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Understanding profitability

Like many owners of small businesses, you probably started your company because you had an idea, saw a gap in the market, or thought that working for yourself would be 100 times better than working in the corporate world. A high proportion of business owners have not received any financial or accountancy training but to ensure the business continues to trade in the long term, it is important to understand a few key financial principles. One of these is understanding profitability and what drives that profitability. This is particularly true at the moment as costs spiral and margins are squeezed, but what does that mean? And what can you do about it?

Over many years of helping business owners to understand finance, we have discovered that most of our clients know what profit is:

It’s how much money your business makes after you have deducted costs and expenses. It is an outcome that results from all the effort and activity running the business.

However, many have difficulty understanding how to influence profitability, which is not quitethe same thing:

Understanding profitability comes from an awareness of the things you do in the business and how that affects the outcome, even though it may not be immediately obvious. This is what financial people refer to as cost drivers.

Understanding profitability and margins are a tool to help measure the efficiency and effectiveness of your company, so it is important to understand how it can be affected and how you can use forecasting and business planning to make sure your cover all the bases. In this blog, we are going to explore how some factors affect profitability, things you may not have taken into account when initially starting your business.

Some examples of costs that can really impact margins and may not be immediately obvious are:

  1. Recall/Return/Replacement
  2. Overservicing

Recall/Return/Replacement of goods

Any business making/selling goods has to consider the impact of product returns. This can be a formal product recall (ranging in cause from  a defect or a safety issue) through to the more common return as a result of customer or consumer choice.

Although the decision for a formal recall is normally made by the manufacturer, it could also be imposed by an industry regulator (Trading Standards for example.)

There are direct costs of a product recall all of which would impact profitability:

  • Getting the product back
  • Storage of returned goods
  • Testing the returned goods to determine the fault and percentage of occurrences
  • Scrapping of products that cannot be repaired and resold, and their destruction
  • Cost of sending replacement products
  • Interruption to normal manufacturing processes and additional labour costs
  • Refunds and cost of transporting faulty goods

Another action that can affect the normal running of your business is notifying interested parties:

  • Your supply chain
  • Consumers of your product worldwide (e.g. advertising costs)
  • Industry regulators/trading standards/safety executive etc.

The financial costs and the effect on profitability to your business of a product recall can go way beyond recall and refund:

  • Ongoing cost to your company’s reputation
  • Court cases/Fines
  • Inability to attract investors 
  • Production stoppage/redesign costs/review of processes
  • Supply chain/retailer trust

The good news is that you can take steps that will help to mitigate product recall/replacement costs:

  • Make sure management teams knows the industry safety standards/regulations
  • Allocate resources to comply with regulations
  • Robust and consistent in-house training
  • Make safety a business priority
  • Establish quality procedures/controls for your business and your suppliers
  • Undertake regular audits, preferably by an independent auditor
  • Maintain good records to allow traceability
  • Have a plan in place for handling a product recall
  • Insure your company against such an event

The more commonplace returns from customers can also be a huge cost to a business:

  • Administration time and effort
  • Packaging/re-packaging
  • The ultimate price that can be achieved for sale of returned goods

It is therefore vital to factor assumptions on the volume and cost of returns into your financial planning to truly understand profitability.

For businesses that supply services, there can still be a re-work cost if the scope of the service isn’t properly agreed up front.

You will find more tips on how to reduce the impact of returned products on the profitability of your company here. Link to : https://www.netsuite.com/portal/resource/articles/inventory-management/4-ways-to-minimize-the-impact-of-returns-on-profitability.shtml

We realise that this is a lot to take in and to plan for, but at Mellor Financial Management, we can cut out the jargon to show you how financial planning can help you to make complicated business decisions. Why not call us to discuss your requirements and make the most of our expertise gained from 20+ years as senior management specialists?

Overservicing

In today’s economy, every business owner is afraid of a bad review and the knock-on effects on company reputation and future business. But there is a big difference between offering good service and going that extra mile, and a tendency to overservice clients.

For example, if you own an electrical contracting business, your employees may go that extra mile by cleaning up after the job or showing the customer how their new installation works – this costs nothing in materials, just a little time and is good customer service. On the other hand, if they installed six plug points when you only quoted for four, that is overservicing and crucially, not a service you have priced/charged for.

Overservicing can result from a number of different factors, for example:

  • A client with too small a budget for the job
  • Adding work that wasn’t included in the quote and isn’t billed
  • The desire to impress a new client by including extra unpaid work
  • Filling time when the business is quiet

Do you recognise some of these traits? Any work that is undertaken but not paid for can be classed as overservicing, and this has a direct effect on the profit margin for each job. But it can also affect your ability to make profits in the future, for example if it becomes normal practice, or if your customers come to expect it, but at a price point that doesn’t reflect the service provided.

The key here is to make sure you/your employees stick to the contract or only doing the job you have quoted for. If you want to offer extras, add them as priced options, so your customers know these are additional to the quoted job. You can learn more about the problems of overservicing here. Link to: https://www.thejoyofbusiness.co.uk/how/weaning-yourself-off-overservicing-clients/

Financial planning

I have met a lot of business owners over the years, who looked at me quite blankly when I asked whether they have a financial plan in place. But financial planning will help you to make better informed decisions about allocating resources in the right place at the right time within your business. Doing a financial plan at the beginning of the year can help to identify problem areas like the ones outlined in this blog and can also form the basis of targets for the year ahead. A good plan includes both a cash flow forecast, and a profit and loss statement. The plan provides you with an overall picture on which to base business decisions, test out scenarios, and sensitivity to help understand the profitability of your business and budget wisely. At a time when many costs are increasing, for example utilities and employment related costs, this puts an added onus on understanding profitability.

If you need to cut through the jargon and get some expert support or advice about financial planning, understanding profitability, and how cloud accounting platforms can help your small business, please get in touch.

Seasonal forecasting

As a business owner, one of your main priorities is to manage the cashflow of your company to maximise profit in the busy times and make sure you have adequate financial resources for the slower times. So, wouldn’t it be great to know in advance when you can expect higher demand for some products or when demand falls away? Seasonal forecasting helps you to predict when these rises and falls occur so they can be incorporated into your business planning. You will be able to place your resources where and when they are most needed to maximise sales efficiently. Equally, if you know when the quiet times are likely to happen, you can improve the accuracy of your cashflow forecasting to make sure you have enough reserves to cover your outgoings.

If you are a new business owner, or you or your management team are struggling to understand financial terms such as seasonal forecasting, Mellor Financial Training courses are designed with you in mind. Our courses are run by experienced Chartered Management Accountants who understand what running a business is like in the real world. What’s more, they cut through the financial jargon to help you attain financial confidence. (Link to previous blog.) Why not talk to us today to see how our finance for non-financial managers course (Link to courses page) can help to bridge that finance skills gap?

What is seasonal forecasting?

Seasonal forecasting is an invaluable tool for businesses to take advantage of a predictable increase in demand because of seasonal events, for example, Christmas, Valentine’s Day, Bonfire Night, the barbecue season, summer holidays etc. Equally as important, you will be able to see when the down times are, so you can plan for those too. Using seasonal forecasting alongside cashflow forecasting helps business owners to work out in advance the periods where sales revenue may increase or decrease, and which products are most affected by seasonal demand. For some tips about best practice for cashflow forecasting you may like to read this article.

First on the list is to determine whether your business has seasonal fluctuations. The nature and intensity of these peaks and troughs can vary from business to business, depending on the industry. For example, for a Christmas shop, anyone can predict when sales are high, but the historical data will pinpoint with more accuracy when the busy time starts and when it falls away. There may also be other fluctuations that haven’t previously been considered. The trading patterns and which product lines are the most affected need to be determined from the data. Once this information is known, a detailed sales forecast can be included in business planning to ensure the business buys in or holds the right amount of stock at the right time.

Secondly, you need to understand the costs of your business and any fluctuations. A cost analysis will help you to understand when you incur the highest costs and the baseline of revenue needed to keep your business running. This knowledge is essential for being better prepared to handle cashflow difficulties so you can talk to your suppliers or obtain short-term finance if needed.

The third step is to understand revenues and again, know where the fluctuations are. A clear understanding of customers and their payment habits can establish who to chase for late payment and who can be offered different payment terms – instalments or discounts for prompt payment, for example. This can help to combat any fluctuations in revenue to make sure your baseline for effective business operations is always covered.

Business planning

Putting together all this information should reveal trading patterns, baseline costs and any seasonal changes. This detailed knowledge of a business means sales forecasts will be more accurate and financial planning can be employed to ensure the business runs efficiently with sufficient reserves to cover any gaps in revenue. You will be able to:

  • Adjust outgoing payments, so you pay more when your revenue is higher and less when sales are lower
  • Negotiate payment terms with your suppliers to pay their invoices quickly in busy periods but have longer to pay when business is slower
  • Determine areas where costs can be cut when demand is low without affecting your company’s ability to do business
  • Clearly see where additional resources may be required to meet seasonal increases in demand, for example stock investment, order fulfilment, extra customer service personnel
  • Order stocks of seasonal products in time for predicted busy periods
  • Keep tight control of stock so cash is not tied up in inventory or resources to manage excess stock when business slows down
  • Accurate seasonal forecasting avoids the selling off of surplus stock at the end of the season – discounting costs money!
  • Build up cash reserves during busy periods so there is a cushion to cover costs throughout the trading year, including slow business months
  • Identify areas to diversify to boost revenues in the off-season, without incurring an increase in costs

You can read more about how seasonal fluctuations in demand can affect your business here.

As a business owner, it is your responsibility to manage the cash flow of your company to ensure it survives the quieter times. We have all seen businesses fail during the pandemic, especially those who were not prepared for leaner times and had no cash reserves to help them through it. In other words, plan for the good and the bad times, just as you do in your personal finances, saving more when you have a higher disposable income and cutting household expenditure when times are leaner.

Using seasonal forecasting will highlight where and when you need to invest, cut costs, diversify or borrow to maximise sales revenues and ensures you have the capital to cover those baseline costs for efficient business operations throughout the year. I hope that this blog has helped you to understand how historical data can be incorporated into your financial planning to help you ride the ups and downs in trading patterns. However, if you feel you are not prepared or there are gaps in your financial knowledge, and you would like to know more, please get in touch to find out how Mellor Financial Management can help you get to grips with your business finances.

What actually is a recession?

If you pick up a newspaper or catch the news on TV, you can’t miss the ‘are we going into a recession?’ headlines. There have been a number of changes in the economy recently caused by the effects of the pandemic, the removal of the energy cap, Brexit and war in the Ukraine, which have fuelled a steep rise in the rate of inflation and the cost of living. Financial pundits are now talking about the UK economy going into recession before the end of the year, as the accumulative effects of these changes start to bite. But what is a recession, and how will it affect your business?

What is a recession?

The technical definition of a recession is two successive quarters (or six months) of decline in the UK economy (GDP). GDP is the value of goods and services measured in pounds sterling, but its growth, or lack of, is normally shown as a percentage. It is when the economy starts to slow down, and this percentage is a negative figure that is defined as a recession. The UK economy last saw a recession in 2020 during the lockdown when GDP fell by 20% from April to June – an unprecedented drop.

The Bank of England has predicted a 13% inflation rate and a decline of 1% in GDP by the end of this year, which will continue to fall throughout 2023. The UK’s leading macroeconomic, social research and forecasting institute, NIESR has predicted that interest rates will rise to 2% by the end of this year and 2.5% in 2023 to try to halt the rise in the rate of inflation.

At the moment, the UK is in a tricky financial position. Normally when a recession is predicted, interest rates fall, and tax rates may be cut to stimulate the economy. But when inflation is high and continuing to rise rapidly, there is an argument for raising interest rates (which we have just seen), and taxes to fight this problem. Read more about a recession and its causes in Forbes Advisor.

What is a recession and how does it affect my business?

A recession can impact businesses differently, depending on the industry and business type (e.g. retail, manufacturing or service.) However, there are key issues that will affect all businesses.

Sales levels

Consumers tighten their belts and cut back on spending, so sales levels will fall, especially for non-essential goods and services. As sales fall, profits will too, so businesses have less to invest in new machinery and resources.

Cost cutting

The impact of falling sales can result in cost cutting including moving to smaller premises or premises in cheaper areas. Manufacturers may have to turn off machinery, close down plants and source cheaper components.

Declining standards

The high standards normally applied to products or services may fall if businesses are forced to cut costs i.e., sourcing cheaper components or letting skilled staff go, which could affect a company’s reputation and profits longer term.

Making payments

When cash flow is reduced, it is more difficult to make payments on time. It is increasingly important that customers pay invoices on time and in full and those who go out of business do not owe money for goods or services.

Obtaining credit

Consumers are not the only ones who cut down on spending, lenders do too. Therefore it could become more difficult to obtain credit, with more stringent terms.

Stock Market

If your business has shareholders, their dividends will decline as profits fall. If the share price is affected, it could have an impact on your company’s financial statement and the Board of directors.

What is a recession and how can my business survive?

In order to survive a recession, you need to be prepared. Your business will need financial resilience to withstand the effects, or even flourish whilst others are floundering. It is very therefore crucial that you understand financial reports/information and are in control of your company’s finances.

Financial planning

In order to have the financial resilience to cope with difficult trading conditions, you need to manage the cash flow of your business. A cash flow analysis can provide a lot of information:

  • Identify trends – products where sales are increasing/decreasing
  • Late payers – who to incentivise/chase to pay on time
  • Inefficiencies – where you could cut costs
  • Potential – where you can reallocate costs

The knowledge gained by financial planning can help you to diversify/pivot when regular sales are falling. This will enable you to react quickly to an economic slowdown, reallocating resources to new income streams that may help your business to succeed when normal trading conditions are challenging. You should build a reserve fund to make sure your company can ride out any difficulties. For more on building financial confidence, read our recent blog on financial resilience.

At Mellor Financial Training, we specialise in finance for non-financial managers and owners of small businesses. So, if you don’t understand financial jargon, or just can’t get to grips with the numbers, gain financial confidence by attending one of our training courses.

Business planning

Alongside a financial plan, every business should have a business plan, detailing your business strategy and the milestones from the present to where your business will be in the future. You need this clear understanding of your business in order to react quickly to changes in the trading or economic environment:

  • What it does and why
  • The market it operates in
  • Its strengths and weaknesses
  • Your competitors
  • Your customers
  • Identify new opportunities

Having in-depth knowledge of your business – how it makes money and how you will reach your goals – is fundamental to business planning. A strong business plan will include contingency planning, so that you can identify new opportunities, capitalise on your strengths and be prepared for obstacles or difficult trading circumstances.

Business planning will enable you to understand your customers and the need your product or service fulfils, so you can decide how to communicate when sales start to decline. Identifying how to meet their needs and capitalising on customer communications could give you the competitive edge. If you don’t have a business plan, or need a guide to what it should contain, the Federation of Small Businesses has a guide on what to include.

What is a recession – is there any good news?

We hope this blog has answered the question ‘what is a recession’, outlined its effects and shown you the essentials for survival. It is important to remember that good financial planning and business planning can provide you with the knowledge you need to succeed where others may struggle. You could identify a:

  • Better business model
  • More cost-effective process
  • Innovative ways of meeting customer need
  • Way to diversify/pivot
  • New markets for your product/service

If you feel there is a financial skills gap in your business, Mellor Financial Training courses cut through the jargon to give you financial confidence. Why not talk to us today to see how we can help you to understand the basics of financial planning? Our finance for non-financial managers courses will give you the understanding and confidence to make crucial decisions in preparation for a recession, to build business resilience and hopefully survive an economic storm.

Financial Resilience

Making business decisions with confidence

We all know that having financial confidence in your personal life puts you in a better position to make informed decisions, for example:

  • Can you afford to go on holiday this year?
  • When will the mortgage be paid off?
  • Do you really need a new car right now?
  • How much should you invest in your pension?

The same principle applies to running a small business. If you understand the financial aspects of your business and how to interpret the information, you can use it to grow. You will have financial confidence that your business has the agility to adapt to unforeseen trading conditions and you will be able to make better and timely business decisions:

  • Is it the time right to invest in new machinery?
  • How many new staff should I set on?
  • How many debtors does my business have right now?
  • If there is an emergency, how much do I have set aside to deal with it?

What is financial resilience?

Financial resilience is about the capacity of businesses to absorb a financial shock or downturn. It is how some businesses can continue to grow, even when normal trading conditions are affected by sudden and unforeseen changes. The events of the last couple of years and the ability of some businesses to cope more easily with the effects of the pandemic have brought the importance of building business resilience to the fore. We have seen how companies with large reserves have been able to adapt quickly to cloud computing, enabling their workforces to work from home, where others have struggled. Some companies have been able to pivot their offering and even capitalise on the change in consumer buying habits. Some agile businesses have been able to establish a competitive advantage and have thrived, despite difficult the trading circumstances.

With the current increase in energy costs, rise in inflation and war in Eastern Europe now added into this equation, it is more crucial than ever for business owners to have financial literacy. Businesses with financial resilience are able to withstand or even thrive during a period of difficult trading conditions. You can read some tips for ensuring you have financial confidence in your business in this inDinero blog by Tony Esposito.

Being in control

I am always surprised by the number of owners of small businesses who leave financial details to advisors or accountants, without understanding or possessing financial literacy themselves. But for your business to have financial resilience, you should know how money moves through it, how much your business is owed and how much it owes other companies. I know that finance and accounting is complicated and full of jargon that can be difficult to understand for those who do not have a background in finance, yet it is critical to the success of your business that you can make sense of financial information, documents and reports.

Do you understand your company’s financial statements? If the answer is no and you need to get comfortable with the numbers, talk to us at Mellor Financial Training. Our speciality is finance for non-financial managers, including business owners and their teams. In fact, anyone in business who needs to get to grips with financial information so they can make better use of it. Aimed at those without a financial background or with a finance skills-gap or requirement, our training courses cut through the jargon, giving you financial confidence, empowering you to make better informed decisions. For more information and to check out our upcoming courses and webinars click here.

Financial planning

Making sure you have a financial plan in place at the beginning of the year is the first step towards building financial resilience in your business. Playing a key role in your financial plan are the three major accounting statements:

  • Cash flow forecast
  • Profit/Loss
  • Balance sheet

Knowing how to manage the cash flow of your business is critical. A cash flow analysis will help you to identify late payers, identify inefficiencies and pinpoint areas where you can cut or reallocate production, component and resource costs. Understanding where your money goes gives you the flexibility to identify new opportunities, allowing your business to pivot or diversify into other areas, so it continues to grow even when sales from your regular income stream may be falling.

Use your financial plan to set your business goals and determine how you are going to achieve them by establishing KPIs against your objectives. Checking your progress against the cash flow forecast will show whether you are on target to reach your business goals and highlight areas where you may be falling behind. A financial plan will help you to understand profitability and what actions you can take to improve. You can read my blog about understanding profitability here.

Building trust and security

Again, just like in your personal life, if you feel secure in your financial plans you will have the financial confidence to know you are prepared for any situation. Build your reserves or an emergency/slush fund, so that if the unthinkable happens and you have to write off a bad debt, action a product recall or defend yourself against a lawsuit, you have the necessary funds in place to finance it. Pay back your debts as soon as you can and make sure your customers pay you on time. If you can demonstrate to your bank or investors that you have met or exceeded your financial goals and obligations, you will instil them with the confidence to back you when you go to them for help.

Knowledge is key

With all things, knowledge is the key to confidence and finance is no different! Business accounts are not just the end result of a year’s trading. Once you know how to interpret them, you can use the financial information as a basis for building business resilience and making important business decisions.

If you own a small business and feel you or your team has a finance skills gap, Mellor Financial Training courses are designed for you because we cut through the jargon and complexity of business finance. All our courses are run by experienced Chartered Management Accountants to ensure we reflect the ‘real world’ view, not a purely academic one. And with flexible learning options, you and your team can attend sessions in Leeds or Manchester or take part either via e-learning or live online sessions. Alternatively, we can deliver our training in-house exclusively for your organisation with specific content that meets your training needs. Talk to us today to find out how our upcoming finance for non-financial managers course can help you to gain financial confidence in your business.

Financial planning for Q4

The kids are back at school, the Christmas season is approaching, and businesses are moving their focus towards Q1 2023. But September is the perfect month to plan to have a great ‘end of year’ in business, so in this blog we are going to give you some pointers on what you can do now to make sure that your business ends this year with a bang! This is especially important in 2022 as inflation is spiralling ever upwards and consumers are cutting back on their spending. Rising costs and changes in the external trading environment mean that this is a good time to take stock and review your financial planning, Q4 budgeting and forecasting to ensure a profitable end to 2022 and establish firm foundations for 2023.

Change is unsettling, but it gives you an opportunity to adapt and ensure your business can grow. Taking stock of where you are now, reviewing what has worked and what can be improved will put your business on a sound footing during these changing times. If you or your management team struggle to understand how historical data can be used to move your business forward, Mellor Financial Training Courses are designed with you in mind. Our trainers cut through the financial jargon to make the course relatable to your business. Contact us to find out how our finance for non-financial managers course can help to bridge that gap in financial knowledge.

Evaluation

Historical data can be your friend when financial planning, so make sure your records are up to date so that you can really understand what is going on. Here are some leading indicators to help you to review where you are now and highlight any changes you may need to implement.

Processes: Have you made changes to internal processes, such as new purchasing/ordering systems? How successful have they been following implementation? Going forward, can more improvements be made to make sure you maximise efficiency throughout the final quarter? Have staff been trained adequately?

Resources: Have they been allocated correctly? Have employees or machines been idling, or have orders been refused because the necessary resources were not in place? Is resource allocation logical and effective to meet your sales forecast for Q4?

Employees: Have you taken on more staff? Have they been trained and reviewed? Are the KPIs for your staff on target or do they need reviewing/amending? Do you have the right number of people in place, or should you let people go to make sure your business is at its optimum strength to meet targets? This could be the best time of year for personal performance reviews, so you can set new KPIs based on your audit, determine where training is needed, and ask employees for their feedback on new processes and customer relationships.

Then we can consider outputs:

Sales: Look at the most recent sales data, plus the figures from Q4 last year, so you can see the relative performance and whether there is a trend. Do some products or services sell more in Q4, have you got enough stock or resource to meet demand? Can you allocate resources into building more stock of those lines? This is where forecasting seasonality will be especially useful for business planning. If your business experiences seasonal fluctuations and Q4 is your busiest time, seasonality forecasting will highlight which lines may need investment or extra resources, where costs can be cut or resources reallocated, and how you can reach maximum sales revenues.

Costs: A cost analysis of the year so far compared to prior years will reveal the baseline of revenue your company needs now to keep going, and this may be different to what you have known in the past. With the rise in inflation and energy costs, you need to factor in the increases for Q4 to see the new baseline figures. Compare them to Q4 2021 to see the percentage increase in costs, so you can make decisions about pricing and promotional strategies to maintain business performance.

Cash flow: A cash flow analysis will reveal outstanding payments due from customers, so you can focus on getting them into your bank account as soon as possible. It will also help you to identify trends and potential inefficiencies. Understanding where your money goes and when is crucial for financial planning.

Profit/Loss Statement: These documents are not just for the end of the financial year. You should also review them either monthly or quarterly to ensure you know what the current financial situation is in order to make adjustments in your financial planning for the next quarter.

For more insights into Q4 planning, read this article from LinkedIn.

Analysing this data will help you to identify whether you have the right level of resources for the final quarter and that your resources are allocated where they will be most effective in helping you to achieve your goals. You will also clearly see where there are gaps, so you can make the right decisions in the right areas of your business to take advantage of increased demand. For many businesses, Q4 is especially affected by seasonality so it is important that you are prepared and know what you can do to streamline your business and what actions you can take to improve profitability. We covered this topic in some depth in my blog about understanding profitability.

Financial planning in Q4

Reviewing the historical data will help you to put a financial plan in place to build resilience, aiding your business to withstand the effects of rising inflation, seasonality and soaring energy prices. Acquiring financial knowledge gives you the insight to adapt or diversify so you maintain that baseline revenue even when income from your normal revenue stream may tail off. You may like to ready my blog about financial resilience for more of an insight into how knowing how to interpret financial information can help with financial planning, business resilience and making important decisions that move your business forward. For tips on things to do in your business as the beginning of Q4 you could read this article at nav.com

If you are struggling to understand financial terms and have no idea about financial planning, there is no need to shoulder the responsibility of making financial decisions on your own. Talk to us at Mellor Financial Management to find out how we can use the skills and knowledge gained from 20+ years as senior finance management specialists to transform your business. We also offer training courses that will build financial confidence in your team.

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