Managing Finance | Business Guides | NatWest International

Managing finances

Our guide to looking after your business finances

Breaking even

The first financial target of any business is to break even - that is to cover all the costs incurred by the business.

How do I budget to break even?

When preparing a budget, it is vital to show the level of sales required to cover the expenses. If the break-even sales figure is close to the sales forecast, then there is little scope for error. If you are a new business, investors will look quite closely at the margin of safety when determining whether to provide support.

If you are a service business, you will need to know how much to charge per hour (though you may offer your customers a fixed price). Your hourly rate equals your annual costs divided by your annual productive hours. Remember that not all of your working hours will be productive - some time will be required for promoting your business, buying supplies, doing the books, etc. You will also need to allow for holidays and illness. For any individual sale you will also need to add direct costs. If you are in manufacturing, then instead of estimating working hours start by estimating the number of products that you will sell. Include all costs - including the cost of your time and depreciation of capital equipment.

Once you know your costs and estimated selling price, you are in a position to calculate how many products or hours of your time you need to sell to break even or cover all of your costs. Any further sales will then provide you with a profit. The easiest way to do this is with a graph. The vertical axis measures money; the horizontal axis measures volume of sales. First plot your overhead costs. This will be a horizontal line - because overheads do not vary with sales. Then add direct costs, to show the total cost for a given volume of output.

Now plot your sales. The point where the sales income equals the total costs is the break-even point. The difference between your forecast sales and your total costs is profit (or loss). The difference in volume between the break-even point and the actual sales is known as the margin of safety.

Is it enough just to break even?

The whole point of calculating the break-even point is to know the absolute minimum level of sales required. If your business is to have a future you will need sales consistently above the break-even point - to give a reasonable profit and to repay any loan finance.

Are my costs too high?

There is almost always scope to reduce costs. If you cannot increase your profit through additional sales, then you will need to look at ways of reducing your costs. If necessary, seek advice from your accountant or business adviser.

For a new business it is likely that costs will exceed income for the first few weeks or months but you should have a plan which allows for this - and you should still be achieving your sales targets or else you will need to worry about finding the cash necessary to cover your costs.

Am I charging my customers too much?

New businesses, when asked how they will attract customers, almost always answer by saying that they will charge less than their competitors. This is a marketing strategy known as cost-leadership. It is impossible for small businesses to sustain because they do not have the economies of scale of large businesses. You may also find that if you start with low prices it is difficult to increase them as customers will want to continue buying at the lower price.

So you should pursue a marketing strategy of differentiation - attract customers by offering better quality, or a service or product that is unique, or because you have particular expertise, or by better after sales service, or by quicker service, etc. This will allow you to charge higher prices.

You should, however, regularly review your costs and prices - and adjust your prices as necessary.

Hints and tips

  1. Keep a close eye on your budgeted income and expenditure. If sales are not as high as required, recalculate your unit cost and sale price. If this is a price you cannot sell at, you will need to take action to increase sales or reduce costs.
  2. Use your break-even sales volume to set monthly and annual sales targets. If you do not achieve these targets, you will need to take remedial action.
  3. Prepare a marketing strategy based on differentiation rather than cost-leadership.
Forecasting sales

Every business needs to forecast sales and then use the information to budget effectively.

Why do I need to forecast sales?

You need a sales forecast because your sales provide the income for the business. Without sales, you have no business. However a forecast will also enable you to set sales targets, budget effectively and prepare a cash flow forecast. Without an accurate forecast of sales you will not be able to determine how much you can afford to spend.

How do I know how much I am going to sell?

A new business has no previous sales figures on which to base a forecast, so will need to carry out market research to prepare a credible forecast. Ideally, get promises of orders in advance of starting your business. Also, interview potential customers. Depending on your business and circumstances, you may be able to test the market with trial products or start in your spare time before committing yourself completely.

If you are already trading, you can base your forecast on current sales. But you should still talk to your customers about their expectations. Will they continue to buy from you? Are they looking for something different? Can you supply it? In short, stay close to your customers. What will be the effect of additional marketing or price increases?

Look at trends in the sector and in the overall economy. Look at how the buying habits of your customers are changing. Look at what your competitors are doing. What effects might that have?

Set a target for contacting potential customers. Some of these will turn into enquiries. And, in turn, some of these will turn into sales. As you gain experience, you will be able to estimate a conversion rate from original contacts, through to enquiries, and then to successful sales.

What information do I need to make a good estimate?

It is not easy to predict sales accurately, as all businesses are affected by external factors as well as by the choices customers make. A good sales forecast will allow for all these factors.

- If you are already in business past performance is a good place to start. If you are starting a new business make a forecast based on rigorous market research.

- Market trends may give an indication of whether you can expect sales to go up or down. Talk to customers about their own expectations regarding future purchases; ask prospective customers about their buying plans

- If you are already in business, what is the effect of additional marketing? Are you planning extra marketing?

- Look at external factors - the state of the economy generally, inflation, interest rates, exchange rates, etc. What effect might these have on your sales?

- What is the alternative to your product or service? How do you retain customer loyalty? Do you keep innovating to retain customers?

Should I overestimate or underestimate my future sales?

A sales forecast needs to be as accurate and reliable as you can manage. After all, you will be committing yourself to expenditure and loan repayments based on the forecast. If you overestimate, then you may not have enough working capital to cover your day-to-day cash requirements.

Remember, though, that there is a difference between forecasts and targets. Your forecast is your best prediction of what might actually happen. Use this to set your budgets and monitor carefully so that you do not overspend.

In addition, you might set rather more stretching targets. If you achieve higher targets, then you will need to revisit the forecast and the budgets - but an ambitious target can be a real motivator to achieve higher levels of sales.

Remember that prospective funders will be looking closely at your sales forecast. After all, it is the sales that produce the income - and the profit - so that is what makes the business an attractive proposition.

What if I do not meet my sales targets?

If sales are falling short of your forecast, then you will quickly run into problems. The most immediate effect will be lack of cash to pay your debts as they fall due. But your profitability will also quickly fall. So you need to act quickly to discover why sales are low and to remedy the problem.

- Aim to raise the profile of your business through additional promotion - perhaps through advertising, but also through press coverage if you can manage it.

- Revise your cash flow forecast and talk to the bank at an early stage if you think that the problem is temporary and that you will just need a short-term cash injection.

- Take steps to cut out all unnecessary expenditure.

- Keep a close eye on performance - if there is no improvement, then you may need to consider the future of your business.

Who can help me prepare a sales forecast?

If you need assistance to prepare a sales forecast - and a marketing plan - then there is help available. Your bank manager or accountant may also be able to recommend marketing support.

Hints and tips

  1. Talk to your customers about their purchasing plans for the year ahead.
  2. Try to anticipate competition that could undermine your plans.
  3. Compare your actual sales with your forecast on a regular basis - keep a sales graph on the wall as a constant reminder of your performance - and be ready to respond quickly if necessary.
  4. Do not forget the need to market constantly - it is very easy to fall into the trap of fulfilling existing orders, and forgetting to look for the next orders, especially if you are working on your own.
Keeping costs down

For your business to be successful, you need to ensure that your income exceeds your expenses.

How do I know when I am spending too much?

Watch the profitability of your business on a month by month basis. If your sales are level and your profit is falling, look closely at your expenditure - and cut costs. It might be sensible to plot both income and expenditure on a break-even graph and put this on your office wall.

If you have budgeted well, and if you achieve your sales targets without over-spending, then you will usually be okay. Watch out, though, if you sub-contract a large part of your work. In this case, you need to watch your break-even point closely as well.

What is an 'unnecessary' expense?

Most small businesses need to keep tight control of their expenditure to remain profitable. Every time you want to spend money, ask yourself how this expense will help you add value to the work that you do for your customers. If you cannot justify the expense in terms of enhancing your product or service, or making you more efficient, then you will probably survive without it.

How do I negotiate better prices from suppliers?

Competition amongst suppliers is the biggest factor on their pricing policy. So keep an eye on the different suppliers in the market and what they are charging. Remember, however, that it does not always pay to buy the cheapest. In the same way that you are aiming to differentiate yourself from your competitors, so are your suppliers. Cost is important - but you may also want to consider the quality of the product or service, after sales service, reliability of supply, etc. But always talk to your suppliers about their prices - and be ready to change if their prices are too far out of line.

You may find that you can get cheaper prices by agreeing to pay more quickly or by agreeing to a long-term supply contract. Your strongest negotiating position is knowing that you can go elsewhere for a lower price.

How do I produce the same quality at a lower cost?

You may think that this is a silly question, since no-one wants to spend more than they need. However, you should be continually watching for new developments and technologies which may enable you to become more efficient and to increase your productivity.

Visit trade fairs to keep up to date with the most cost-effective equipment. Experiment with new approaches. If you employ staff, ask them for their ideas - you need to do your best to ensure that they are using all their time productively, rather than wasting it on administration or other activities that do not generate income.

Hints and tips

  1. Good cost control is part of effective financial control, so ensure that you have a good accounting system. Check the figures regularly - at least monthly - and act on the figures promptly if you identify problems.
  2. Beware of false economies. Compromising your level of quality and service could lose you business. If cost cutting leads to deterioration in working conditions for staff, there is a danger that they become demoralised and perform less well - which will exacerbate the problem.
  3. Confront cost problems immediately - and take action before the problem becomes insurmountable
Managing cashflow

Every business has to watch very closely its income, profit and cash situation.

Why do I need to forecast my cash flow?

It is essential to know how much money a business will need to meet payments when they are due. A cash flow forecast helps analyse expected receipts and payments and can be used to determine whether there is a need for an overdraft to provide sufficient working capital.

For new businesses, it is particularly useful to be able to determine exactly how much finance will be required to take the business through its early stages and to pinpoint when money will be needed. The cash flow forecast is the key part of any business plan from the point of view of potential funders.

What information do I need to write a cash flow forecast?

A typical cash flow forecast is split into three sections: receipts (all monies coming into your business from sales, loans, etc); payments (for expenses, loan repayments, drawings, etc); and balances (a monthly balance and a cumulative balance - which should be equal to the cash in your bank account).

A cash flow forecast only shows cash in and out, so non-cash items like depreciation are not included.

In order to prepare a forecast you will need to prepare budgets for sales and expenditure. From these, you can estimate when you expect to receive money for your sales (unless you are in a cash business, like retail, you will provide customers with an invoice and expect to wait some weeks before you are paid). You can also estimate when you might have to pay for the expenses that you incur - for staff wages, rent, insurance, advertising, bank charges, interest, raw materials, etc. You should also include loan repayments, your own drawings or salary and VAT if applicable.

How do I ensure that I can meet my expenses?

A cash flow forecast gives you a basis for predicting your receipts and payments and thus ensuring that you have enough money to cover the payments as they fall due. If you do not have enough money to put into the business, and you have to wait for receipts to start flowing, then you will need some additional working capital - often provided by the banks in the form of an agreed overdraft.

One of the most important forms of finance for a business is creditor finance - that is, paying your own creditors as late as you can reasonably manage. The longer you delay paying them, the smaller your overdraft. However, if you delay too long, they will not be impressed and may even stop supplying you.

If you have longer term finance needs (for the purchase of capital equipment, for example) then you may also need a term loan. As an alternative, you may be able to secure so-called asset finance - as a lease or hire purchase arrangement.

Once you are established and have built up a track record, you can speed up the payment of your invoices by using factoring or invoice discounting. However, these are relatively expensive options and are not worthwhile until your business starts to grow.

How can I get customers to pay quicker?

There are many ways to ensure prompt payment and most of them have to do with good planning and communication with your customers. Here are some guidelines:

- Check the creditworthiness of your customers before you start to offer them credit.

- Agree payment methods and terms prior to allowing credit.

- Use a written contract to set out your trading terms - and if you provide goods, include a 'retention' clause so that ownership does not pass to your customer until you have been paid.

- Send out your invoices so that your customers receive them before the end of the month - which should mean that you get paid at the end of the following month.

- Ensure that invoices are correct.

- Keep in close touch with your customers while waiting for payment.

- Monitor overdue invoices closely and contact customers regularly about late payments.

- Stop deliveries to customers if they exceed their credit limit or fail to pay within the agreed timescale.

- You might also offer discounts for prompt payment - but watch for the customer who pays late and also tries to take discount. Remember to build discount into your costing and pricing.

What can I do if I run out of cash?

It is not easy to raise additional cash at short notice or in a crisis, so cash flow problems are usually shouldered in the first instance by a business' suppliers. However, they can cause difficulties by making a statutory demand for payment or by starting bankruptcy proceedings. Ideally, you will be monitoring your cash position carefully; if it looks like you may have a problem, talk to your bank at an early stage about increasing the level of your overdraft. If you do find yourself short of cash, reassure your suppliers and work hard to get in the money owed to you so that you can pay your suppliers.

- Talk to your bank about your overdraft arrangements.

- Talk to your suppliers and reassure them that they will be paid shortly - if necessary, agree a payment schedule with them and pay over a number of months.

- Check that you have invoiced all of your own customers - and offer an incentive to pay early.

- Review all of your costs and cut down your expenditure as much as you can.

If the problem looks insurmountable, talk to your accountant or other professional adviser. It is an offence to continue to trade once you know that you are insolvent - once you know that you cannot pay your debts as they fall due.

Hints and tips

  1. When you prepare your cash flow forecast, you should also undertake a 'what-if' analysis. What happens if sales are 10% less than forecast? What happens if raw materials increase in price by 20%? You can then forecast the worst-case finance requirement - which mitigates the need to go back to your finance sources for more cash.
  2. Invoice your customers promptly and accurately - and follow up to check that they have paid.
  3. Review your actual cash flow regularly - at least every month. Check that it is line with your forecast and act quickly if it is not.
Raising capital

An early challenge for anyone about to start in business is to convince investors or lenders to invest and lend you money.

What are the main options for raising money?

There are various sources of finance available for starting or growing your business. The first is that you provide all the necessary money from your personal resources, but this is not an option open to everyone.

If you are starting up, or are already in business and want to expand, then there are two main sources of finance: equity and loan finance. Venture capital firms and business angels can provide equity investments in exchange for shares in your company. They'll be looking for above-average returns and an exit route, usually within five years. They'll probably want some say in the way that you run your business, but can also prove to be an excellent source of expertise and contacts.

If equity is inappropriate, or you don't want external investors, then an alternative is loan finance. This allows you to keep total ownership and control of your business, but you'll probably have to provide personal guarantees. Lenders will look at the gearing (the ratio of loan finance to total finance) and won't lend if the gearing is too high. They'll also look at interest cover - the number of times that forecast profit exceeds interest - and won't lend if this figure is too low.

Who lends money and why?

Most loan finance comes from the banks. They lend around £40 billion each year to small businesses, though other finance houses also provide loans. Sometimes loans come in the form of factoring (factors pay out against your invoices, though this is effectively just a loan secured on your sales book). Sometimes, they come in the form of asset finance, though this is effectively a loan secured on your capital assets.

The finance institutions take in deposits and then seek to make a return on this money. The level of interest charged depends on their perception of the risk of lending to your business. In general, small businesses are regarded as being a higher risk, so finance institutions charge a higher rate of interest and look for enough security to cover the loan in the event that you can't meet the repayments. Administration costs can be as high for small loans as they are for larger loans, so arrangement fees are also usually payable.

As with other costs, do what you can to reduce the interest charged. Don't be afraid to negotiate. As you build up a credit record the bank will be better able to assess the risk that you represent, and should be willing to reduce the interest charged, provided you keep up your repayments.

In addition to the commercial financial institutions, there are a large number of Community Development Finance Institutions. Many of these are managed by local enterprise agencies, but there are other non-bank loan funds as well. Whilst they'll also be looking for good propositions, and personal commitment, they are often willing to lend on softer terms - possibly a reduced rate of interest, less need for security, and so on. Ask your bank manager or a professional business adviser for a list of organisations.

How much capital do I need to raise?

This depends entirely on your personal circumstances and the nature of your proposed venture. Prepare a detailed cash flow forecast as accurately as you can for the first year - this will give you a pretty good indication of your requirements. Allow yourself a level of contingency to avoid having to go back for additional finance.

Can my business succeed without raising capital?

Every business needs adequate finance - to buy capital equipment and to provide working capital until sales start to produce income. You may find it difficult to get credit initially and may have to pay rent in advance, provide deposits for telephones, and so on. If you don't have sufficient personal assets, then you've little choice but to look for investors or lenders.

Even if you've got the necessary resources, you should approach your business planning as if you had to raise the money externally. This should convince you that your business venture is a risk worth taking.

Depending on your personal circumstances, you may be able to start on a small scale, perhaps part time, reinvesting the profit that you make and building up the business to the point at which you can work in it full time.

Who can help raise the money that I need?

It makes sense to talk to your bank at an early stage about what they require from you to support a loan application. However, there is merit in preparing the best possible case so it may help to seek appropriate advice. They should be able to help you determine the ideal mix of equity, loan finance and grant aid, prepare a suitable business plan and complete any application forms that might be necessary.

Hints and tips

  1. The key to raising finance is a solid business plan, with rigorous market research to justify your sales forecasts, together with a demonstration of your determination and commitment.
  2. Explain to prospective investors your total financial requirements, split into capital for fixed assets and working capital.
  3. Don't expect investors to agree immediately. If they refuse to support you, ask for feedback, address the issues, revise your plan and go elsewhere. If financiers question the viability of your idea, perhaps you should too.
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