Previously good businesses are now under stress – here’s what’s needed to regain control over the future. By Rick Gomez.
“It’s only when the tide goes out that you learn who’s been swimming naked.”
This famous quote was made by legendary investor, Warren Buffet, CEO of Berkshire Hathaway.
It formed part of his chairman’s statement when addressing the impact of Hurricane Andrew on the insurance leg of his conglomerate. Despite the category 5 storm, Berkshire Hathaway reported negligible losses whilst many other insurers went bust.
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The premise behind Buffet’s quote is simple. When disaster strikes, it exposes those businesses whose performance was simply a by-product of the trading conditions around them, not one of sound decision-making.
However, in the coronavirus (Covid-19) pandemic, it is not just the reckless that have been found swimming naked. The sudden tide of events has left even good companies exposed.
Importance of Budgeting and Financial Controls
Let’s consider a few well know businesses that have hit the rocks: Carillion. Debenhams. Northern Rock. BHS. Laura Ashley. Barings Bank.
Whilst they each faced different pressure points which contributed to their failings, they seem to all have one thing in common:
These companies all had poor financial controls.
Whether it be high operational gearing, over-expansion, unsustainable levels of debt, gigantic pension plan deficits or poor cash flow, these can all be traced back to poor financial controls.
If companies want to survive now, they will need to have much better controls.
Traditional Approach to Budget Setting
The most well-known financial control is the budget. Most accountants have been involved in helping to set, analyse and/or review them for your respective companies. It is a core role of all management accountants.
For those of you who have had the pleasure, you’ll know by far the most common approach to budget setting is the ‘incremental approach.’ The premise here is simple:
- Start with the current years actual results as the base for next year’s budget
- Tack on a desired level of growth (say 5%)
- Pop in some cost uplifts for inflation (e.g. utility costs, rent reviews)
- Put in a ‘stretch’ target or two (e.g. say save 2% on staff costs)
- Presto – out pops next year’s budget.
It is the most common as it is the simplest and quickest way to do it. Particularly if you are a multi-site business like Debenhams or BHS whereby building a ‘bottom-up’ budget on a site by site basis using input from several hundred store managers is likely way too time consuming and you’d end up with a whole lot of ‘budgetary’ slack.
But to use this approach, you have to make a lot of assumptions.
The key one being that the environment your business operated within the current year will be extremely similar to the one you are going to operate in next year. Fundamentally, this means you are operating under the proviso that there will be VERY little uncertainty that faces your business.
Debenhams – a case study
Let’s apply this thinking to Debenhams back in 2006.
The company is fresh off a floatation and a healthy company valuation. It wants to keep the momentum going and now have the cash flow to do so. Its finance team prepares an incremental budget that spits out a profit figure for the following year. The problem is the company knows it is not incremental growth your shareholders are looking for.
The only way to hit those numbers is to expand.
So, it puts an aggressive plan in place to double the number of your stores. It then goes to the finance team to revise the budget to include your expansion plan.
They are going to need to make some assumptions about those new stores. The only real basis they have is performance of the existing stores. So they apply this. For the sake of argument (and prudency), they revise those numbers down by 5%.
Even with that – the budget looks achievable and certainly enough to satisfy shareholders.
10 years or so later, Debehams is stuck with long 18 year-leases on properties that no one is visiting along with all of the operational gearing (rent, insurance, staff) that comes with it. Throw in the debt obligations needed to finance that failed expansion, and you have got one deadly Molotov cocktail.
How can we learn from this?
I think one of the deadliest mistakes made here was the underlying assumption that the current positive trading conditions would continue indefinitely. How else do you explain locking yourself into an out-dated business model for such a long period of time? Even the most successful businesses need to be prepared for uncertainty. Whilst that may sound like its counter-intuitive, an article written by my colleague, Andrew Booth, details how companies can do so by using ‘scenario planning’ which will enable companies to examine a range of possible futures and ‘rehearse’ for them.
5 steps to better budgeting and financial controls
Whilst all businesses are different, there are some key principles I think most/all would be well to adopt in this current climate to help them to ‘re-establish control over their financial plan:’
1. Produce Multiple Versions of a Budget to Align with Different Possible Scenarios
- The economic conditions in a post COVID-19 world are impossible to predict, which therefore makes the traditional incremental budgeting approach obsolete. A ‘set-it’ and ‘forget-it’ approach is virtually impossible.
- Several versions of a budget should be produced to coincide with different possible scenarios the company may face post Covid. (e.g. if I’m a restaurant chain I’d be budgeting for a world where no-one is comfortable going out until a vaccine is produced and also for a world where people are going out more than ever as they are sick of being indoors).
2. Adopt Appropriate Financial Controls to Coincide with these Scenarios
This could include:
- Temp Staff and OT freezes
- Preparing for a leaner operational structure (e.g. say reducing the number of wait staff in a restaurant as perhaps diners will be more comfortable collecting their food from the counter)
- Travel freezes and strict expenditure policies (given staff are used to meeting from home)
- Closely monitoring working capital cycles (e.g. making sure receivables days are shorter than payable days)
- All capital expenditure to be authorised by board members. (no operational staff should be spending unless they have pre-authorisation to do so).
3. More Flexibility and Fluidity with Budgetary Reviews
- Move to a Monthly Rolling budget (as even with the best scenario planning, we are in unprecedented times and therefore most of our assumptions are likely to be wrong)
- Increased Focus on Regional Splits (we’re seeing this in America whereby the reaction to lockdown has varied wildly depending on the demographic of the population)
4. Regular Cash Flow Forecasts
- Cash was always King – but in a post-Covid world it is a dynasty.
- Adopt soft capital rationing internally
- Immediately seek additional finance if a cash flow forecast reveals you are expected to fall below this threshold
- Some of these controls/actions are a bit extreme to implement indefinitely. Care will need to be taken as to the appropriate point for some of these to be relaxed.
The actions a company should take to ‘re-establish control’ over its financial plan post-Covid-19 aren’t that much different to the usual types of controls a company should operate.
These are techniques, tools and actions that sound companies should always be adopting (cash flow forecasts, monitoring working capital cycles, considering alternative scenarios when budgeting) or at the very least have up their sleeves in case things take a turn for the worse (securing finance, putting hard restrictions on expenditure).
These are all things a sound business is likely to already be doing.
No matter favourable the business climate may seem, things can change in a heartbeat. But those businesses who have sound practices are far more able to withstand the pressure put on them from factors like Covid-19.
Whereas those businesses who were swimming naked before the pandemic are now stood cold and exposed.
Rick Gomez is a CIMA-qualified accountant and current senior tutor at iCount Training (Manchester). He prefers not to swim naked.
AAT Comment offers news and opinion on the world of business and finance from the Association of Accounting Technicians.