Spotting the fault line

The overriding lesson from the calamities in the global financial mess was that monitoring systems were inherently flawed.

 

Exotic trading products and programmes were created which like the Frankenstein monster quickly became uncontrollable. Risks were taken on an unprecedented scale and those supposedly monitoring risk were “asleep at the wheel”.

 

Recklessness was encouraged and became the default position. There were no checks and balances – it became for the participants in the so-called casino bankers a safe bet.

 

What’s the worst that could happen following a spectacular flame out? Maybe you lost your job and had to move to another bank or institution. Get it “right” and the rewards were sky high.

 

Whenever there is a bonus culture unless the supervisory systems are rigorous there will be potential for abuse.

Apart from the self-inflicted wounds the general public also paid the price for this flawed culture.

 

One whistle-blower at Barclays was quoted as saying “It's a very high-pressure environment. The way we are paid means there is a lot of emphasis on getting people to invest more of their savings in the stock market than they should.' He added “Some of the things we sell —such as structured products — are rubbish.”

A little like bolting the stable door after the horse has bolted the regulatory authorities have now decided it is time for a closer scrutiny on bank, building society an insurance company staff being paid commission on sales.

 

This follows years of obvious laissez faire when for example it was quite normal for people to borrow based on self-certification of earnings, a recipe for disaster if ever there was one.

 

Whether through greed or stupidity there will always be people willing to take potentially catastrophic chances.

 

 

Avoiding burning your fingers

 

With the plethora of companies coming to the market much focus is being placed on EBITDA – earnings before interest taxes dividends and amortisation.

 

EBITDA has increasingly become the key metric to show the "intrinsic operational performance" of the business, i.e., the performance when all costs that do not occur in the normal course of business (e.g., restructuring costs, ramp-up costs, consulting fees for special projects, special legal fees) are ignored. While this is helpful in general, it is often misused by declaring too many cost items as "one-offs" and thus boosting profitability.

 

Many of the companies have as yet only traded at a loss and based on their history, there is no basis for concluding that these unprofitable companies will ever make money.

 

That’s the stock in trade for a company about to float whilst losing money. If it were making a profit before its IPO, it would be harder to make bullish forecasts about how much profit the company will generate in the future.

 

Ironically for a company losing money, the sky’s the limit when it comes to predicting how bright its future revenues will be. 

 

In tandem with the ability to forecast a spectacularly profitable future is the functioning of one of the market’s most basic laws: momentum. In other words powered by its own performance a stock that is gaining value up will continue to appreciate in value just because it is going up. 

 

More specifically, when there is no real positive cash flows on which to value a stock, its price will rise because investors who do not own the shares will want to climb aboard the bandwagon rather than miss out. 

 

This wave of “new buying” can help to drive up the shares further, which will attract a new buyers creating a dangerous bubble. 

 

It would probably be a more prudent strategy to avoid the money-losing IPOs and invest in companies who are making a profit before they try and float their shares. 

 

However forecasting the price of stocks remains an inexact science and unfortunately for the investor there is as yet no failsafe basis on which to explain why stocks go up and down.

 

Reviewing your business plan a worthwhile exercise

As business practices change and external factors come into play a regular review of the company’s business plan will ensure that the company stays ahead of the game.



The review if done correctly should result a realistic, objective and clinical appraisal of the business.



Following an analysis of the business plan it should be easier to communicate objectives and strategies to those funding the operation and also to the company’s employees.



The review will serve as a reference point when determining the effects of alternative courses of action on business operations.



A clear assessment of current working practices should highlight areas where the company may require outside assistance.



An analysis of the current inventory levels and receivables will provide the answer to the future growth and capital requirements of the business.

Danger signals

 

Very few companies explode like a super-nova the warning signs are usually visible for some time ahead.



The following is a basic check list which should help to determine whether the problems are of a temporary nature or have more serious implications for the future of the company:



The most important element in any business is maintaining a healthy cash flow. It is imperative that a strict control is maintained on all outstanding invoiced amounts.



The value of an efficient credit control system cannot be over emphasised.



Do not focus on generating sales with little margin in the belief that over time things will improve. Being the “cheapest supplier” will not provide an automatic route to more satisfactory profits in the long term. It is often better to keep your powder dry.



If you are constantly in danger of breaching your credit arrangements with the banks or suppliers this is a clear indication that the company is not trading satisfactorily.



As conditions deteriorate more and more time is spent focussing on the problems and not enough on to how to position the business for the future.



Particularly for owners of SME’s it is not easy to take the necessary remedial actions and very often this is where an outsider can be of assistance in repositioning the business before it is too late.

 

Fraud the ever present danger

 

One of the lessons of the recent economic downturn was the need for all businesses and organisations to remain alert to the potential for fraud.

 

Entrepreneurial owners of SME’s are a prime target for fraud as overseeing finances doesn’t always come naturally to them. If a founder is focusing mainly on the product or service being sold, and only minimally on administration, it leaves a business vulnerable to fraud.

 

In smaller organisations fraud can take many forms e.g. invoice scams, to suppliers providing kickbacks for inflated purchases, theft of stock, fictitious expenses etc.

 

For larger organisations the potential for various fraud activities exists but the numbers involved are far greater.

 

It is vital that all organisations have systems in place to monitor all of the company’s finances and commitments in a clear and concise format.

 

Simple but effective systems of checks and balances can go a long way to limiting if not removing the risks.

 

It is all but impossible to ensure that any organisation is “fraud proof” but by establishing robust and efficient systems some measures of comfort can be introduced.

 

Cash-flow the life blood of a company

Credit control has never been more vital. It must be a priority that all businesses ensure that their customers are settling invoices on time.

 

With slim operating margins the norm, very few companies can afford the spectre of significant bad debts.

 

Small businesses in the UK are owed billions of pounds in late payments, but new research has shown that a third are reluctant to chase slow-paying customers because they are worried about upsetting them or feel embarrassed.

 

Four in five, SME’s say they avoid chasing debtors because they find the process 'uncomfortable', while the remaining 20% are afraid of antagonising customers.

 

This is a dangerous approach resulting in more than a third of UK SMEs reportedly writing off thousands of pounds of bad debt every year.

 

The following are some procedures which companies can employ to increase the efficiency of credit control.

 

Set credit limits for each customer and review these regularly.

 

Be concise in trading terms for example it is better to specify 30 days from date of invoice rather than 30 days from end of month.

 

Issue monthly statements detailing invoices paid and those outstanding.

 

Score your customers and set a collection policy accordingly.

 

Do not let overdue payments go unchallenged.

 

Evaluate aged debtors on a weekly basis.

 

Prioritise collections and press for settlement of the highest values first.

 

Have a plan of action if payment is not forthcoming within a set date.

 

Despite the vital importance of maintaining a healthy cash flow three quarters of SME’s do not have a person or a procedure in place for chasing bad debt and a vast majority have no established escalation process for late payments. This is a recipe for disaster.  

 

Efficient control of stock turnover

Stock turnover ratio equals cost of goods sold during a specific time frame, divided by the average stock holding during the period.

 

The result of this ratio gives the "number of days that on average money is tied up in stocks". The longer this is, obviously the worse this is for the business as the money is not available to be used elsewhere.

 

An stock turnover ratio of 20 means that the average amount of stock holding during the year has been renewed, or turned over, 20 times over the course of the year.

 

Dividing the number of days in the period under consideration by the turnover ratio tells you how many days it takes, on average, for the warehouse to empty and then be refilled. The number of days in a year, 365, divided by 20 is 18.25. So the entire stock is fully sold and replenished every 18.5 days, on average.

 

As a general rule, the higher the stock turnover ratio, the more efficient and profitable the firm. A high ratio means that the firm is holding a low level of average inventory in relation to sales.

 

Carrying stock ties up money. This money is either borrowed and carries an interest charge, or represents funds that could otherwise be better used in servicing other elements of the business.

 

There are additional costs in holding stocks such as storage and the risk of getting spoiled, breaking, being stolen, or simply going out of style.

 

Wherever possible companies need to reduce stock holdings and there are various means by which to achieve this aim:

 

Liquidate slow-moving or obsolete stocks.

 

Introduce more efficient production techniques to reduce stock holdings.

 

Rationalise the product range weeding out the under performers and thereby reduce stock carried.

 

Negotiate sale or return with suppliers in order to avoid being stuck with unwanted product.