SMEs – in a world of pain September 2011

Publication No. 11-02 Contents

The engine is stalling 1Australia’s small to medium enterprises sector has always been the engine room of economic activity.

Cashflow management in challenging 2times In today’s uncertain economic environment, many small to medium size businesses are struggling to make ends meet.

Keep the spark in your banking 3relationship SMEs should always remember that communication is the key to a good relationship with their bank.

Page 1 1The engine is stalling

Australia’s small to medium Declining confidence enterprises sector has always A recent survey by Telstra Business and the been the engine room of Council of Small Business of found economic activity. more than half of all Australian small businesses (52%) think the economy is in Accounting for more than 95% of all worse shape than six months ago and only businesses and more than a third of GDP, 20% expect it to improve before 2012. Small Australia’s 1.2 million SMEs employ over five business confidence has slipped 10% since million Australians across hundreds of the start of this year and 31% since the end different industries. The vast majority are of 2009. The research also showed that only micro-SMEs, employing less than 20 40% expect their sales to grow in the people, and these businesses are the most current financial year, and more than a third vulnerable to economic shocks. (35%) said the health of their own balance sheet had declined since the end of 2010. Right now, the Australian SME engine is stalling, with many businesses under severe There is also strong evidence that the number financial stress. This is largely because the of small businesses with outstanding tax sharp decline in business and consumer debts has risen. The Australian Tax Office confidence around the country has translated has responded by increasing the number of directly into lower sales and profitability. garnishee orders it has issued to recoup funds directly from small business owners’ In particular, businesses involved in building bank accounts and as part of the crackdown, and construction (directly and indirectly), the ATO has also issued more penalty retail, manufacturing, transport, tourism, notices to Directors where they are breaching hospitality and services are under pressure, repayment plans. reflecting factors such as lower investment and discretionary spending, higher operating If a penalty notice is issued, the Directors costs and the broader impacts of the high have up to 21 days to settle or place the Australian dollar. SMEs potentially unable to company into liquidation or administration. If meet their liabilities should be addressing they do not, the Directors can become this issue with their lender before it’s too late. personally liable.

Insolvencies on the rise

The downturn across much of the economy is having a major impact on many businesses. Official figures released by the Australian Securities and Investment Commission for the year to June 30 showed the number of companies entering external administration rose almost 6% in the period. A strong increase in external administration appointments in June saw insolvencies increase to 5.9% from 4.4% for the 11-month period to May 2011.

Page 2 Court liquidations in Australia rose 7.7% in the 2011 financial year; voluntary liquidations initiated by directors were up 10.1%; while receivership and voluntary administration appointments were down.

Appointment type 2010 2011 Change

Court liquidations1 2,463 2,653  7.7%

Creditors voluntary 3,939 4,337  10.1%

Receiverships2 1,350 1,346  0.3% Voluntary administration 1,527 1,486  2.7% Communication is key 1 Includes provisional liquidations. 2 Includes receivers, receivers and managers, controllers and Current business conditions have forced managing controllers. many lenders to review their lending criteria and it has become harder for some SMEs to With many small business owners having secure funding. However at the end of the used their own assets as collateral for day, lenders would rather find a solution to borrowings, such as their family home, assist a business and help to mitigate and personal insolvency is also on the rise. manage risk than have that business fail altogether. Cash flow remains king Having a strong relationship with lenders Good cash flow management is essential, and good administration processes in place which as an owner involves making sure is important at all times, but especially when you get paid by your customers as quickly a business is encountering financial as possible, good management of accounts difficulties. If kept informed, lenders are payable, accounts receivable and inventory, often able to provide value-added support and strict cost control to reduce overheads. and solutions, and may be able to assist a In effect, cash flow is the oil that lubricates distressed business by restructuring their every small business’ engine and without it, repayment obligations to avoid a formal the business will fail. insolvency appointment.

SMEs should be aiming to send out their invoices as soon as possible rather than waiting, and invoices should detail specifically when a payment is due. Late paying customers should be notified immediately with a reminder and action should be taken promptly on past due outstanding accounts extending to legal recourse if warranted. New customers without a prior credit history should be asked for an upfront payment deposit, with the remainder payable in instalments or due on completion.

Page 3 Cashflow management in challenging 2times

In today’s uncertain economic After all, having eight weeks rather than four to fix a more significant problem or negotiate environment, many small to with a financier is exponentially better. medium size businesses are struggling to make ends meet.

When operating in a financially distressed environment, time and cash are the most desirable and scarce commodities. If both of these were in plentiful supply there is no doubt that most companies would eventually manage to solve their problems – be it at a price – or they simply would not have a problem to solve.

But given we live in the real world and do not have access to either a money tree or a time machine, time and cash are major constraints Get in the zone when turning around distressed businesses. First step is to ‘get in the zone’… do not A common mistake is to accept cash and time think of this as permanently fixing the as fixed variables – then embark on a balance business (you need to do that too but that sheet and/or operational restructure within comes later). these confines. For example, “we only have $X and four weeks to decide on whether we This is about acquiring time to both fix the sell, save, or close down the business”. business and/or negotiate a balance sheet structure so the business has a sustainable This is a one dimensional view and can future. severely limit the number of strategic options available to fix a business. A far better Do not focus solely on large profit and loss approach is to acknowledge these constraints items. Just because something is a small but also pursue tactics which will increase percentage of revenue, does not mean it is cash and therefore time. not important if you can use it to ‘buy’ another two months trading.

Strategic options Whilst materiality is important, so is variability. For example, you may be able to change a small item by a large amount (e.g. discretionary spend). Conversely you may not be able to Small increase in change a large item at all (e.g. equipment time = large leasing or rent). increase in options Accounting practices may lead to poor decisions in a cash-strapped environment. Time The profit and loss statement aligns costs with revenue, but in cash terms they may occur at

Page 4 different times. For example, depreciation vs „„Delay non-essential capex; capex; and COGS vs purchases. „„Approve payments on a weekly basis (easier to manage and prioritise); and

„„Communicate the position to all people who can incur expense (stop or delay discretionary spend).

Most cash management improvements are the result of work from multiple people within the organisation – mostly from outside the finance department and Boardroom.

I see therefore I can manage

A business experiencing cash flow problems becomes impossible to manage if it does not have timely and accurate cash visibility. In practice, this involves building a direct cash flow model (i.e. from direct inputs, as opposed to profit and loss and balance sheet inputs).

The model should be ‘fit for purpose’ and Also, an over reliance on the profit and loss there are a number of nuances which make statement may lead you to ignore opportunities this a different exercise than building a to release cash from the balance sheet. For normal financial model: example, selling existing inventory at a loss „„Timing: Generally the model will cover negatively affects EBITDA but may gain you approximately 13 weeks, which is long valuable time. enough to view the impact of a monthly and quarterly cycle – but not too long to Establish control lose accuracy of inputs. At this early stage, although you may not yet „„Focus: Isolate large and highly variable have a working cash flow model, you can payments, as these will need to be implement initial cash control techniques. managed individually, (e.g. fuel in a For example: transport business, wages, raw materials etc.) „„Assess purchasing authority levels (buy less, lower working capital); „„Conservatism: Do not allow multiple layers of conservatism to be built into the „„Consolidate bank accounts (easier to model. An overly conservative model manage); may lead to bad decision making „„Ensure collections staff are adequately (e.g. do not cut off your arm if you do not resourced (do not strip resources from need to! Accuracy is the key here). here!);

Page 5 „„Metrics: Sometimes measuring cash Remember, build the model as status quo balances is not the best metric, only – do not bank on an improvement if it especially if operating close to facility has not yet been actioned. limits – in these circumstances, cash out equals cash in: we pay what we can Now you have the team in place, have based on what we collect. Therefore, the identified the magnitude and timing of your business may appear steady, but if challenges, and have a tool and process to creditor balances are continually manage it, it is time to get moving. No-one increasing it is actually getting worse. ever solved a problem by building a cute For these reasons, it may be best to model – it is what you do with it that matters. measure working capital – for example, overdue creditors or a combination of If you are in a cash crisis, then this is an debtors, inventory and creditors. approach to help navigate the obstacles in front of you. While it is not a linear process, Once the model is built and key people you still need to follow the steps of visibility, involved, a business should then have then control, then improvement. enough information to answer three key questions – How long have I got? What happens if I do nothing? How significant are the cash challenges?

Page 6 Keep the spark in your banking 3relationship

SMEs should always remember that communication is the key to a good relationship with their bank.

Ensure that you have a regular dialogue with your bank relationship manager. You need to build an enduring relationship based on sharing the good and bad times.

The following points are central to the relationship:

„„Your banks are a critical stakeholder in your business. You need to treat them properly and make sure they understand your business thoroughly so that when you ask for their support, they are fully aware of your circumstances. Banks hate surprises, so it’s all about constant and open communication. This helps them to understand your situation and illustrates that you know your business as well. not like it when borrowers exceed their „„Understand the terms of your loan borrowing level, whether on an overdraft agreement, particularly its structure, your account or another type of credit facility, responsibilities and any default clauses. so be aware of your limits and reporting This includes being aware of the facility’s obligations. As always, communication is expiry date so that arrangements can be the key so don’t wait for the bank to chase made to refinance your debt if required. you for the information. It’s also vital that you understand the covenants of the loan, and whether the „„Temporary funding requests that are conditions your business is required to outside seasonal and industry trends meet under the terms of the contract are are alarm bells for banks. If you need to actually being observed. Breaching debt borrow more money, the first question the covenants can trigger interest rate lender will ask is “why?” Although it may increases or loss of collateral and your be to fund business growth, without clear bank may even demand payment in full if communication the bank may interpret certain restrictions and commitments are an unexpected request as a sign that the not fulfilled. business is in financial trouble. You need to be prepared to provide a sensible „„Account conduct determines your reason as to why you require the relationship with the bank. SMEs need to additional funds. be aware of their financial reporting requirements under the loan. Banks do

Page 7 „„Manage your bank’s expectations. If „„The maintenance of stable you tell your bank that you are going to management is also essential in do something, then make sure you do it. conveying an acceptable risk profile to For example, if your cash flow statements lenders, as the loss of key personnel can suggest that the business can trade within be a major disruption to a small to the facility limits and it then fails to do so, medium sized enterprise. Make sure your ability to access future funding may your bank understands any material be impeded. In a worst case scenario, changes to your team, including why it the bank may even withdraw its support has occurred and how you are dealing and take action to recover its debts. with the transition to new management.

„„Creditor management could ultimately Beyond establishing clear lines of impact upon your own credit rating, communication and an element of trust with particularly if your business undergoes your bank, it is important to ensure that financial difficulties and you have appropriate standards of reporting, levels of provided personal guarantees. insurance and consistency in management are maintained. Most importantly: As illustrated above, creating and „„General reporting and statutory maintaining an enduring relationship with payments must be up to date. Failure to your bank is not only relatively easy to do adequately manage PAYG, BAS and but extraordinarily valuable if you are superannuation payments are the first navigating your business through an warning signs to your lender that their uncertain future. loan may be at risk. Furthermore, the Australian Tax Office has the power to contact your bank and deduct payments from your account for outstanding taxes, potentially damaging your business’ reputation in the process.

„„Keeping up insurance is important to banks, again demonstrating the relative risk profile of your business to existing and future lenders. This includes insurance over assets, loan insurance, key person insurance, public liability, professional indemnity and other relevant insurances.

Page 8 Contact us

Melbourne KordaMentha Pty Ltd KordaMentha Pty Ltd Level 24, 333 Collins Street Level 5, Chifley Tower, 2 Chifley Square 3000 Sydney 2000 Victoria, Australia New South Wales, Australia Tel: +61 3 8623 3333 Tel: +61 2 8257 3000 Fax: +61 3 8623 3399 Fax: +61 2 8257 3099 Email: [email protected] Email: [email protected]

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This publication, and the information contained therein, is prepared by KordaMentha and staff. It is of a general nature and is not intended to address the circumstances of any particular individual or entity. It does not constitute advice, legal or otherwise, and should not be relied on as such. Professional advice should be sought prior to actions being taken on any of the information. The authors note that much of the material presented was originally prepared by others and this publication provides a summary of that material and the personal opinions of the authors. Limited liability under a scheme approved under Professional Standards Legislation.

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