, consider bridging finance: The three factor forecast itself could be valuable information for the lender in making this decision.
- If the business is significantly over-leveraged, and the debt is less than $1 million, take early advice on the possibility of small business restructuring. This is a fast process which can quickly deal with debts which are hampering the business.
Three Factor Budgets – A Useful Tool
Businesses in distress need to act quickly to ensure that short-term cash issues don’t lead to a sustained lack of working capital and insolvency. In order to ‘avoid the wall‘, business owners and directors need to consider what steps they can take to improve their budgeting and forecasting. In our view, three factor forecasting is a useful tool for any smaller Australian business, but especially those that are experiencing financial difficulty.