Forecasting, Financing & Fast Tracking Your Business Growth

TABLE OF CONTENTS
TABLE OF FIGURES ............................................................................................................................................. 5
1 INTRODUCTION ......................................................................................................................................... 7
2 STRATEGIC VISION ..................................................................................................................................... 9

2.1 HAVE A VISION............................................................................................................................................11
2.2 WHY FORECAST? ............................................................................................................................................12
2.3 PROFILE OF SUCCESS.........................................................................................................................................14
2.4 MAKING FORECASTING EFFECTIVE .......................................................................................................................17
2.5 UNDERSTANDING CUSTOMERS ..................................................................................................................19
2.5.1 Market Segmentation ...........................................................................................................................19
2.6 REALISTIC ASSUMPTIONS ...........................................................................................................................21
2.7 GETTING STARTED WITH YOUR FORECAST ..............................................................................................................23

3. REVENUES ................................................................................................................................................28
3.1 PRODUCT SALES ..............................................................................................................................................30
3.2 PRICING ........................................................................................................................................................33
3.3 GEOGRAPHICAL EXPANSION ......................................................................................................................36
3.4 NEW PRODUCT REVENUES .............................................................................................................................38
3.5 ALLIANCES, PARTNERSHIPS, LICENSING AND DISTRIBUTION AGREEMENTS ..............................................39
3.5.1 Licensing ................................................................................................................................................40
3.5.2 Strategic Alliances ..................................................................................................................................41
3.5.3 Distribution Channels .............................................................................................................................41
3.6 FRANCHISING .............................................................................................................................................43
3.6.1 Being a Franchisor .................................................................................................................................43
3.6.2 Being a Franchisee .................................................................................................................................44
3.7 PROJECT MANAGEMENT ............................................................................................................................45
3.8 OTHER INCOME ..............................................................................................................................................47
3.8.1 Grants & Financial Assistance ...............................................................................................................47
3.8.2 Intellectual Property Income .................................................................................................................47
4. COSTS .......................................................................................................................................................49
4.1 COST OF SALE .................................................................................................................................................51
4.1.1 Refunds, Warranties and Guarantees ....................................................................................................52
4.1.2 Loyalty & Awards Programmes .............................................................................................................52
4.2 OPERATING EXPENSES / OVERHEADS ................................................................................................................54
4.2.1 Marketing ..............................................................................................................................................55
4.2.2 Marketing ‐ Market Research ...............................................................................................................56
4.2.3 Marketing‐ Marketing Effectiveness ..................................................................................................... 57
4.2.4 Competitive Intelligence .......................................................................................................................57
4.2.5 Marketing – Customer Retention ..........................................................................................................58
4.2.6 Marketing ‐ Branding ............................................................................................................................60

FORECASTING, FINANCING & FAST TRACING YOUR BUSINESS GROWTH

The definitive eGuide for developing company financial forecasts.
4.2.7 Information Technology – As A Revenue & Profit Driver .......................................................................61
4.2.8 Information Technology – As A Cost Of Doing Business ........................................................................62
4.2.9 Employee / Personnel Costs ...................................................................................................................63
4.2.10 Staff & Management Incentives (Commissions, Bonuses)................................................................66
4.2.11 Director / External Advisor Payments ...............................................................................................67
4.2.12 Other Operating Expenses ................................................................................................................67
4.2.13 Building Lease ...................................................................................................................................68
4.2.14 Insurance ..........................................................................................................................................69
4.2.15 Legal Costs .........................................................................................................................................69
4.2.16 Accounting Costs ...............................................................................................................................70
4.2.17 Taxes..................................................................................................................................................70
4.2.18 GST (General Sales Tax) ....................................................................................................................70
4.2.19 Income Tax........................................................................................................................................71
4.2.20 Other taxes .......................................................................................................................................72
4.2.21 Tax Planning .....................................................................................................................................73

5. BALANCE SHEET, WORKING CAPITAL & CAPITAL EXPENDITURE .................................................................74
5.1 BUSINESS CHALLENGES – MANAGING YOUR CASH FLOW .......................................................................................77
5.1.1 Managing Working Capital ...............................................................................................................77
5.1.2 Managing Receivables ..........................................................................................................................78
5.1.3 Managing Payables ..............................................................................................................................79
5.1.4 Managing Inventory..............................................................................................................................80
5.2 FUNDING WORKING CAPITAL AND GROWTH ....................................................................................................83
5.2.1 EQUIPMENT FINANCE – LOANS AND LEASING......................................................................................83
5.2.2 Factoring ...............................................................................................................................................85
5.2.3 Inventory Finance ..................................................................................................................................85
5.2.4 Production Finance ...............................................................................................................................86
5.2.5 Warehouse Finance...............................................................................................................................86
5.2.6 Vendor Finance .....................................................................................................................................86
5.3 BUSINESS GROWTH – INVESTING IN THE FUTURE .......................................................................................87
5.3.1 Capital Expenditure ...............................................................................................................................87
5.3.2 Manufacturing Challenges ....................................................................................................................89
5.3.3 Research & Development challenges ....................................................................................................89
5.4 LIMITS TO GROWTH – CAN YOU GROW TOO QUICKLY? .............................................................................91
6 FINANCING ..............................................................................................................................................92
6.1 DEBT ...........................................................................................................................................................95
6.2 EQUITY .......................................................................................................................................................98
6.2.1 Dividends and Retained Profits ..............................................................................................................98
6.2.2 Employee Shares & Options ...................................................................................................................99
6.2.3 Other Reserves .....................................................................................................................................100
6.3 HIGH GROWTH COMPANY’S – SPECIAL CONSIDERATION .......................................................................................102
7 REPORTING & ANALYSIS ............................................................................................................................... 104

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© 2007‐ 2008. Knowledge 2020 Pty Ltd. Please do not reproduce any of the text without prior permission, which
will often be granted. Contact markostryn@knowledge2020.com or visit online at http://www.forecastvision.com
The above text contains generic financial information that does not constitute financial advice.
Last revised: September 2008


7.1 CASH FLOW & CASH MANAGEMENT FORECASTING .............................................................................................105
7.1.1 Cash Flow & Investors ..........................................................................................................................107
7.2 RATIO ANALYSIS............................................................................................................................................108
7.3 VARIANCE .................................................................................................................................................109
7.4 SCENARIO ANALYSIS .................................................................................................................................111
7.5 SENSITIVITY ANALYSIS ....................................................................................................................................113
7.6 RISK MANAGEMENT .................................................................................................................................114
7.6.1 Business Risks.......................................................................................................................................114
7.6.2 Financial Risks .....................................................................................................................................114
7.6.3 Risk Management Framework ............................................................................................................117
8. ACQUIRING OR SELLING – VALUATION & OTHER CHALLENGES ................................................................ 118
8.1 INCREASING YOUR BUSINESS VALUE ........................................................................................................120
8.2 ACQUISITIONS ..............................................................................................................................................122
8.2.1 Vertical Integration ..............................................................................................................................123
8.3 DUE DILIGENCE .........................................................................................................................................124
8.3.1 Due Diligence – Organisational & Financial ........................................................................................124
8.3.2 Due Diligence – Market Opportunity ..................................................................................................125
8.3.3 Due Diligence – Legal, Technical & Manufacturing ............................................................................ 126
8.4 EXITING YOUR BUSINESS ..........................................................................................................................128

9 REVIEWING YOUR FORECAST .................................................................................................................. 129

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TABLE OF FIGURES
Figure 1 Company Stakeholders ..................................................................................................................................10

Figure 2: The Valuation Increases as the Company achieves its Milestones. .............................................................13

Figure 3: Porter's Five Forces Model ...........................................................................................................................15

Figure 4: Five Forces Model & Bread Producers .........................................................................................................16

Figure 5: Segmenting Your Market into Attackable Niches ........................................................................................20

Figure 6: Revenue Streams & Assumptions for an Airport .........................................................................................22

Figure 7: Front Cover to Aggregate Forecast ...............................................................................................................24

Figure 8: Linking Actuals from Accounting Software ...................................................................................................26

Figure 9: Overall Expenses ...........................................................................................................................................27

Figure 10: Expenses in Detail ......................................................................................................................................27

Figure 11: Forecasted Income Statement....................................................................................................................28

Figure 12: Revenues and Assumptions ‐ Charity ........................................................................................................32

Figure 13: Evaluating Growth Opportunities ..............................................................................................................37

Figure 14: Process for Assessing Alliance Opportunities ............................................................................................39

Figure 15: Process for Valuing IP ................................................................................................................................48

Figure 16: Fixed and Variable Costs ............................................................................................................................49

Figure 17: Strategies for Customer Retention ............................................................................................................59

Figure 18: Building a Financial Model to include new and existing Revenues ...........................................................60

Figure 19: Tax Modelling ............................................................................................................................................72

Figure 20: Forecasted Balance Sheet ..........................................................................................................................75

Figure 21: Equipment Lease & Own Options ...............................................................................................................83

Figure 22: Capital Expenditure Model ........................................................................................................................88

Figure 23: Calculating Gearing ....................................................................................................................................93

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Figure 24: Covenant Modelling...................................................................................................................................97

Figure 25: Financing a High Growth Business ...........................................................................................................102

Figure 26: Cash Flow Forecast Modelling .................................................................................................................105

Figure 27: Variance Analysis in Reporting ................................................................................................................110

Figure 28: Graphical Analysis of Scenarios ...............................................................................................................112

Figure 29: Average Business Value by Industry. SOURCE: BizExchange Index March 2008 Quarter Results .........119

Figure 30: Increasing Business Value ........................................................................................................................121

Figure 31: Organisational & Financial ‐ Due Diligence ..............................................................................................125

Figure 32: Due Diligence ‐ Market Opportunity .......................................................................................................126

Figure 33: Organisational, Legal, Technical & Manufacturing Due Diligence ...........................................................127

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1 INTRODUCTION
Entrepreneurship has its glamour. However behind the world of
intense negotiations, last minute deals and successful garage
visionaries are the less glamorous concepts that you must get right –
cash flow, working capital, pricing strategy etc.

This eGuide is all about financial forecasting. It addresses the truism
“failing to plan is planning to fail”. A forecast is simply a translation of
the vision and strategy of your company into financial numbers. Many
entrepreneurs and managers find this process tedious and
intimidating. External support is not always there for you. This eGuide is here to assist you.

Your company must be self‐sustaining over the short term and profitable over the long term. It
must generate sufficient cash to pay the bills and maintain increasing levels of sales.

I wrote this having spent many years working with fast growing dynamic Small & Medium
Enterprises. These dynamic companies continually faced the longer term financial challenges
which would help determine their success.

Most businesses use adequate to good Management Accounting packages such as MYOB, and
Quicken. These tools are perfect for audit and for a historical review of the enterprise, but do
not address future challenges. How are key expansion questions such as the following
answered?

• What is our company worth today? How can we increase its value in the future?
• How can we afford to fund our growth? How will our needs for ever increasing amount
of working capital be addressed?
• Should we purchase? Should we build / buy that new automation system or factory?
• Our new venture? Should we pursue the opportunity to develop and market a new
product range?
• Buy versus build? Should we invest in the capacity to produce key inventory ourselves
or outsource this?

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• Our acquisition plans? Will the anticipated future profit streams and the savings from
synergies justify the cost of acquisition?

The forecasting process is often one of iteration, where you can plan different ‘what if’ figures
model and assess the different outcomes. If you increase the sales budget, how many
additional sales people will you need to generate that level of extra sales? What will happen to
your cash flow in the months that it takes for the salespeople to reach peak performance?

Developing your forecast on a spreadsheet or custom building standalone or web‐based
software allows you more flexibility and complexity in trying out these different scenarios.

The different scenarios will also show the impact of relevant risk factors. How will interest
rates affect the demand for housing? What is the relationship between the amount of rain next
summer and my company’s ice cream sales?

I’ll make a couple more points before getting into the detail:

Firstly, there's no need to reinvent the wheel in regards to building your own forecasting
spreadsheets. There are a wide range of software packages and spreadsheets commercially
available. They vary in quality, robustness, price and applicability to your demands of your
particular company or industry. I have not specifically mentioned any in this booklet, but my
organisation would be delighted to understand more about your specific operating conditions
and talk you through your options.

Secondly, I’ve tried to cover as many different types of industry, position on the supply chain,
and way of doing business as I can within the limited space below. I haven’t managed to cram
in every variable for every company, but would be delighted to receive your feedback about
what needs to be addressed. The booklet is only in PDF soft copy at present, meaning that I can
update it whenever I need to. Hence your insights would be most welcome.

Happy reading and most important of all, good luck with your venture!

Mark Ostryn
markostryn@knowledge2020.com
September 2008

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2 STRATEGIC VISION
It is often said that there are four types of company:

• Those that make things happen.
• Those that watch things happen and respond.
• Those that watch things happen and don’t respond.
• Those that didn’t notice that anything had happened.

We’d all like to be in the first group, but no matter how visionary we are, much of our work is in
responding to other’s first moves. We’ve even got it wrong from time to time, and not
responded when we needed to!

This eGuide is all about planning to make things happen – having a strategy. We’ll also try to
help you with responding to market shifts – mainly by forecasting that they will occur and doing
some scenario planning (what if….?), some sensitivity analysis (if interest rates increase by x%
what will be the effects on sales?) and some risk management.

A business entity is simply a collaboration of resources that is must make the greatest possible
return on a flow of financial inputs provided to it.

• These inputs are DEBT, primarily from financial institutions and EQUITY from
shareholders.
• The company itself is a collection of productive resources – brainpower, technology,
manufacturing processes and intellectual property that must turn these financial inputs
into productive assets.
• The end financial output must represent either a greater or a more secure rate of return
than competing investment proposition that also require those debt and equity inputs.

Thus your company is only sustainable if, for a given level of risk:

• A holder of EQUITY in your company (i.e. a part‐owner) can get a greater return on that
investment compared with other investment opportunities
• A holder of DEBT in your company earns a market competitive rate of interest for
lending funds to your company.

Along the way there are also other stakeholders in the company that also need to be satisfied

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Figure 1 Company Stakeholders

While many of these stakeholders may not have a direct bearing on the performance
measurements generated by the company, their indirect impact may be substantial e.g.

• Requirement for environmental measures, sustainability etc.
• Requirement to look at the community impact of decisions to locate in a particular
city, provide employment to residents of that city
• Requirement to look at “financial dispersements” made by the company which may
not be “financial rational” to shareholders, but which may show the company as a
good corporate citizen e.g. charity donations etc.

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2.1 HAVE A VISION

“You can analyse the past but you need to design the future. That is
the difference between suffering the future and enjoying it” Edward de
Bono

Forecasting is more than looking at what you achieved last year and extrapolating it forward for
the next few years. That’s called backcasting! Forecasting requires you to think about what
you want to be in the future, consider what it going to take to get you there, and think about
what how your industry, you customer and the world in general can change in the meantime.

How will the following global trends affect your customers and your processes and

Look how rapidly, new technologies and ideas are spreading. What will telecommunications
and the internet look like in ten years time?

How will substantially higher energy costs and green issues affect the way we all do business
and consume?

There are many, many of these big questions to ask: Globalisations of plagues and diseases,
restrictions on alcohol and “junk” food, wealth disparities between rich and poor people,
continued growth of China and India, increasing migration, evolution of cities, evolution in
genetic research, development in nanotechnology, changes in life expectancy, exponential
growth in innovations and inventions, changes to family life.

The list is endless. What will impact on your business?

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2.2 WHY FORECAST?

As forecasts are invariable inaccurate or even wrong, is it worth going through the forecasting
process?

You must have a set of financial projections, a numerical statement of what you want your
company to achieve. Additionally, lenders need to see a strong likelihood of repayment; angel
investors and venture capitalists will calculate what they think is the value of your venture.

These figures will be used by the investor to calculate the potential future value of your
company based on a valuation technique such as multiples of earnings or profits or discounted
cash flow. If they are convinced that your framework has been scrupulously prepared using
best available information, they will have more confidence to invest in your company.

The process of generating these figures also adds reality to your expansion plans. For example,
if you want to open up a production facility in China you will need to research and allocate the
costs for doing so. Having performed that financial analysis, you will be in a better position to
assess alternatives such as outsourcing manufacture instead.

A supplier of funds will also see where you are more financially vulnerable and where you are
most likely to require financial injections. You may find that you do not require all of the $5m
invested upfront and by having it staged over time you have the opportunity to obtain a higher
valuation for your company as you move through from start up to expansionary phase.

The following real life model has a series of performance milestones that the company is
forecasted to achieve, prior to them receiving additional funding at the pre‐negotiated price
per share

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Figure 2: The Valuation Increases as the Company achieves its Milestones.

In short, while no investor is expecting you to get your future projections "correct", the thought
process discipline required to do the projections in the first place alerts you to potential
opportunities or threats that you may not have otherwise considered.

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2.3 PROFILE OF SUCCESS

Successful growth companies will share many of the following characteristics:

• Proprietary technology, owned by the company. This acts as a barrier to entry,
preventing other players from coming into the market. That way margins can remain
higher, and there is less need to discount price in the face of competition.
• Entrepreneurs with a great track record – i.e. previous successful ventures.
• Large and growing potential market for the product or service. Typically with a forecast,
the demand curve will start off slowly as the product or service establishes itself as
“needed” by its target market. Earlier versions may be slower sellers, and the company
has to adjust its operating cost base in order to fulfil growing demand. Here, working
capital pressures can be at their greatest.
• Good potential sales and sustainable margins. This can be through ownership of
Intellectual Property or proprietary know‐how.
• A tendency for the company to remain innovative and on the cutting edge of technology
• A proven market need for the product, established through researching and testing the
market
• A sustainable competitive advantage with high barriers to entry for potential
competitors.
• A greater possibility for strategic alliances to leverage the strengths of other companies

An excellent framework for assessing where your company is in relation to its competitive
environment is Porters Five Forces Model. Developed by Michael Porter, the model describes
five forces that determine the competitive intensity and therefore the attractiveness of a
market. These forces are continually changing and such continual changes also require that
you continually reassess your marketplace.

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Figure 3: Porter's Five Forces Model

To illustrate this, imagine the competitive forces of a bread producer:

• Their bargaining power with their customers – the supermarkets and catering firms.
• The impact of health trends on the types of bread they produced.
• The changing cost of raw materials such as grain and transportation charges.
• Bread substitutes. What else can people eat for lunch apart from sandwiches?
• The impact of local bakeries and local franchises on total demand.

This and other factors can be mapped to the following diagram:

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Figure 4: Five Forces Model & Bread Producers

Prior to forecasting the number for your own venture, you may want to review the key forces
that will affect your industry over the next five years or so, using the Five Forces framework.

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2.4 MAKING FORECASTING EFFECTIVE

Following in from this, consider the following:

• Do you know how marketplace trends will affect your company over the short and
longer term?
• Have you established your company’s goals and priorities for the next financial year, and
beyond to the next three to five years?
• Have you set financial targets for the next financial year?
• Do you have a method for measuring your company’s performance against your goals,
priorities and financial targets?
• Does your management team know your company’s goals and financial targets for the
next financial year, and what they need to do to achieve them?
• How frequently will these targets be reviewed?
• What incentives do the key managers have to achieve these targets?

"Planning differs between budgeting and forecasting in intent. While
the budget is used to control, the forecast is used to predict, the plan
sets out desired outcomes and expectations usually over a longer‐
term period. In essence plans are used to affect change." PA
Consulting Group

There are several major steps to ensure that the forecasting approach is effective and that the
results are credible:

• Forecasts imply a plan so your team should be familiar at least with the aims of their
own functional or strategic area. Issues such as confidentiality which may preclude full
openness should be ironed out prior to a session.
• Parameters and assumptions such as the size of the market, major production or
product changes, expected sales growth, exchange rates and so on should be set early
and disseminated uniformly to form the basis of the plan.
• The sales budget should be the first part to be tackled, as it reflects the economic and
competitive forecasts and shapes all of the other component parts of the budget. All

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other budgets should be developed consistently with the sales volumes. Manufacturing
production targets, stock levels and product support are all dependent.
• Once the forecast has shaped up, your cash flow forecast is needed to assess
affordability. This will ensure that the forecast when finalised is consistent with broad
financial parameters and does not, for example, assume unrealistic borrowing
requirements.
• Effective forecasting requires good communications throughout your organisation. The
budgeting component may move up and down the organisation and sanity checks
between senior managers of the various divisions may be required before all changes
are agreed.
• Once agreed, the final figures need to be reviewed and confirmed that at a corporate
level the return on assets / investment is sufficiently high. If not, consideration needs to
be given to cutting costs, selling more or increasing efficiency.

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2.5 UNDERSTANDING CUSTOMERS

An important aspect of forecasting is in understanding the makeup of customers who purchase
your products. One key issue for planning is – are they profitable? Consider the types of
products they purchase and the services that they may require with them. Consider also the
implications of negotiating a volume deal over time with a large company.

Will the discounted price, plus all of the free priority support and service offering they may
require, make Big Company overall a viable customer?

And what if Big Company doesn’t renew or repurchase in the future. Might you have lost the
focus or even the contact of smaller customer companies?

2.5.1 MARKET SEGMENTATION
Importantly, you will also need to consider what customers you effectively wish to target.
Some target markets can be addressed more profitably than others. As a general rule, you can
segment your market by dividing up your total market into a series of niches, and reviewing
each niche (below) in order to rank the priority levels that you will address those markets.
Some niches may never be cost effective, as it will cost you more to service them than the
revenues you can expect from them.

Take the potential market for a product such as a device to test water quality at the water
source rather than back at the laboratory. There are several different niches that the product
can be sold into, but the company has limited resources and cannot attach all niches
simultaneously.

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Figure 5: Segmenting Your Market into Attackable Niches

Management and advisors have determined that given limited personnel, promotional; budget
and R&D funds, it would be best to concentrate on two specific niches (1.3 and 2.1) initially,
before attempting to grab the wider market.

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2.6 REALISTIC ASSUMPTIONS

Your forecast should document all assumptions used when you created this view of the market.
Some of these assumptions may be controllable e.g. the per capita take up of a new medical
device over time, and some uncontrollable, such as the future price of a barrel of oil.

Taking the Australian car industry as an example, the total population of Australia is 21million
and car ownership is at around 12 million. To forecast the total sales of a particular car brand,
you would take into account:

• The growth of total population of Australia in the forecasting period.
• The number of people under 17, or those in the upper age bracket ineligible to drive.
• The trend in car ownership per household.
• The trends in type of car (sedan, convertible, 4WD) likely to occur.
• The trends in public transport available.
• The costs of car parking in major cities.
• The reputation of the particular brand and model of the car
• Relative running costs of that model compared with competing models

And a whole host of other factors.

It can often be informative to map out each of the key revenues and costs of your business, and
place alongside them all of the assumptions that you have made. For example, an airport will
have several revenue streams, each of which will depend on a range of future assumptions that
you will have input. Some of these assumptions are general and will be made across a range of
revenue streams (e.g. total passenger or freight traffic, which in turn will be partially based on
general economic health), and some will be specific to a particular revenue stream e.g. the
viability of Tax Free shops may depend on future adjustments to the consumption tax both in
Australia and overseas in the future.

A mapped out list of assumptions may look something like this:

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Figure 6: Revenue Streams & Assumptions for an Airport

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2.7 GETTING STARTED WITH YOUR FORECAST

Before you calculate and type in your first numbers, you have to consider a series of issues
pertaining to your forecast. These include:

CUSTOM SOFTWARE OR EXCEL SPREADSHEET?

The market for purpose built financial software is expanding, both as downloadable software or
software‐as‐a‐service, where you log on to a provider via an internet connection. Amongst
spreadsheets, typically Excel® based, you may choose to build your own from scratch (with its
inherent time consuming challenges) or purchase ready made forecasting spreadsheets. The
merits and pitfalls of each option call for another booklet worth of discussion!

If you wish to consider alternatives to spreadsheets as a platform for your forecast, you may
also want to review:

• Software based pre‐built financial models that require you to simply input your forecast
data.
• Pre‐built financial models accessible on demand via the internet (software as a service)
• And for large companies, a range of ERP, Business Performance and Business
Intelligence tools

TIME SPAN OF FORECAST

How long do you want to forecast forward for (in years)? This answer will depend on what you
want from your forecast. If you want to do a discounted cash flow for a valuation, or if you
want to track the longer term performance of return on your assets, you’ll probably want to do
at least five years. If you are about to commercialise a gold mine, it will be more like thirty
years! Conversely, if your concern is running out of money and you want to track your end of
month, or even end of week bank balance, you’ll need to focus on one year or less.

LENGTH OF EACH PERIOD

When you’ve decided how many months or years forward you wish to forecast, consider then,
an ideal number of columns that are useful for your business and are not time consuming or
unnecessary for you to fill in. A 60 column spreadsheet (monthly forecast for five years) is
unnecessarily large, unwieldy to view on your screen and the monthly figures will likely become
meaningless as your move toward the distant future.

COMPANY STRUCTURE

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How will you sub‐divide your forecast as to make it meaningful without overburdening yourself
with data? Assume you have 10 product groups with a total of 700 SKU’s and sales offices in 10
territories in Australia and another 20 worldwide. Will you try and incorporate all of this data
on a single spreadsheet? Will you create separate spreadsheets and feed in the macro data
into a master spreadsheet? How will you make allowance for future products or territories?

The following company has a model for each division (see the worksheet tabs) and the front
cover simply aggregates the data from these worksheets:

Figure 7: Front Cover to Aggregate Forecast

Issues such as how the various financial statements, produced by your company, its subsidiaries
and other wholly or partially owned trading entities consolidate. This is further complicated by
inter‐company trading and borrowings, minority interests and joint ventures.

COLLABORATION

Are you producing this forecast alone or will parts of it be delegated to other individuals. If it’s
the latter, will you be dividing it up into several sections or will more than one person be
working on a particular section. Will your forecasting platform allow for version control or
multi‐user inputs? Would you prefer that rights to edit the data are restricted, and a certain
sub‐group can only have access in view mode?

USABILITY

Aligned with collaboration, on a slightly different subject, will other people who have not been
involved in the construction of your forecast be able to intuitively understand your forecasting
model if you weren’t there to guide them? Along with documenting the assumptions that you
made when producing the figures, you will need to make abide by certain rules so that the logic

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and process behind the model is transparent. This will range from including a Table of Contents
in the forecast; to shading input cells yellow (normally) to differentiate them from calculate
cells.

DEALING WITH COMPLEXITY

Producing a thorough forecasting model may be much more complex that you will have give
allowance to. Consider some of the following challenges:

• The phasing in of receipt and payment of Sales Taxes such as GST and their impact on
cash flow.
• Taking account of the time span between receiving an order, completion, delivery,
invoicing and payment for the goods and services.
• The capacity to produce meaningful working capital estimates when so many variables
have to be factored in.
• Applying depreciation and amortisation estimates to tangible and intangible assets.

Accept the fact that these financial forecasts you produce will be a simple approximation, and
resist the urge to try and make certain parts of the forecast unnecessarily detailed (coffee
supplies in the staff room) when others can only be a simple approximation (extrapolated 20%
growth in revenue between 2012 and 2013).

HISTORICAL DATA

You’ll need to have an up to date set of financial statements with sufficiently detailed
background information behind them to get started. The key detail may also relate to trends in
sales across product lines and seasonal fluctuations. Details of this data may help you detect
and programme in growth trends. You’ll also need to know the detail behind your current
status of payables, receivables, loans and other balance sheet items, as they will form a part of
your near term forecast.

Also you will need to factor out (or in) the following:

• Historical items of income or expense that were unusual, non recurring or unlikely to
have any influence within the forecasting period.
• Revenue that was derived from assets no longer operating within the company.

INTEGRATION WITH YOUR ACCOUNTING SOFTWARE

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Will you want to integrate a feed of the ACTUAL financial performance into your forecasting
spreadsheet / software? This would:

• Save manually rekeying to input your actual financials.
• Provide comparisons between your actual financials and what you had previously
forecast.

Some forecasting packages provide a mapping function so that you can link Excel outputs from
your accounting software into your forecasting software

Figure 8: Linking Actuals from Accounting Software

DESIGN AND USABILITY

If you are opting to build your own forecasting spreadsheet, make sure that it is well designed,
easy to manipulate, well documented and understood by other users. Design tips include:

• Modularise the model into different sections with summary sheets that bring together
the various components.
• Ensure that you can support a simple sensitivity analysis, looking at the effects of a
change in one variable on the financials.
• Show clearly which cells are input cells and which cells are calculated by the software.
• Document your assumptions separately.
• Do not hard code variables into a formula. P (price) and Q (quantity)

Here’s an example of the need to modularise your model into different sections in order to not
have one overly complex summary sheet.

You may have a summary sheet of overall operating expenses:

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Figure 9: Overall Expenses

But feeding in to that total Administrative Expense, there may be a sheet where these expenses
are broken down into their individual components – salaries, leases, office equipment etc. This
sheet in itself may also be a summary of what has be calculated at a lower level. For example,
the staff costs would have been calculated by a lower level sub‐sheet:

Figure 10: Expenses in Detail

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3. REVENUES
Forecasts begin with your analysis of the revenue potential of your company’s products and
services.

The first, key financial statement is the Income Statement, often known as a Profit and Loss.

The forecasted income statement is a summary of all of the expected revenues and expenses
incurred during the forecast period. These includes the sales of major items, their cost of sales,
operating expenses, a portion of the capital costs of operating the company, interest and tax.

Figure 11: Forecasted Income Statement

This statement takes account of when revenues and costs were earned or incurred, not when
payment and receipts were made. Making a profit here, does not necessarily mean that your
company won’t go broke. In business, cash is king and survival is only guaranteed if either your
inflow of cash is greater than your outflow, or that you have the means to fund a

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haemorrhaging company through external funding. We’ll discuss the all important cash flow
statement in Section 7

Looking through each of the components of the Income Statement.

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3.1 PRODUCT SALES

The sales revenues for each product / service line are a major component for the forecast.
Everything else is geared around your company’s ability to exploit its sales potential.

This is an easier process if you have historical sales data and the industry is relatively stable,
compare to if you are a trailblazer launching a new product into a new market.

One approach to forecasting product and service revenues for more difficult markets to assess
is to look at the size of the addressable market in the next period, evaluate what the relative
shares of competitors will be and then multiple units sold by price.

Key factors affecting the sales volumes include:

• Previous year’s sales – is there a trend?
• Sales trends in the overall market
• New promotions, sales initiatives or other marketing drives
• New product launches

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• Overall changes in the economy
• Changes in consumer tastes
• Seasonal trends – ice cream sales in summer compared to winter
• Changes in competitive strategy
• Varying competitor scenarios

If you have multiple product lines, services, divisions or geographical locations, you’ll naturally
be forecasting each as a separate line item. It is important to forecast each of the product lines.
Consider also what the effects are on sales of one product line on another product line:

• One product may be complementary to another in which case there is a direct
relationship between one and the other. As one increases, so does the other.
• Increases in sales for one product may negatively affect the sales of another product
• The sales of two lines of product may both increase as a result of outside factors – sales
of gym memberships generally increase at the beginning of the year after people make
New Year resolutions.

Then factor in all of the potential revenue streams that could accrue to your company in the
coming years? These may be new revenue streams that you currently do not enjoy, including:

• Existing products into new market
• Complementary products
• Packaged bundles of product
• Upgrade revenues
• Support revenues
• Training revenues
• Service revenues
• Consulting revenues
• Licensing revenues

This is equally applicable in not‐for‐profit organisations where several revenue streams may
accrue. One interest exercise may be for you to map each of the potential sources of revenue,
along with their assumptions. For a charity this may include:

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Figure 12: Revenues and Assumptions ‐ Charity

When considering future revenues, it is important to keep a running total of the installed base
of total users of your product or service. They may require service, upgrades or support at any
time in the future. They would also be a great prospect for future company offerings, provided
they are satisfied with their current products. So

• How many people are out using your product (installed base)?
• What is the propensity for customers (in % terms of installed base) to seek out
additional products, services or support?
• Can you increase the frequency of purchases for each customer? Or, the value of each
purchase made.

Total Revenue is simply price per unit x number of units sold. This can be increased in one of
three ways:

• Increasing the number of customers
• Increasing the value of each sale
• Increasing the volume of each sale.

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3.2 PRICING

Price is a key business driver and a proper pricing policy can assist growth more than either
increases in volume or cost reductions. Depending on your industry and your company’s
strength within it, you may have the capability to set price. If not, you still may have the
capacity to create your own niche (perhaps through sustainable product differentiation) in
order to obtain economic profit. The introduction of 3,4, and now 5 bladed shavers have
allowed producers such as Gillette to charge enormous price premiums on what was once a low
margin industry.

Here are some alternative pricing strategies. Consider which you would want to apply to what
products or services you sell or intend to sell and how you’re pricing policy may change over
time:

PRICING DESCRIPTION ADVANTAGES DISADVANTAGES
APPROACH
Cost Plus Standard margin Easy to calculate and Doesn’t take market
above cost administer conditions into account.
Price may be lower than
what many consumers
are prepared to pay.
Market Based Sets price to Higher profit margins. Determine the value that
capture the full Flexibility to reduce as each customer places on
value that competitive conditions change each of your products
customers place across each geographical
on your product territory.
Penetration Setting price low Opportunity to grab market Risk of competitor
Pricing to gain market share rapidly and hence deliver retaliation, and that the
share or achieve those economies. product is successful at
volume and Damage to competitors the low price point.
economies of
scale.
Skimming Price high to High initial margins from Locking out a market
maximise margin cashed up customers. unprepared to pay this
from those price.
customers willing Competitor me‐too’s
to pay the most.

You will also want to consider the impact of discounting your price on your Gross Margin over
time

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DISCOUNT PRICING IMPACT
OVERVIEW
(1) If your present margin is:
20% 30% 40% 50%
(2) And you reduce price
by 10,20, or even 30%:
(3) Then to produce the same gross
revenue your sales volume must
increase by:
10% 100% 50% 33% 25%
20% ‐ 200% 100% 67%
30% ‐ ‐ 300% 150%

If a company is operating on a 30% gross profit margin and introduces a 10% discount sale (10%
discount on gross revenue), the company would need to generate an additional 50% in sales to
maintain that 30% profitability level.

This is optimistic at the best of times: 50% more sales, half as much again! Even more startling,
at 25% discount strategy (25% discount on gross revenue at 30% margin); sales would have to
increase by an enormous 500% to maintain that profitability. This would be unheard of and
illustrates how ill advised such a discount would be.

More broadly, does a particular customer’s sales volume justify the discounts, rebates, or
promotion structure you provide to that customer?

Conversely, if you adopt a premium pricing strategy

PREMIUM PRICING
IMPACT OVERVIEW
(1) If your present margin is:
20% 30% 40% 50%
(2) Then you increase price by
10,20% or even 30%:

(3) Your sales could decline by the
amount below before your gross profit

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is reduced
10% 33% 25% 20% 17%
20% 50% 40% 33% 29%
30% 60% 50% 43% 38%

This shows the amount by which your sales would have to decline following a price increase
before your gross profit would be reduced below its present level. For example, at the same
40% margin, a 10% increase in price could sustain a 20% reduction in sales volume. Less work
for more return!

Finally, if competitive pressures are forcing you to evaluate your current pricing, consider some
of the following options for offering “a better deal” to certain customers:

• Discounts on volume.
• Time dependent promotional bonuses.
• If selling through channels, marketing allowances and co‐operative advertising
• Alternate payment terms e.g. discount on early payments.
• Bundling multiple products.
• Money back guarantees

All of these initiatives would need to be included in a forecast.

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3.3 GEOGRAPHICAL EXPANSION

New markets may be alluring whether you are considering increasing sales, improvements in
operational cost‐ effectiveness or new international customers, but your forecasting process
need to rigorously assess their cost benefit. This is particularly so in the sales start up phases
where it may be expensive to establish a brand and a suitable distribution channel in a market
that may have little awareness of your products and services.

In short, does my international expansion add value to the company or does it simply just grow
my top line revenue figures?

When considering expansion the forecast needs to evaluate the prioritisation of country’s (size
and accessibility) and an entry plan for each including company expansion, acquisition or
partnering with a local provider.

When forecasting product revenues, you need to consider and evaluate the following

• Determining the total customer base or market size.
• Segmenting the market to identify what portion should be targeted by your product or
service.
• Expected penetration of the product or service into the market segment.
• Competitive environment.
• Respect for intellectual property and legal infrastructure.
• Expected price per unit.
• Expected distribution margin when selling through wholesalers, retailers or agents.
• Relative pricing of incumbent suppliers.
• Consumer affordability.
• Regulatory approvals for foreign product.
• Transportation costs.
• Local labour costs.
• Political & other risks (legal, currency, corruption, bureaucracy, IP protection).

A local provider can be valuable when preparing an entry strategy, particularly if they have a
privileged market position, brand recognition and access to powerbrokers, resources,
transportation or distribution systems.

In short there are four major ways that you can sell products in overseas markets

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• Branch office – Gives control of the business, but establishing the infrastructure may be
expensive
• Distributor / Local Agent – Low risk and low investment, but distributor may not give
your products much attention, while taking a proportion of your margin.
• Joint Venture – Partner has already established infrastructure and risks / costs are share,
however you must be prepared to give up some control of the operation
• Online – May be cost effective, but it’s hard to get noticed.

One of the first steps in considering the internationalisation of a venture would be to map out
all of the issues that need to be researched, prior to making any substantial decisions on the
above. A large English language provider of eShopping websites would be likely to produce
something like the following when initially considering growth opportunities in China:

Figure 13: Evaluating Growth Opportunities

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3.4 NEW PRODUCT REVENUES

Forecasting the revenue potential of new products is more problematic than with existing
products as you have no past history of sales figures to project from.

Some considerations include:

• Does the customer have to change behaviour?
• Does purchase decision maker have to define a new budget for the item?
• Are the technology standards of the product being universally adopted?
• Will the product create other costs or complications for the customer?
• Will there be obsolescence costs created by the customer changing their current way of
doing things?

Once the new product has launched:

• How quickly will sales ramp up?
• What are the costs of bringing this product to market?
• How much will it cost to achieve adequate exposure in the market?

The commercial viability for any new product needs to be established early in the new product
development programme. Aside from the bottom line financial impact, consider the following:

• Will it encourage customers to buy other products as well?
• Can the development act as a catalyst for improvements in overall manufacturing
efficiency and quality?
• Can new intellectual property be generated or new manufacturing techniques
exploited?

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3.5 ALLIANCES, PARTNERSHIPS, LICENSING AND DISTRIBUTION
AGREEMENTS

There are a wide range of alliances that can be formed using your or others unique know how,
location, technology and intellectual property. These alliances can help you increase your
revenues and profitability without the risk that “going direct” would assume. Broadly speaking
such alliances and partnerships include: joint ventures, marketing alliances, licensing
arrangements, selling/distribution agreements, channel partnerships and software agreements.

These alliances and partnerships may give you a competitive advantage, create barriers to entry
and help you reach customers more efficiently.

The MindMap diagram below looks through the process timeframe for considering a
partnership / alliance, through the evaluation of benefits, negotiation process and exit
provisions. The process starts at 1 and runs clockwise to 9.

Figure 14: Process for Assessing Alliance Opportunities

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The alliances pathway may actually be a more flexible, less resource intensive and lower risk
method of achieving your goals than a merger or acquisition.

3.5.1 LICENSING
Licensing is the capacity to exploit other parties IP, processor technology in return for agreed
fees.

Licensing can generate a revenue stream by giving permission to others to sell your products or
integrate your technology or know how into their products or services.

This revenue stream may potentially be lower risk as many of the costs of market entry may be
removed. In addition, the licensee may incorporate their own know‐how into the final solution
that may be well targeted at their customer base.

Licensing works by transferring technology to a licensee and fees can be generated through
royalties, management assistance etc. These royalties can be either from upfront payments,
running royalties or a combination of both.

It is also possible to negotiate multiple non‐exclusive licenses or minimum guaranteed license
revenues

From a business and forecasting perspective, the following needs to be considered:

• Is the license exclusive or nonexclusive?
• How long should the license be granted for?
• What is the size of the market and market penetration?
• Without the license, what is the investment required for manufacture?
• Does the market already exist or must it be created?
• Without the license, how much will it cost to establish sales channels?
• What is the prospective return on investment?
• What are the nature and extent of competition to be expected?
• What is the market life for the licensed technology?
• What kind of lead time will the license afford?
• What technical help, know‐how, or show‐how is provided?
• Without the license, what would it cost to “reinvent the wheel”?
• Will we create a new market or reduce production costs?
• Are profit margins in the industry sufficiently high?
• How do we wish to get paid?
• Can the licensee sub‐license?

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Finally, there’s an often quoted 25% rule of thumb for licensing revenue. It’s 25% to licensor,
75% to licensee of an expected profit margin. Probably best used as a starting point for
negotiations!

3.5.2 STRATEGIC ALLIANCES
The world doesn’t come looking for a better mousetrap, and the economy is a machine that
involves companies acting together as well as competing (co‐opetition). It’s very difficult to
build a wholly self sufficient company, so it makes sense to assemble a group of companies
together that form a sustainable force.

Alliance opportunities enable:

• INNOVATION: Generate new product ideas and accelerate commercialisation.
• EXTENSION: enable your company to enter new channels and reach new custom
segments.
• GEOGRAPHIC EXPANSION: Enable your company to enter new markets or improve
existing international or interstate operations using the alliance partner’s local assets.
• PERFORMANCE IMPROVEMENT: Enable improvements in efficiency and lower
operating costs and capital requirements through outsourcing.

3.5.3 DISTRIBUTION CHANNELS
It’s easy to see why a food manufacturer would use wholesalers or supermarkets to sell their
products, but a component of your forecast is to evaluate whether your financial interests are
best served by using a channel strategy. If you were comparing product revenues and costs by
using direct sales versus via indirect, here are some of the key considerations:

• LOWER COST: Using resellers can save on the costs of a direct salesforce while
extending the range of customers you are effectively speaking to. Similarly you may
save on warehouse management, inventory management and logistics by taking up
space in distributors facilities rather than building your own.
• INTEGRATION WITH OTHER PRODUCTS: Your products may require integration or
bundling with other products in order to provide a complete solution to customers’
requirements. In this instance you may require specialist resellers with integration skills
to sell complementary technology and effectively support and advise customers.

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• CUSTOMER REACH: As your business grows you may require resellers to reach a diverse
range of customers. If your product addresses many market segments and requires
geographical coverage then customer convenience in accessing a reseller becomes a
key criteria

If you are considering using non‐direct sales, remember to evaluate a range of options, which
ultimately will depend on your own industry structure. These include: master distributors, local
distributors, value added resellers, integrators and the rapidly developing channel of online
selling via the web (auction sites, catalogues etc)

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3.6 FRANCHISING

With brand name backing and reliable systems in place, it’s no surprise that franchising is one
of the fastest growing forms of business structure in Australia. In industries from fast food to
accountancy advice, franchising removes much of the need for promotional expenditure to
brand build and gives clients the reassurance that they can trust the products and services of
the franchisee.

Franchising works best for businesses that have a good past sales and profit history can be
easily replicated in new territories are easy and inexpensive to operate and have good brand
name recognition.

3.6.1 BEING A FRANCHISOR
The "franchisor" authorizes the proven methods and trademarks of their business to the
"franchisee" for a fee and a usually a percentage of gross monthly sales. In return for this,
support systems, advertising, training and other benefits will be made available to the
franchisee.

The key financial benefits of franchising your operation are:

• Once you have a methodology and a structure in place, it’s easier to open “cookie
cutter” type operations through franchisees than doing it yourself.
• Costas are substantially lower as the franchisees upfront fees will defray much of the
risk.
• The franchisee may have much greater experience dealing with their local market.
• Greater motivation on the franchisees behalf to make it successful than if you were to
do it through your own employees.

The key downsides of franchising your operations are:

• There may be some loss of control, as it may be more difficult to manage and get things
done through an individual franchisee than through a staff member.
• Getting the price right. Price it too high relative to the franchisees income streams and
it’s a permanent de‐motivator to the franchisee. Price it too low, and you’ve left value
on the table.
• Potential for conflicts: An incompetent franchisee can damage the customers goodwill
for the brand by providing inferior goods and services

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The key issues and controls you need to put into place are:

• Length of agreement – could be from five (sufficient time to realise returns from the
initial outlay and the lean start up period) to twenty years.
• What would trigger an early termination of a contract?
• What is the extent of a territory?
• Exclusive or non exclusive?

3.6.2 BEING A FRANCHISEE
The key financial benefits of purchasing a franchise are:

• You will most likely to have a recognised brand and an exclusive territory such that you
can go to market and earn positive cash flows comparatively quickly.
• Much of the expensive legwork in establishing this brand and promoting it will be done
for you saving you time and money, while having customers directed to you.
• The systems and processes created and developed by the franchisor will already be in
place, saving you time and money in having to create your own.

The key downsides of being a franchisee are:

• An incompetent franchisor can destroy their franchisees by not promoting the brand
adequately or being too aggressive for profits.
• You may or may not respond favourably to the lack of independence from the
franchisor, their methods and the controls they have in place for monitoring your
business.
• The success or otherwise of your operation may be due to factors outside of your
control – e.g. the decisions and behaviour of the franchisor or of other franchisees.
• There may be restrictions against the sale or transfer of the franchisees business.

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3.7 PROJECT MANAGEMENT

Much of the emphasis of this book so far is on the production and sale of tangible goods and
services. If your company’s business is based on the successful completion of specific projects
including a whole series of different financial and forecasting considerations come into play.

Your success is dependent on the successful management of a set of resources – people and
expertise, materials, money in order to achieve the objectives of a project. The goal is profit;
the classic constraints are time, quality and budget.

Your initial analysis determines the price you will charge for the project based on an estimate of
the costs involved. From a financial viewpoint the key risk is that the project timescales or costs
overrun, and this can be partially mitigated by:

• Thorough pre‐planning and consideration of each variable.
• A clear understanding and alignment with the customers’ requirements.
• Taking account of all potential risks and having a strategy in place to address them.
• Having flexibility in the contract to be able to pass on unforseen challenges to the
customer.
• Effective people, process and budgetary management throughout the project phases,
including sub‐contractors.

To ensure that the project remains on cost and on time, consider the following:

• What is the critical path and what are the interrelationships and interactions and
interdependencies between the resources?
• What key events, milestones, progress evaluations and critical activities been identified?
• Has time been allocated for quality, customer and stakeholder involvement?
• How has time contingency been incorporated into the plan?
• How thoroughly have target or actual project costs been clearly identified and
documented?
• Does the project cost estimation involve cost related risks and how are these managed?
• Is the project budget consistent with the project requirements, assumptions, risks and
contingencies? How will the project costs be managed to ensure that the project is
completed within budget?
• Is there a satisfactory process for accounting of project purchasing and other
expenditure? Has this purchasing process been documented?

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• Can you identify the root causes for budget variances, both favourable and
unfavourable? Is this reviewed?
• How has cost contingency been incorporated into the plan?

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3.8 OTHER INCOME

There are a wide range of other items that can fall into the “Other Income” category of your
Profit and loss. These can range from Grants from governments of private bodies, donations or
even the proceeds of your intellectual property. Some examples follow, but they’ll depend on
your own circumstances.

3.8.1 GRANTS & FINANCIAL ASSISTANCE
Financial assistance programmes at a federal (AusIndustry), state and export body (Austrade)
level can assist with grants and loans and tax offsets.

Examples include:

• AusIndustry’s support programs provide financial, managerial and technical support to
innovative early stage companies, their R&D Tax Concession programmes allows tax
concession of up to 125% of expenditure incurred on R&D and they offers specific
industry support in areas such as Tourism, Automotive, Biofuels, Climate change and
green based initiatives.
• EFIC (Export Finance & Insurance Corporation) is Australia’s export cr3edit agency offers
export guarantees and direct loans.
• State governments offer a variety of programmes for SME’s. In NSW, for example, the
Department of State & Regional Development (DSRD) provides assistance with
commercialising R&D, regional relocation incentives, export incentives and payroll tax
rebates.
• Austrade, Australia’s export authority provides an Export Market Development Grant
(EMDG), as a rebate on the proportion of total expenses incurred on eligible export
promotion activities.
• Regional, state and national governments worldwide may offer an incentive for
company’s to locate or relocate their activities there, particularly where they provide
employment (especially skilled employment) to local residents.

3.8.2 INTELLECTUAL PROPERTY INCOME
Obtaining a royalty stream from your Intellectual Property can, once the IP has been developed,
protected and marketed, be one of the significant income streams as it goes straight to the

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bottom line. (IBM for example many billions of dollars of income annually accruing from their
past IP).

Here’s a MindMap checklist of the considerations when embarking on a route to market that
involves the development and licensing of IP.

Figure 15: Process for Valuing IP

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4. COSTS
This section looks at each of the key costs payable by your company, both variable (expenses
that change in proportion to the activity of a business) and fixed (those which don’t change in
proportion to the business).

This simple diagram illustrates the two types of cost:

TOTAL COSTS
$
Costs

Variable Costs

Fixed Costs

Units Produced

Greater Fixed and Variable profit are achieved by greater revenues and less costs. The business
Figure 16: margins and Costs

challenge pre‐empted by your company forecast is to regularly eliminate unnecessary costs and
reallocate resources to activities that will generate the greatest returns. Forecasting to reduce
costs need to take the following into account:

• Likely cost savings given risks of executing and variability of outcomes
• Costs and investments required to achieve savings e.g. severance fees, new structures
and technologies
• Impact on revenue and earnings
• Timing required to implement initiative and realize benefits

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• Execution risks.

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4.1 COST OF SALE

Cost of sale refers to the direct costs attributed to the production of goods sold by your
company, including the material costs and labour costs incurred when producing the goods.

The formula for this is:

In a retailing or wholesaling company a large proportion of your cost of sale will be finished
goods inventory. A full discussion on reducing the risks from an extended working capital cycle
may be found in the section on Risk Management.

You may be reviewing your sourcing strategy as there may be substantial cost savings from
sourcing from outside Australia, particularly in the Asia Pacific region. However, these reduced
costs must be weighed up against

• the costs and risks of a build‐up in inventory from having to purchase more,
• the costs involved in having a lengthier supply chain with much of your stock “on the
water”
• advanced contractual commitments to produce more in remote manufacturing plants.

Thus you have to weigh up reduced costs with the potential of carrying greater inventory and
less flexibility.

Also, a lower cost of sale will also result from making adjustments to the costs involved in
serving a customer. This could result from automated order taking processes to reducing

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delivery costs to automated purchasing set up based on minimum reorder quantities being
reached by the customer.

4.1.1 REFUNDS, WARRANTIES AND GUARANTEES
Having your company back the products that you sell with a money back guarantee or a
warranty on product failure, are almost essential components of establishing a credible brand.
Even if you don’t offer one, the legal system would probably step in to ensure that justifiably
dissatisfied customers could enjoy a cooling off period, or that you were guilty under the Trade
Practices Act of “misleading and deceptive conduct”.

From a forecasting perspective, you need to consider the following:

• The potential for faulty (or even non faulty) product to be returned as new. What is
your policy for this? If you deal through channels, do they get a replacement product or
money back guarantee? Will you refund customers money even if the product is perfect
and the customer simply decides that they don’t want it?
• The potential for product faults within warranty period. How much warranty will you
provide? What is your process for fixing faulty product – service agents, back to
manufacturer? What commercial arrangements will be in place for this?
• The potential for product faults outside warranty period. Is it worth fixing the product?
If so, by whom? What strategies do you have in place for replacing or upgrading the
customer’s product?

4.1.2 LOYALTY & AWARDS PROGRAMMES
They are both cost to the business, and a future revenue driver. An airline will give away free
flights and upgrades to frequent fliers, but the act of accumulating points in the first place may
have generated some brand loyalty – if only to get the free flights!

The challenges are

• Giving away something in return for engendering loyalty for the product, rather than
merely getting something for nothing.
• Making sure that the giveaway is actually redeemable. Qantas, like most airlines, face
constant criticism for the non availability of free flights.
• Accounting for the cost of freebies that have not yet been redeemed.

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The latter is a forecasting issue, as there are liabilities created on the balance sheet. You need
to give consideration to:

• The probability that they will be redeemed at all. Some customers may simply not both
with the free gift or service.
• The cost of them being redeemed. Returning to the airline example, the marginal cost
of giving away a seat on a plane that wasn’t full anyway is lower than the cost of turning
away a paying passenger because their seat had already been taken by a free flight
redeemer.
• Expiry dates on redemption. This will lower the liability, but could also engender ill will
when customers lose out when they simply don’t take up an offer prior to expiry.

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4.2 OPERATING EXPENSES / OVERHEADS

Overheads refer to the ongoing expenses involved in running a company. These refer to all of
the necessary costs in running a company – rent, telecommunications, accounting fees that do
not directly generate revenue.

Included within the profit and loss account (income statement) are those Operating Expenses,
i.e. the ongoing costs for running a business, plus a proportion of the Capital Expenses, known
as depreciation for expenditures on assets that will give benefit beyond the current twelve
month period.

A component of your forecasting process should involve consideration of what percentage of
revenues should be spent on overhead. More importantly,

• How do they compare with other organisations in your market space?
• How can you reduce this percentage over time, and therefore increase your profits,
without affecting the efficiency of your company?

In the long term, you may need to review your entire operating processes, ensuring that they
can evolve to be the best in the industry and that they can see the company through both
booms and busts in the economic cycle. Key issues include:

• Where can work can conducted most cost effectively? Are there parts of your operation
that can be relocated to other (non CBD) offices, interstate or overseas?
• Can you shift work to a supplier based their capabilities? Do they have a superior cost
structure compared to yours?
• Can you outsource or use shared services? In recent years, internal telemarketing
teams have been outsourced to call centres, while IT departments have been replaced
by specialist IT service companies monitoring your network performance with back up
facilities and timed response rates.
• Can you transform your entire way of doing business? How can you optimise your
workforce, processes and technology to provide the most productive and efficient
environment for your company?

The following sections look at all of the different components of your overheads.

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4.2.1 MARKETING
Budgets need to be developed in order to ensure that your products and services are exposed
to your target audience. The methods of marketing used and the marketing spend / total
revenue ratio will vary across firms and industries and across the life cycle of a particular
product. First of all, seek out and use available data (online industry reports) to gauge an idea
of a realistic cost of creating a brand, and creating an awareness and desire for them to
purchase your goods.

Managers frequently underestimate the costs of marketing, and in order to cut through the
advertising clutter in order to obtain consumer awareness, these costs have to be maintained
over an extended period of time.

Within the marketing budget, has your company taken the following into account?

Advertising Placements Fees, Concept Development, Channel or Industry Specific

Bundling Cost of bundled product, Promotion, Packaging, Fulfilment, Support

Channel Distributor & Reseller expenses including ‐ catalogues, co‐operative
marketing, product management services, PR Programmes,
publications, reseller presentations, technical training, trade show
appearances, vendor nights, website listings

Collaterals Logo, Domain Registration, Brochures, Case Studies, CD's, Demo
Disks, folders, electronic presentation, Not For Resale Software,
Merchandise (caps, mugs etc), Packaging

Direct Marketing Direct Mail, Direct Fax, Infomercials, Telemarketing
Electronic Marketing Website development & maintenance, Web ad development, CD
ROM distribution, Search Engine costs.

General Administration Training, Equipment Rental, Hardware, Meals & Entertainment,
Research, Consulting, couriers, Resource Materials, Software, Travel,
Web Hosting
Public Relations Editorial Guides, launch events, Press Kits, PR Agency, Press Mailings

Sales Promotions Bundling Costs, Design Development, Price Promotions, Seminars &
Other Events

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Sponsorship Physical facilities, Causes, Events, Celebrities

Trade Shows & Events Stand costs, Personnel costs, transport & accommodation, advertising

Ultimately, your company will need to have a realistic proportion of forecast revenue set aside
for promotional expenditure. This can be in the range of 15‐30% of total revenue and will
depend on criteria like the number of new product releases, how competitive the market is etc.
A good guide is to look at the financial statements of publicly listed companies to review the
relationship between their marketing expenditure and revenue / profit. However, do not
assume an instant correlation between promotional spend and revenue. It takes a lot of
exposure and brand building before the effect on sales can be truly felt.

Much of the wastage involved in marketing can be eliminated through intelligently Test
Marketing a certain proportion of your target market by using short campaigns in certain, well
defined geographical locations to ascertain whether the marketing message is understood,
what media provides the best value for money (response per dollar spent) what the propensity
is for the customer to buy and how satisfied is the customer with their purchase. Global brands
will frequently use a test market such as Australia to determine the likelihood of success prior
to investing in global marketing.

In addition to the marketing spend involved in promoting current and forthcoming products,
you will also need to allocate expenditure on the following:

4.2.2 MARKETING ‐ MARKET RESEARCH
Understanding the consumer’s motivations, their need for your services and their perceptions
of your products must be an essential part of the new product development, launch and sales
cycle for your products. Some key questions need to be addressed within your Market
Research brief:

• What is the potential size of the market and the estimated level of sales?
• Is this market growing or declining? What factors will affect this market?
• Have you clearly defined the market sector for your product or service?
• Have you researched your market territories been researched thoroughly? What local
differences, customers, language and regulation are likely to affect your final product?

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• What is the consequence of making product changes for these different geographical
territories?
• If you are exporting, how competitive will your products remain if exchange rates
change?
• What are the appropriate channels to market? Direct selling, online, agents,
distributors, retailers? What is the possibility of channel conflict if more than one route
is utilised?
• What branding and other promotional effort is required?
• What is the shape of the competitive market place like now and what is it likely to look
like in the future? What competitors and competing products have been identified?
What future developments are there likely to be in these products and how will your
competitor respond to your product launch?

4.2.3 MARKETING‐ MARKETING EFFECTIVENESS
You should set some budget aside for measuring the effectiveness of alternative forms of
promotion, and use the knowledge derived to plan alternate marketing strategies. With online
marketing and Web analytics, it has become a whole lot easier in recent years to quantify key
interrelationships between customer exposure – customer interest – leads and customer sales.

4.2.4 COMPETITIVE INTELLIGENCE
It is important to invest in the capability to collect and analyse what is going on in your market.
You can get swamped by all of accessible online information (websites, newsletters, search
bots, share trading sites etc) about your competitors, future competitors, suppliers, customer
trends etc. The challenge is not in finding it, it’s having the headspace to filter, analyse it and
think about the repercussions of it for your own growth. To really understand what is going you
will require a time and a financial commitment:

• Purchasing filtered specialised news services that deliver relevant, industry specific
news to your desktop.
• Joining trade associations, networking forums and industry groups that allow you to
network to find out what is going on.
• Undertaking international reconnaissance. While you may not be a global firm at
present, overseas trends may well impact your own market as well as alter the

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landscape and potential for export. Jump on a plane and talk to people at
international trade shows, exhibitions, industry forums etc.
• Consider outsourcing information filtering to Information specialists well versus in
reading, condensing market data and producing it for you in the form of updates,
newsletters, alerts.
• Developing an in‐house “Knowledge Base” and train your staff to listen to
observations, rumours and opinions.

4.2.5 MARKETING – CUSTOMER RETENTION

To grow your market, you naturally have to find new customers and much of the here is
dedicated to the goal. However it is an often stated, yet important truism that it costs
significant less to have an existing customer purchase from you that it is to source a new one.

The growth in technology has made suppliers lazy in this goal and the use of impersonal
technologies such as e‐mail newsletters and other one way electronic messaging can make us
lose contact with the customer, their requirements, and whether indeed they are shopping
elsewhere. Repeat purchases, upgrades, subscription renewals etc are then at stake.

There are a wide number of Customer Retention strategies, but they can be summarised in the
following ways:

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Figure 17: Strategies for Customer Retention

Customer retention and the capacity to provide them with new and additional services, renew
their subscriptions, charge them retainer fees etc, provides some interesting financial modelling
challenges.

Here’s a sample Excel® based model for a company that sells hardware, software and services
to both new and existing customers:

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Figure 18: Building a Financial Model to include new and existing Revenues

The model has been set up so only the yellow cells need to have an input.

There is a known population of pieces of hardware out in the market at the beginning of a
period, plus a forecasted assumption that around 65% of that existing population will purchase
a “renewal”. This 65% renewal rate on existing customers plus the new customers acquired in
that period then become the new hardware population at the beginning of the following
period, and the calculation is made again at that point.

4.2.6 MARKETING ‐ BRANDING
Creating a unique identity for your company or product is a business necessity in order to
achieve customer recognition while fashioning an image for the offering.

Established brands can have great intangible value in themselves, but the costs of establishing
and sustaining a brand can easily be underestimated. These costs include:

• Design and production of all elements of brand – stationery, signage, advertising etc.
• Brand maintenance: Registering trademarks, providing permission for authorised usage
of trademarks and tracking, litigating and threatening to litigate against unauthorised
usage.

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4.2.7 INFORMATION TECHNOLOGY – AS A REVENUE & PROFIT DRIVER
The use of technology within your company can loosely fall under two categories – as an
investment in driving revenue, profitability and growth, or as a cost of doing business.

Excellence in information technology can drive real improvements to your company’s bottom
line. IT must deliver value to your company, rather than simply be a cost that should be
contained.

The rapid adoption rate in E‐ Commerce, Enterprise Resource Planning (ERP) systems, Customer
Relations Management (CRM), Knowledge Management, Business Intelligence & Analytics and
many web based technologies elevate IT considerations from being merely a cost to being a
driver of profitability and growth.

Effective use of technology creates competitive advantage. IT expenditure tied to your
company's business strategy will have the most clear‐cut business value, in terms of return on
investment. Moreover, when IT solutions and business strategy are woven together, companies
are finding that business benefits are often broader and deeper than expected.

Investments in the following technologies can all have long term highly positive payback in
terms of customer relationships and business efficiency:

• E‐Commerce: including a web store, inventory management process, order fulfilment
process and accounting system.
• Customer Relationship Management (CRM): Systems for tracking customer data and
customer interactions, as well as internal project tracking.
• Enterprise Resource Planning (ERP): An integration suite of most of the internal
processes within an organisation including manufacturing (scheduling, materials,
workflow and quality), supply chain management (inventory, suppliers, scheduling),
financials and project management.
• Management Accounting Software. While common low cost generic software such as
MYOB and Quicken may service your organisation for a while, at what point do you
require the greater functionality of mid‐range accounting packages?

As you grow, you will also need to cost in other applications such as purchasing management
software, business process automation, document automation, asset management and other
applications specific to your production, R&D and warehousing operations.

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Consider with each the following costs: the “per seat” licence, the implementation costs, the
renewal costs, the additional customisation costs through their life, and the costs involved in
migrating the data to larger systems should your growth take hold.

4.2.8 INFORMATION TECHNOLOGY – AS A COST OF DOING BUSINESS
Outside of staffing costs, Information Technology costs can be one of the most significant
operating costs of your company. As you grow your company, consider the future costs of
some of the following necessities:

• Hardware, software and networking products for your team
• Connectivity solutions with customers, suppliers, distributors etc.
• Disaster recovery and contingency planning requirements.
• Network and data security.

Even without the business benefits, there are commercial costs for not investing in technology.
Consider the costs of the following lost hours due to printer problems, network problems, loss
of unsaved work & failure to back‐up documents, equipment purchase delays, inadequate
computer training, inefficient processing power, computer downtime (crashes/system failure)
associated with inexpensive or inferior equipment, inefficient systems and double entry, poor
document management and access, complicated systems or retrieval of data

Also consider the lost revenue because your phone lines are engaged or your equipment is
inefficient, because sales data is not immediately accessible to your sales team and because
your sales team does not have a contact management system to remind them to call back
potential clients.

Key areas for considering appropriate levels of IT expense include:

Personal Computers Considerations:
Required power of a new computer
Ability to upgrade PC’s versus purchasing new ones
Rent v Lease v Buy equation
Software Considerations:
Are software upgrades always necessary?
Are service / support agreements with software vendors being fully utilised?
How many of your applications software can be utilised via SaaS (Software
as a Service), whereby applications are accessible via the web rather than
via the desktop*.
Is there an appropriate level of documentation being purchased with the

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software, particularly as most vendors no longer package documentation?
Servers There is likely to continue to be a rapid increase in the number of servers
that your company operates as it continues to grow.
There are also technologies (e.g. virtualisation software) that can reduce the
number of servers, as well as the use of distributed applications.
Broadband Rapid increases in broadband take up in recent years. However the market
will continue to become more competitive and technologies will ensure that
“Moore’s Law” continues.
Outsourcing The extent to which high fixed costs e.g. IT professionals can be outsourced.
Wide range of personnel and procedures outsourced to specialised
companies providing full system monitoring, application development etc.

*‐ Established software providers such as salesforce.com (Sales Tracking) and NetSuite (integrated
CRM, ERP and Ecommerce software) utilise the SaaS Model, enabling perpetual license fees rather
than larger one off costs, automatic roll out of upgrades and effective disaster recovery.

4.2.9 EMPLOYEE / PERSONNEL COSTS
Staff costs, including a reasonable “living wage” for yourself, the owner, can account for a large
proportion of total business costs for your company.

In addition to salaries, bonuses and commissions you will need to factor in the following other
employee entitlements.

• Superannuation
• Annual Leave
• Long Service Leave
• Cumulative sick leave
• Post employment benefits
• Termination benefits

Depending on how your organisation remunerates its employees there may also be share based
benefits ‐ such as shares owned, options etc.

According to a recent study (AMI‐ Partner Inc 2002) less than 50% of total human resources
spending are on direct staff salaries and wages:

• Staffing Services 49%
• Legal, HR Services 16%

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• Recruiting/ Benefits/ Administration / Miscellaneous 16%
• Payroll Services 8%

The key issues for consideration are:

• Labour force required to service the level of sales and support activity within the
company.
• Use of commissioned staff
• Use of overtime
• Use of contractors rather than full time employees
• Use of outsourcing
• Possibilities of promotions or other changes in role necessitating change in salary rate.

Like IT costs, training costs can be seen as either a cost of an investment in the skill set of your
company’s employees. Consider when forecasting, ways to best allocate spending to improve
effectiveness of your company’s learning and development processes. The training areas to be
considered include: leadership; management development; professional skills; technology
skills; and new product skills.

One key forecasting question, given that staff costs are often the most significant single cost in
a company, is – how many staff do you need? The answer can be clearer cut in some job
functions than in others. For production, it may be whatever keeps the assembly line in
operation if you decide to produce in‐house rather than outsource. In customer service
however, you may passively say whatever it takes to answer every inbound customer call, but
this passive approach needs to be considered in the light of having an active policy to perhaps:

Discourage low value calls by improving the quality of web based documentation and FAQ’s.

Or

Encourage high value customers by having an outbound call centre that checks up on their
levels of satisfaction.

Another example where you need to evaluate your personnel resource is in the availability of
sales people or pre‐sales engineers to close business. Particularly, what are the costs of getting
a new customer or getting an existing customer to buy more?

When looking at obtaining a new customer, you need to consider a Sales Funnel for your own
company. How many initial contacts do you need to obtain one sale? What is the cost of

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servicing those initial contacts (salesforce, presentations, proposals etc) in order to make that
sale?

In this example, 250 initial prospects, pipelines through to only 10 sales, but you must cost in
the resource of making contact with all of those initial 250.

A major cost in business is that of staff turnover. Every time one of your team members leaves,
you lose their expertise, their experience and their knowledge of the customers, products and
your internal systems. Whenever they leave you must incur costs of recruiting and hiring and
the cost of time that it takes them to be fully effective. While a certain amount of staff
turnover may be a good thing in terms of bringing in new individuals that could invigorate your
company through fresh ideas, you must also factor in the expenditures required to keep good
staff happy and motivated, thus reducing the turnover rate in the first place. Examples include:

• Employee share schemes and other financial incentives
• Training and development programmes
• Providing appropriate work / life balance including flexible hours
• Keeping the team informed including effective appraisal processes.

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4.2.10 STAFF & MANAGEMENT INCENTIVES (COMMISSIONS,
BONUSES)
Depending on the nature of your industry a considerable component of your employee costs
will be variable and relate to performance based incentives –

These incentives will relate to the achievement of a predefined target.

For sales staff and managers this achievement could include any of the following, and more:

Calculated as a total company, as a team or as an individual:

• Total sales
• Total sales growth
• Total growth in gross margin

Calculated as a total company

• Profitability
• Growth in profitability
• Growth in business value (e.g. share price of a listed company)

Performance based incentives may also apply to project staff for on time delivery of projects,
production & warehouse staff for efficient scheduling and working capital management, and for
a whole host of other individuals and teams in your company.

You’ll need to design incentive schemes as part of the forecasting process. However, ensure
that you take the following into consideration:

Is the behaviour that you are trying to incentivise creating the most desirable outcome for the
company in general? Will, for example, individuals:

• Achieve targets that may be detrimental to the performance of the company e.g. a
salesman targeted on revenue, may not care about the profitability of his / her
customer transactions.
• Defend the performance of their own silos instead of helping to shape action across the
whole organisation
• Tend to be ego driven and seek to enrich themselves at the expense of the organisation.

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Ultimately, incentives and performance goals should be related to achieve best results. They
will need to be constantly re‐evaluate as there may be circumstances where they can de‐
motivate if the individual is not achieving goals or if the maximum earn outs has already been
achieved and the individual is squirreling away some achievement for the next period!

You may also consider another tool for rewarding and motivating employees‐ by providing
them with shares or share options in the company via an ESOP (Employee Share Ownership
Programme. Section 6 deals with this in more detail.

Finally, incentives need not be financial in nature. Employee care, recognition and the
opportunities for promotion can often be far greater incentives.

4.2.11 DIRECTOR / EXTERNAL ADVISOR PAYMENTS
While evaluating personnel costs you must consider an allocation for non executive directors,
and external advisers. For your company to prosper you must attract, motivate and retain
highly skilled people for these roles.

With the increased scrutiny of, and litigation against Directors in recent years, there are
substantial risks in becoming a Director, as well as the requirement that a Director spends a
good deal more time scrutinising the reports provided by management, questioning the
strategic direction, sitting on committees and understanding the risks. The additional time
dedicated has resulted in higher fees for skills personnel, plus higher costs as companies
typically indemnify directors for breaches of laws (environmental, discrimination etc) for which
they might be personally liable.

A directors’ remuneration may be performance related and you could offer non‐executive
directors and advisers a share plan where some of their fees are provided as shares in the
company.

4.2.12 OTHER OPERATING EXPENSES
Here we are concerned with the ongoing day to day costs for running a business for a
predefined period of time – i.e. the next twelve months. They would include the following

• Motor Vehicles – lease, operations, petrol, parking, tolls
• Stationary & Office Supplies
• Signage

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• Staff Amenities
• Printing
• Postage
• Telecommunications
• Newspapers & Magazines including Subscriptions
• Travel
• Entertainment
• Cleaning
• Repairs & Maintenance
• Bank fees
• Regulatory compliance‐ lodgements, ASIC etc
• Professional services – accountant, bookkeepers, legal, consulting

Your income statement (Profit & loss account) will also contain a component called
“Depreciation”. This is the reduction in value in a particular period of the assets that were
originally purchased under capital expenditure.

Thus when your company purchases the following assets that will likely last for several years

• Computer & Office Equipment
• Office Furniture
• Office Fixtures and Fittings

only the annual depreciation is expensed as depreciation.

4.2.13 BUILDING LEASE
The size and functionality of premises for office space, manufacturing facilities and warehouses
need to be constantly considered, and a forecast that assumes rapid growth must also take into
account, the extent to which current premises may be stretched or dysfunctional in the event
of that growth.

Leases are a commitment on space and while premises may be subleased in the event they are
inadequate, consider the following costs:

• Built in CPI (Consumer Price Index) increases
• Option to extend lease at a pre‐agreed pricing formula.
• Whether the lease includes services such as cleaning, security etc.

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Important to cost in proper control of your bookkeeping – importance of decent accounts
package – what to look out for in accounts package – costs of not having decent package etc.

4.2.14 INSURANCE
There are a wide range of different types of insurance required for your company. The purpose
of most of this insurance is to transfer some of the risk within your operations onto an insurer
in return for a premium. Some such as Workers Compensation are compulsory, others such as
Professional Indemnity high recommended, and others such as Key person life insurance
optional.

They can be grouped into sections as follows:

• Professional Indemnity –important if you are involved with providing special services
or advice where the consequences of following your advice could lead to
detrimental outcomes.
• Public Liability – Either for the public to protect your company when customers
could suffer personal injury or property damage, or for employees to insure for
negligence against injuries resulting in the place of business or while travelling.
• Workers compensation ‐ This insurance is usually required by the state in which the
company operates. It provides valuable protection to workers and their employers in
the event of a workplace‐related injury or disease.
• Property Insurance ‐ This type of coverage will insure inventories, facilities,
furnishings, and equipment from fire, theft, etc.
• Key person life ‐ This type of coverage insures for business interruptions and/or
financial loss due to the death of a key officer or owner.

4.2.15 LEGAL COSTS
Legal costs are often underestimated by high growth organisations, particularly where they are
seeking to enter new markets, protect intellectual property, and form contractual relationships
with suppliers and customers or change shareholder agreements. Consider and cost in some of
the following:

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• Changes in ownership & structure of your company. Legal negotiation and agreement
may be required where the classes of shares and their rights change over time or where
commitments are honoured to provide shares, options or profit share.
• Trading Agreements: An expanding company will be subjected to the necessity to
create a wide range of trading agreements including franchisee / franchisor, exclusivity
on particular geographical territories or market sectors, royalties on revenues received,
licensing of product etc.
• Intellectual Property: The cost of researching, registering, protecting, enforcing and
litigating major IP forms IP such as patents, trademarks, copyright and designs can be
significant for a company on the cutting edge of research, design and prototype
manufacture. Such costs will multiply if seeking to have a full standard patents with up
to 20 years protection across a range of jurisdictions (countries)
• Environmental Regulation: Environmental considerations are important to proposed
developments in Australia and the continued operation of a project or venture.
Legislative controls cover a wide range of relevant areas including: land use and
development, environmental impact assessments, building and pollution, waste and
contamination.

4.2.16 ACCOUNTING COSTS
Accounting costs will include any outsourced services (e.g. bookkeeping) that you use in order
that your company accounting records are in compliance with the required standards,
accounting advice, any external independent audits that may be required to satisfy external
parties, tax compliance services and any Due Diligence projects you are required to undertake.

.

4.2.17 TAXES
To paraphrase Benjamin Franklin, nothing is certain except death and taxes. There are still a
bewildering number of taxes, rates and duties bestowed on the company by a variety of local,
state and federal jurisdictions and the statute book grows larger each financial year.

4.2.18 GST (GENERAL SALES TAX)

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GST is a broad‐based tax calculated at the rate of 10% on the value of the supply of a broad
range of goods and services. It is paid at each step of the supply chain and the liability to pay is
on the supplier of the GST items. Assuming your company is registered for GST (your projected
annual turnover is > $50,000) you will claim an input tax credit which offsets the GST included
in the price of GST items.

Your forecasting process needs to take account of

• The GST component of each transaction.
• The due date (monthly, quarterly etc) when GST payables and receivables due are
netted out.

4.2.19 INCOME TAX
The plethora of assumptions in the forecast needs to be continually updated with real figures if
the cash flow needs of the company are to be adequately understood.

The tax situation will vary whether your company is classed as a sole trader, partnership,
company or trust.

Company Income is taxed at the company tax rate of 30% and distributed to shareholders via
dividends will be subject to top up tax at personal tax rates. However companies can retain
after tax profits indefinitely. Tax rules are different for other forms of company structure such
as a Partnership or Trust.

Your forecasting will need to account of issues such as tax refunds due from previous trading
activity, losses carried forward, tax concessions and timings of tax payments.

Here’s a sample of income tax as part of the financial modelling process.

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Figure 19: Tax Modelling

4.2.20 OTHER TAXES
You will also need to take the following additional taxes into account when forecasting:

• Fringe Benefits Tax (FBT) ‐ Levied in respect of the total value of taxable benefits
(technology, cars, discounted loans, family schooling) provided to your employees as
part of their package.
• Customs Duty ‐ imposed on various goods imported into Australia at rates prescribed in
the customs legislation.
• Payroll Tax ‐ imposed by the various States and Territories on wages paid or payable by
an employer to an employee.
• Stamp Duty ‐ levied by each of the States on documents and transactions such as
transfers of property (including businesses and other business assets), sales of
marketable securities which are not quoted on ASX (including shares and units in unit
trusts), leasing and hiring arrangements and most secured lending transactions and
some unsecured lending transactions.
• Land Tax – imposed by each of the States on the ownership of land within the State or
Territory.
• Municipal Rates ‐ a common levy imposed on the value of land serviced by local or
municipal governments.

When operating internationally, your company will also need to factor in the various national
and local taxes and other charge applicable within that jurisdiction.

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4.2.21 TAX PLANNING
Income Tax deductions can be claimed for a wide variety of expenses. Typically, any expense is
tax deductable if it is incurred in order to run the company. These could typically include
borrowing expenses, bad debts written off, and an increase in inventory value across the
financial year, insurance, tax advice and recruitment costs.

You can claim capital works deductions for property improvements. This applies to extensions,
alterations and improvements to buildings and structural improvements. To qualify for the
deduction, the building must be used for the production of assessable income.

Naturally a range of opportunities to take advantage of tax breaks. Specialist advice is most
appropriate here.

One final message. Before entering overseas markets it is important to get professional tax
advice as to your obligations and how to structure overseas transactions.

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5. BALANCE SHEET, WORKING CAPITAL & CAPITAL
EXPENDITURE
One of the key financial statements required to be produced by any private registered or
publicly listed company is a Balance Sheet. The Balance Sheet shows the assets, liabilities and
equity in your company as a snapshot at a particular point in time.

The Balance Sheet is a snapshot of what you own and owe and

Simply speaking – assets are what the company owns and liabilities are what it owes. The
balance sheet equation can be expressed simply as

And can be illustrated by the following forecasting balance sheet.

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Figure 20: Forecasted Balance Sheet

Definitions of each are as follows:

ASSETS LIABILITIES
CURRENT Assets, including cash, Liabilities, including payables,
inventories and receivables held loans and taxes that will be
for the purpose of being realised settled within the next 12
or traded within the next 12 months
months
NON CURRENT Assets, including property, plant Liabilities, including interest
and equipment, investment bearing loans and borrowings
properties and intangible assets that will be held beyond the next

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that will be held beyond the next 12 months.
12 month reporting cycle

The balance sheet shows the liquidity of your company, which is the ease in which assets can be
converted into cash in order of liquidity.

However the balance sheet does not show the value of the firm, quality of management, and
economic and market conditions in which your company operates.

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5.1 BUSINESS CHALLENGES – MANAGING YOUR CASH FLOW

Estimating and monitoring the future value of assets, liabilities and equity is a very important
component of the forecasting process. You must consider the company’s capacity to fund the
ownership or access to assets which help to create value for the company by generating profits
and growth.

Conversely it is possible to go broke while making a profit. How? Simply through shortages in
working capital where continual growth consumes cash. Debts generated by increasing sales
cannot be collected quickly enough to pay off the increasing bills from suppliers whose
products you are selling more products from. You require more inventories to service the
growing number of customers who will eventually purchase your goods, given a time lag. If you
don't have enough cash fluidity in the working capital cycle, you capacity to fund expansion is
severely limited.

5.1.1 MANAGING WORKING CAPITAL
Working capital measures the funds that are readily available to operate a company. Working
capital comprises the total net current assets of a company, which are its stocks, debtors, and
cash—minus its creditors.

The working capital cycle describes capital (usually cash) as it moves through a company: it first
flows from a company to pay for supplies, materials, finished goods inventory, and wages to
workers who produce goods and services. It then flows into a company as goods and services
are sold, and as new investment equity and loans are received. Each stage of this cycle
consumes time. The more time the stages consume, the greater the demands on working
capital.

Early warning signs of insufficient working capital include:

• pressure on existing cash;
• exceptional cash‐ generating activities such as offering high discounts for early payment;
• increasing lines of credit;
• partial payments to suppliers and creditors;
• a preoccupation with surviving rather than managing;
• Frequent short‐ term emergency requests to the bank, for example, to help pay wages,
pending receipt of a cheque.

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We should now look in detail at the different components of working capital and review how
they can be improved:

5.1.2 MANAGING RECEIVABLES
Your understanding the ability of a customer to pay, propensity to pay on time and how you
can speed up the collections process is an essential part of the cash flow and profitability
process.

Firstly, consider the time lags that occur between when the customer originally orders a
product or service and when revenue is collected from that customer

Review the processes that you plan for your company, and build into your forecast how the
transition between them can be speeded up. Here are some ideas, which may be applicable to
you depending on your own company:

• Introduce retainer payments – a guaranteed fixed sum payment, usually monthly
that enables the customer to call on you for regular work.
• Try to have the customer make as much payment upfront e.g. ask for 1/3rd when the
job commences, 1/3rd while in progress and the remaining third on completion.

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• Send the invoice as quickly as possible.
• Offer discounts for early payments – say within seven days.
• Ensure that your credit reference checking is stringent prior to offering credit terms.
• Ensure that your customers know the payment terms and other credit policies.
Make them highly visible in the invoice.
• Incentivise the customer to make payments using the method least costly to you –
direct debit to your bank account avoids the fees payable to the providers of credit
cards.
• Use collections as a way to motivate your sales force. Delegate to them the
responsibility for timely receipt as a condition of bonuses.
• Ensure that regular statements are sent to customers to act as a reminder.
• Be prepared to follow up late payments with phone calls or emails.
• Charge interest or service charges on overdue balances.
• Aim for partial payment where you know that the customer may be experiencing
financial pain.
• Keep records including client’s reasons for slow payment? It will make it easier for
you to validate the reasons the client gives the next time they pay late.
• Don’t hesitate for too long in using debt collection services.

Note that as you grow you may lack the capacity or inclination to manage accounts receivable
processes internally. There are many professional services you can utilise by outsourcing the
debt to a reputable collector.

5.1.3 MANAGING PAYABLES
Accounts payable is the process of paying your suppliers, and like accounts receivable there are
plenty of opportunities to improve your cash flow and profitability here.

• Before looking at some simple ways to improve your cash flow, review first whether it is
necessary to buy the goods and services that you are purchasing in the first place.
Above all are your variable costs increasing faster than your revenue? Are you
predicting those sales accurately? Can you purchase second hand rather than new? In
the current economic downturn, the auction sites are spilling over with great bargains in
nearly new office furniture.

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• Don't be too hasty when paying suppliers. Dun &Bradstreet estimate that the average
largish company is taking more than 50 days to pay suppliers – and that those are
increasing as we head towards a downturn.
• Are you asking your supplier for discounts? Negotiate with each of them as you may be
surprised at what they can offer you, particularly if you are likely to purchase in
quantity, be a regular customer over time or when your supplier is operating in a
competitive market.
• Try to get credit rather than cash terms with suppliers, but ensure that your own
systems can cope with that.
• Make sure that you are being accurately billed. Suppliers do make mistakes. Their
invoice personnel may not know about the discount you were offered by the
salesperson.
• Have a good payments tracking system so that it makes it easier to go back to them for
better trading terms and bulk discounts.
• However, don't damage your credit rating or string out supplier payments too long. It
may not help in your future dealing with the supplier. If there was a shortage of product
that you normally rely on from that supplier, would you expect to receive your fair
allocation?

5.1.4 MANAGING INVENTORY
The ultimate key to success here is to ensure that you have sufficient stock in your warehouse
or retail premises to meet your customer’s needs, that you are not holding onto unsold stock
for long and that you can order and receive stock from supplier at just the right time to achieve
this. Remember that your value of stock you carry can be magnified by slow moving items,
which in turn tie up your cash in an unproductive way.

Effective inventory management is imperative in ensuring proper cash flow management and
profitability. You need to know how quickly items are selling, as well as what products are
obsolete, what are trends, seasons and fashions depending on your products, what it costs you
to store inventory and what your margins are on finished products.

Consider your inventory in three categories

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Now what can go wrong?

• Inadequate tracking system or a mismatch between supply and demand that could
result in too much overall stock, too much old or obsolete stock. There needs to be
proper control over inventory ordered, with optimal ordering cycles, supplier flexibility,
regular stock takes and efficient warehouse system. The challenges can be multiplied by
a factor of thousands when you consider all of the individual unique SKU’s
• Theft, shrinkage and spoilage are all important aspects and you should budgets for
proper physical safeguards over inventories including locked storage areas for high
value items, limited access to secured areas and adequate security at warehouse
locations.
• Review your supply base, could you rationalise the number of suppliers and thus
negotiate better discounts, service, quality or delivery lead times
• Inevitably you will have slow moving items. You will need to make allowance where the
value of the inventory falls below its cost e.g. when you need to respond to a
competitors price discounting initiative, when newer versions of products outdate
current stock. The magnitude of this will depend on the industry you operate within.
Fashion items may rapidly decrease in value over time, as will the value of newly
released DVD's

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Ultimately, accept that you will never get things totally right. You’ll need a rule of thumb for a
proportion of total items that are going to be sold for less than cost. This also include fixing or
damaged inventory as well as staff discounts.

When producing a forecast, it is important to consider that some costs will be variable and
some fixed, and some costs will fluctuate more over time. Consider the longer term input costs
and maintain the flexibility to transfer components of cost from variable to fixed such as
building factories rather than outsourcing manufacturing.

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5.2 FUNDING WORKING CAPITAL AND GROWTH

There are a wide range of options available if you are seeking to fund a growth in your working
capital, either through finance of the equipment itself or the production facilities required to
build your products. Loans, leasing and factoring are commonplace means, but consider also
the availability of inventory, trade and production finance through more specialised finance
providers.

5.2.1 EQUIPMENT FINANCE – LOANS AND LEASING
If you are seeking to acquire equipment to facilitate more rapid growth or your company, there
are a wide range of leasing, loan and hire purchase options as illustrated:

Figure 21: Equipment Lease & Own Options

The options can be explained as follows:

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HIRE PURCHASE EQUIPMENT FINANCE LEASE OPERATING
LOAN LEASE

DEFINITION Agreement to Borrow money Agreement Agreement to
purchase to purchase where financier rent equipment
equipment over equipment provides finance for use in
time for you to lease business for
equipment. fixed term, the
Financier owns
Purchase usually returned at term
equipment until
possible at end end.
final payment is
of term.
made

BENEFITS Can choose what Legal ownership, 100% finance 100% finance
% you wish to but mortgaged provided. provided.
finance. to financier.
No interest rate Can upgrade
Can purchase at Loan can be fluctuations equipment
any time repaid any time. without
Rental payments
concerns for
Interest Able to utilise tax deductible
disposing it.
payments & balloon payment
Can claim input
depreciation tax at period end Rental payments
tax credit via a
deductible tax deductible
Interest GST BAS
Able to utilise payments & Can claim input
balloon payment depreciation tax tax credit via a
at period end deductible GST BAS

No interest rate Deposit is
fluctuations optional

Can claim input No GST on loan
tax credit via a or repayments
GST BAS

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IS IT RIGHT? Ideal if you wish Ideal for claiming Ideal if you want Ideal if you want
to own at end of input tax credits to lease to upgrade
period. equipment

Table: Types of Loan & Lease – Adapted from Commonwealth Bank Table

5.2.2 FACTORING
This is typically arranged with a financial institution and involves them lending cash to you
based a proportion of the face value of invoices. The institution provides a flexible line of credit
and promptly pays up to 90% of your book debts in cash. The balance is paid to your company
when the debt has been collected from your customer. This process creates a flexible line of
credit, allowing you to fund your rising cost of working capital that will come from business
expansion.

Naturally this comes with costs attached and while it brings forward your cash receivables, it
does so at the expense of the loss of some of the gross margin you would obtain from the
customer.

5.2.3 INVENTORY FINANCE
Inventory Finance enables established businesses to finance their purchasing of stock – raw
materials, work in progress or finished goods for resale to customers. Usually, the following is
applicable:

• The inventory does not have to be presold.
• Flexibility on the matching of repayments to the speed that your stock is sold
• No security on assets or property is required
• A line of credit facility is usually established.

Inventory Finance can resolve some of the cash flow issues when a rapidly growing company
continually needs access to ever increasing working capital. In addition, access to larger stock
levels may also provide you with the opportunity to negotiate bulk discounts and early
payments rewards with suppliers, but this has to be offset against the additional costs that this
finance brings.

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5.2.4 PRODUCTION FINANCE
Finance arrangements may be available to fund your outsourced production costs. This may
include manufacturing, processing or refining costs that add value to your goods for sale. Like
inventory finance the following is usually applicable.

• The products to be produced don’t have to be presold.
• No security on assets or property is required
• A line of credit facility is usually established

5.2.5 WAREHOUSE FINANCE

Aligned with Production Finance, Warehouse Finance may be of value if you need to obtain and
store bulk container loads, particularly for bulk buying. If you do not have the warehousing and
storage space, you finance provider may assist you to form a partnership with a large logistics
provider who can assist with storage and distribution of your products.

5.2.6 VENDOR FINANCE
Another form of finance which can also increase your revenue stream is vendor finance. Here’
you will form a partnership with a large finance provider and through this partnership, offer
your customer financial options when purchasing your products. As your customer has easier
access to funds, their purchasing options may be greater. This is common with cars and office
equipment such as computers, and is promoted to B2C customers as “no interest, no
repayment” schemes.

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5.3 BUSINESS GROWTH – INVESTING IN THE FUTURE

A key forecasting principle is that over the long term, the assets must generate profit. That rate
of profit generated must be higher than the rate of interest incurred on the interest bearing
liabilities. When you plan to purchase assets, review the long term value that will be derived
from them, whether those assets are tangible (plant & equipment), intangible (patents,
goodwill) or even entire companies in an acquisition.

• Sale & Leaseback: Opportunity to derive cash by selling property or large equipment
and leasing it back. You remain the tenants or continue to use the property and
equipment.
• Appreciating Assets: Certain assets particularly land and buildings may rapidly
appreciate in value over time. Other assets integral to the operation of the company
such plant & equipment and motor vehicles may depreciate.
• Intangibles: In certain industries, intangible may form a major part of your longer term
assets. These include patents and other intellectual property, brands and goodwill, and
can be the lifeblood of your company, the source of many of the high value sales and an
important item in the valuation of the company.
• Investment in associates or other non related businesses: Investments are additional
assets not needed for the main part of the company. They are generally acquired using
surplus cash that the company is not using for working capital or CapEx.
• Acquisitions: Your company may perceive that it needs to make strategic investments in
related companies‐ suppliers, customers and associates. These may in the future lead
to strategic acquisitions. This is covered in Section 8.
• Investments in unrelated property, shares, trusts and interest bearing securities: These
have no relationship to the core business, but may be a simpler way of obtaining higher
returns (at least in the short ‐ medium term) that deploying those funds in company
related activities.

Throughout your forecasting period you may want to look at the structural nature of your
organisation and how well it handles a given set of inputs (cash, resources, labour etc) in order
to produce the most efficient set of outputs – finished products, profits and growth. The major
outlays that you have to plan for come under the category of Capital Expenditure.

5.3.1 CAPITAL EXPENDITURE

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Capital Expenditure occurs when a company spend in order to purchase fixed assets, or
upgrade existing fixed assets. These include property, equipment and industrial buildings and
the outlay is made to increase the scope of the company’s operations. If the asset is going to
be used beyond the immediate financial year, the cost must be capitalised. Those costs are
then depreciated over the life of the asset.

There are four types of costs relating to tangible assets that can be capitalised:

• Costs that produce a benefit lasting beyond the current tax year.
• New assets that have a life beyond one year.
• Improvements that prolong the life of an asset (enhancements, repairs etc)
• Adaptations that allow the asset to be used for a new or different purpose.

For forecasting and modelling purposes here is a sample Capital Expenditure forecast of a chain
store retailer that is opening up new branches, closing old ones, refurbishing existing ones and
ensuring that the appropriate IT and warehousing expenditures of each are taken into
consideration.

FY 07‐08 FY 08‐09 FY 09‐10 FY 10‐11
New Stores ‐ Greenfields 2.30 2.57 2.53 2.44
New Stores ‐ Acquisitions 3.10 2.53 3.41 2.41
New Stores ‐ Replacements 2.70 3.00 2.97 2.85
Store Refurbishments 1.90 6.00 2.09 5.70
Store Extensions 3.10 5.97 3.41 5.67
Stay in Business ‐ R&M 2.60 6.10 2.86 5.80
Stay in Business ‐ Operational 3.30 14.50 3.63 13.78
MIS 12.10 6.00 13.31 5.70
Distribution 2.50 2.58 2.75 2.45
Property Developments 3.70 11.33 4.07 10.77
Gross Capex 37.30 60.58 41.03 57.55
Property Sales ‐6.10 ‐15.30 ‐10.00 ‐10.77
Net Capex pre Fitout Leasing 43.40 75.88 51.03 68.31
Fitout Leasing ‐3.30 ‐14.50 ‐3.63 ‐13.78
Net Capex post Fitout Leasing 46.70 90.38 54.66 82.09
Acquisitions 12.00 3.60 5.20 5.60
Total Capex & Acquisitions 58.70 93.98 59.86 87.69

Figure 22: Capital Expenditure Model

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The following are a series of questions that need to be addressed and include in your growth
costings:

5.3.2 MANUFACTURING CHALLENGES

• Can you make any improvements in efficiency?
• How close are the manufacturing facilities to your distribution channels? Is
responsiveness affected? Could you reduce transportation charges? Is there
government or other incentives for you to relocate company facilities?
• How available are raw materials and what are the likely cost fluctuations?
• What is the maintenance requirement of the manufacturing plant? Have they been
costed in, in downtime costs?
• What opportunities are there for vertical integrating your manufacturing? Can you
create efficiencies by manufacturing rather than sourcing components? If you supply
product to another manufacturer, can you enhance the value of their end product by
producing it yourself?
• How effective are your inventory control systems?
• How effective are your QA system?
• How old is your equipment? Can newer technologies create cost efficiencies?
• What is likely to be the turnover of key personnel? What value do these personnel
bring to your organisation and how dramatic is the learning curve for replacement
personnel?

5.3.3 RESEARCH & DEVELOPMENT CHALLENGES

One of the key challenges here is to ensure a pipeline of new product innovations that relace
and enhance the current product offering. Dedicated resource in terms of research, market
analysis, partner involvement and the development of business cases need to be costed and
included in the forecast.

For both new product development and general R&D consider the following:

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• What is the research capability of your development team? Are there any skill sets that
you are lacking? How well equipped are your laboratories and development areas? Can
they be improved? What access can you have to superior, shared resources?
• What manufacturing support is there for R&D? Can tests and small production runs be
fed through to your plant?
• Do your research staff have a true vision of how the marketplace is evolving? Can their
managers inspire a vision and facilitate an innovative & creative environment? Do they
understand costs and benefits? Are they focused on market realities and optimise cost
with performance
• How able is your company to recruit and retain specialists? Tech managers who
understand financials,
• How proprietary is their technical knowledge and are there risks of that changing?
• Can they both create and shape future developments as well as act in the defensive
through lowering offensive manufacturing costs, low cost product improvements and
supporting economies of scale requirements?

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5.4 LIMITS TO GROWTH – CAN YOU GROW TOO QUICKLY?

Economic downturns can challenge the most successful rapidly growing companies, but much
of the problem could be that they grew too fast in the first place, by undertaking sub‐optimal
growth. Recently Starbucks announced the closure of 75% of its Australian locations. These
locations were opened during times of economic growth, but were built in the first place
without rigid demographic analysis and without a clear understanding of the tastes of an
Australian coffee drinker. It is possible to grow too fast when an investor’s demand for growth
exceeds the strategic business rationale for doing so and it turns into growth only for the sake
of growing.

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6 FINANCING
The freeing up of excess working capital may be the cheapest form of financing. However,
there will be some occasions as you grow where external finance is the most appropriate way
of obtaining a large scale input of funds into your operations. You may be expanding your
product range, processes, research capabilities or your geographical reach, and simply making
internal adjustments will not give you the financial flexibility you need.

As well as having an operational strategy in place, a rapidly growing company also requires a
financial strategy, which is a set of policies that determines the sourcing and distribution of
funds.

Even smaller organisations must have a framework for assessing their financial strategy and
ensuring that it is aligned with the operations of the company. Why?

• To assist in making acquisitions that can help grow the company through diversification,
horizontal / vertical integration or simply scale by acquiring competitors.
• Ensure that there is sufficient access to finance that the company can draw on in periods
of underachievement.
• Ensure that free cash flows are either profitably reinvested into the organisation, or
distributed to shareholders if such reinvestments cannot obtain a market rate of return.
• Ensure that the cash reserve is deployed appropriately.

Key issues:

• Most companies will be financed by a mixture of debt and equity. A healthy growing
company should have an “appropriate” balance of debt (borrowings) and equity
(ownership). This “appropriate” capital structure needs to give consideration to your
company’s future revenues and investment requirements.
• Debt finance is less costly because debt holders expect a lower rate of return in
exchange for greater certainty of repayment and a preferential position in the event of
bankruptcy. Debt is also tax deductible, thus further reducing the cost of debt to the
company.

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• One of the purposes of forecasting is to ensure that you have sufficient debt capacity in
place to be able to cope with a range of different scenarios that could occur. One key
issue is to watch the interest charges incurred by borrowings. Profits can be reduced or
even eliminated by borrowings which in turn have to be funded by a reduction in
owners’ equity. In the current economic circumstances with rising interest rates this is
all the more prevalent.

The amount of debt in your company is known as its gearing ratio and may be simply calculated
as follows:

DEBTS
Interest Bearing Loans & Borrowings 500,000
Redeemable Preference Shares 60,000
Cash & Short Term Deposits ‐250,000
NET DEBT 310,000
TOTAL EQUITY 1,000,000
TOTAL CAPITAL EMPLOYED 1,310,000

Gearing = Net Debt / Total Equity 31.00%

Figure 23: Calculating Gearing

An acceptable level of debt may be something that you and other shareholders / directors have
agreed upon, or it may be imposed on the company by means of a banking covenant on the
debt (see later).

What is an acceptable level of debt? The finance text books are crowded with debate about this
issue, but much of the answer depends on the industry that you are operating within, the
growth stage of the company and your company’s capability to be able to cost efficiently access
either one or both means. Here are some key pointers:

DEBT EQUITY
ADVANTAGES Funds growth while avoiding Returns to the shareholder are
diluting the ownership interest based on “best efforts” rather
of equity holders. than a legal obligation to repay
Tax efficient use of operating debt.
cash flows. The cost of debt is Equity holders may be lower
tax deductible. expectations that debt holders in
a recessionary environment.
DISADVANTAGES Debt must be serviced with Equity holding pattern likely to
interest payments that are be more volatile if company

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increasing in the current listed and traded on an
environment. exchange.
Higher levels of debt (relative to
serviceability) can adverse affect
credit ratings.

Overall, smaller organisations, particularly those that are enjoying rapid growth are more likely
to be characterised by lower debt levels, simpler capital structures, mainly short maturity
senior bank debt, lower dividend payouts and share based incentive compensation.

Equity includes

• The original share capital rose for the company
• Any additional capital raisings
• The accumulated profits from previous years not dispersed through dividends.

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6.1 DEBT

Your company is more viable long term if the borrowings match the assets e.g. a company with
mainly long term assets requires mainly long term borrowings. You should not arrange short
term borrowings to acquire non current assets, as the short term cash inflows from revenues
generated by the non current asset will more than likely not match the outflows from payments
due on the asset.

Loans have the potential to be substantially reduced if other cash flow components could be
managed.

You will need to consider appropriate levels of debt. Too much debt as a percentage of total
company value can mean:

• Interest payments will swell and put pressure on your company to be able to cover
interest and principal repayments.
• A lower credit rating for companies who are rated by credit agencies such as Moody’s
and Standard & Poors

A loan, usually obtained from a financial institution is a common form of debt. This loan will be
either

• secured where you will pledge and asset such as a property as collateral, or

• unsecured such as an overdraft, credit card debt or a bond.

The timing of borrowing repayments is important as sufficient cash will be required, or new
borrowings arranged. You'll need to predict the likely cash situation at the time and the likely
need to arrange new funds.

You may also have given commitments to lenders, such as banks, that the company maintains
certain pre‐agreed ratios for liquidity (cash buffers) and other criteria. These are known as
covenants, and commit the company to agree limit other borrowing or to maintain a certain
level of gearing. Other common limits include levels of interest cover, working capital and cash
flow.

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The example below shows financial forecasting to take account of two covenant ratios

a) That Group EBITDA must always remain more than three times the value of the interest
repayment on debt.
b) That the leverage ratio (debt / total tangible assets) must not exceed 40%.

Both these measures illustrate that the company directors will need to recast their forecasts in
the light of the potential of both covenants being broken.

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Covenant One - Group EBITDA >= 3x Net Interest Expense
q1 07-08 q2 07-08 q3 07-08 q4 07-08 q1 08-09 q2 08-09 q3 08-09 q4 08-09 q1 09-10 q2 09-10 q3 09-10 q4 09-10
Current Forecast Forecast Forecast Forecast Forecast Forecast Forecast Forecast Forecast Forecast Forecast
EBITDA 4,082,982 1,460,022 2,003,966 3,018,251 3,466,860 3,114,287 1,883,344 1,774,560 1,669,881 1,435,217 1,287,166 1,411,923
Net Interest Expense 867,111 867,111 867,111 836,778 806,444 806,444 776,111 745,778 745,778 715,444 685,111 685,111
Forecast EBITDA Ratio 4.71 1.68 2.31 3.61 4.30 3.86 2.43 2.38 2.24 2.01 1.88 2.06
Covenant 3 3 3 3 3 3 3 3 3 3 3 3

5.00

4.50

4.00

3.50

3.00
Forecast EBITDA Ratio
2.50
Covenant
2.00

1.50

1.00

0.50

0.00
q1 07-08 q2 07-08 q3 07-08 q4 07-08 q1 08-09 q2 08-09 q3 08-09 q4 08-09 q1 09-10 q2 09-10 q3 09-10 q4 09-10

Covenant Two - Leverage Ratio - Must be <=40%
q1 07-08 q2 07-08 q3 07-08 q4 07-08 q1 08-09 q2 08-09 q3 08-09 q4 08-09 q1 09-10 q2 09-10 q3 09-10 q4 09-10
Current Forecast Forecast Forecast Forecast Forecast Forecast Forecast Forecast Forecast Forecast Forecast
Senior Debt 70,000,000 72,569,143 74,446,451 72,949,767 72,349,159 64,291,890 58,000,000 58,000,000 58,000,000 58,000,000 58,000,000 58,000,000
Total Guarantees 14,225,000 14,225,000 14,225,001 14,225,001 14,225,001 14,225,001 14,225,002 14,225,002 14,225,002 14,225,002 14,225,003 14,225,003
Total Senior Debt 84,225,000 86,794,143 88,671,451 87,174,768 86,574,160 78,516,891 72,225,002 72,225,002 72,225,002 72,225,002 72,225,003 72,225,003

Total Assets 213,083,514 213,241,245 215,853,343 216,578,522 214,744,907 208,614,591 203,167,522 199,748,882 200,352,532 194,839,199 191,577,315 192,683,384
Less Goodwill 12,593,811 12,593,811 12,593,811 12,593,811 12,593,811 12,593,811 12,593,811 12,593,811 12,593,811 12,593,811 12,593,811 12,593,811
Total Tangible Assets 200,489,703 200,647,435 203,259,532 203,984,712 202,151,097 196,020,781 190,573,711 187,155,072 187,758,722 182,245,389 178,983,504 180,089,573

Forecast Leverage Ratio 42% 43% 44% 43% 43% 40% 38% 39% 38% 40% 40% 40%
Covenant 40% 40% 40% 40% 40% 40% 40% 40% 40% 40% 40% 40%

45%

44%

43%

42%

41%
Forecast Leverage Ratio
40%
Covenant
39%

38%

37%

36%

35%
q1 07-08 q2 07-08 q3 07-08 q4 07-08 q1 08-09 q2 08-09 q3 08-09 q4 08-09 q1 09-10 q2 09-10 q3 09-10 q4 09-10

Figure 24: Covenant Modelling

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6.2 EQUITY

Equity is the residual interest in the company’s assets after the deduction of liabilities. It is
made up of contributions from owners; pre and post start up investors, retained earnings and
reserves.

Along your growth path, you are going to be reviewing a range of issues pertaining to
ownership of your company. While you may start off being the 100% shareholder, your funding
and control needs may change to where this ownership is diluted and

• ownership is split amongst a number of shareholders,
• an external investor such as a business angel or venture capitalist becomes involved as a
result of your funding and expansion needs
• you want to keep your own managers motivated and incentivised by offering employee
shares or options.

The issues that surround deal making with external investors, convertible debt to equity shares
and dilution provision in shareholder agreements all go beyond the scope of this eGuide.

6.2.1 DIVIDENDS AND RETAINED PROFITS
Dividends are the distribution to the shareholders of a certain amount of the profit made by the
company. Whatever is not distributed is reinvested into the business as Retained Earnings.

You will need to consider the necessity of declaring a dividend. Determinants include:

• How much cash is available ‐ liquidity
• Debt covenants restricting the payout amounts to shareholders
• Stability of earnings.

Dividend policy revolves around public perception rather than rational company objectives‐ i.e.
that the firm should maintain or increase its dividend payout every year. However, the real
issue is whether the firm can gain a better return on those funds than the shareholder.

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The rational approach to dividend payments is that if the company cannot reinvest the earnings
at a higher expected return that the shareholder would obtain through use of the money in an
alternative investment proposition, then the company should pay the Dividend.

Several factors should be considered when thinking about investing retained profits. These
include

RETURNS ‐ The percentage you earn on an investment is key. Some products, like bonds, offer a
specific, guaranteed return. Some products offer a higher return, but it is not guaranteed.

SAFETY ‐ What’s the risk factor? Conservative investors might choose a bank savings account
because the return is safe. Aggressive investors might prefer to lean towards property or
shares, but their money is not insured, nor is the return guaranteed.

LIQUIDITY ‐ If and when you need your invested money, how quickly can you access it? Money
market accounts and savings accounts are considered liquid assets because they can be turned
into cash quickly. Products with staggered maturity dates give you access to cash at different
times.

DIVERSITY ‐ A smart way to reduce risk is by spreading your money among several types of
investment products. For example, you could bonds and shares.

6.2.2 EMPLOYEE SHARES & OPTIONS
An employee ownership programme is a very useful motivational tool for helping your
employees to have the same overall goals as the business. You may choose to have either a
broad based scheme whereby all of your employees can own shares in your company via an
ESOP (employee share ownership plan) or where you offer shares or share options to a few key
employees.

If you are considering proving shares to employees, you will want to consider the following:

• Will the scheme be motivational for the group of employees who now have shares, as
well as the entire company?

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• Will the shares be provided free or via a loan, known as an Employee Share Loan Plan
(ESLP)? How will the loan be structured and repaid? Will the employee have the
capability to accumulate more share, say via a regular saving and investment plan?
• What opportunities will there be for employee salary sacrifice to purchase shares?
• What are the tax implications from both the company and the employee’s perspective?
• How will the scheme grow? Could it be a lead in for the retirement of an owner, where
a team of employees acquire the company? (The leveraged ESOP) This is starting to
become a valid opportunity for the owner to exit the business without a trade sale of
public listing.
• What will the criteria be for an employee who wishes to sell their shares?

Another alternative, share options give your managers the right (but not the obligation) to
purchase company shares at a pre‐agreed fixed price for a specific period of time. Again, these
act as a motivator to increase the value of the company, in order that these options have a true
value.

From a forecasting perspective, it enables the capital base of the company to expand, it
encourages the reinvestment of company profits into the company to fund its further growth,
and it requires the owner to provide finance or arrange financial sources for employees wishing
to acquire shares.

6.2.3 OTHER RESERVES
There may be other reserves in the equity component of your Balance Sheet. These include:

Types of Reserves
Shareholder Contributions This includes
a) options, where investors subscribe funds to acquire an option that
gives them the right to acquire funds at a later date.
b) Forfeited shares reserve, where investors failed to pay a call on
partly paid shares.
Realised Gains These include:
Gains made on disposal of capital types of profit
Retained earnings
General reserve
Capital profits reserve

Unrealised Gains These include:
Asset revaluation reserves
Foreign currency transaction reserves

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6.3 HIGH GROWTH COMPANY’S – SPECIAL CONSIDERATION

It is frequently said that company’s most able to raise capital are those least in need of it.
Conversely, those growth companies with the highest potential to succeed in rapid business
expansion are those least able to obtain the finance since their propositions will be the most
untested and thus the highest risk.

Figure 25: Financing a High Growth Business

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Venture capital (or angel investing for start ups) is high‐risk capital directed towards new or
young businesses with prospects of rapid growth and high rates of return. Venture capital
companies will provide capital for R&D and new product development for an idea, and will
cater for early stage and later stage expansion companies, as well as finance for management
buyouts and buy‐ins of established companies.

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7 REPORTING & ANALYSIS
Behind the financial statements sit a whole series of analysis about whether your company is
heading in the right direction. This section is dedicated to:

a) Reviewing your cash flow forecast.
b) Reviewing your performance ratios.
c) Tracking your actual performance to your budget
d) Explaining the value of considering alternative scenarios for your company

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7.1 CASH FLOW & CASH MANAGEMENT FORECASTING

“You can lose money for a while, but you only run out of cash once”

The cash flow forecast is an absolutely essential part of your company reporting. Its proper
management is a discipline that ensures a company is kept in a healthy state.

Cash flow is simply the movement of cash in and out of the company. Cash flow management
is essential as a discipline that tells you how much cash is in the company at any future point in
time. It reduces the risk of insolvency and can reduce the cost of financing an entity. This is by
reducing the amount of capital employed.

Here’s a sample cash flow forecast outlining the forecasted inflows and outflows from a sample
company.

Figure 26: Cash Flow Forecast Modelling

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This will determine your financial capability to expand and whether external financing or tighter
cash management is required for any financial shortfall.

A properly formulated cash flow forecast will pinpoint whether you can afford your working
capital requirements, pay your debts and reward your shareholders and whether you afford the
asset purchases required to facilitate growth.

The cash flow forecast shows where the cash is coming from and where it is used in the running
of the company. It is in the form

This statement provides an early warning of potential cash shortages, identify whether
additional funds will be needed, identify potential surpluses that can be invested to generate
additional income and assists in preparing requests for financiers for additional funding.

The danger signals, of insufficient cash being generated include:

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• Net cash flows from operations are negative
• Receipts from customers are lower than payments to suppliers and employee.
• Cash flow from operating activities is lower than the after tax profit

With this forecast, you must also take into account, various risk factors. If you’ve got very little
set aside in your account, what percentage shortfall in revenues earned will make you unable
to meet your month end payments?

7.1.1 CASH FLOW & INVESTORS
Finally viewing the cash flow statement from a potential investor’s standpoint, before investing
the investor needs to be convinced that cash will be created, that can be eventually taken out
of the business by the investor. The investor will seek a cash flow model incorporating the
following variables with built in scenarios that can be changed in a “What If…?” Type format.

• The estimated costs of acquiring a customer
• pricing and gross margins,
• accounts receivables aging,
• realistic administrative costs,
• taxation
• depreciation.

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7.2 RATIO ANALYSIS

You need to include within your forecast, a series of ratios that review the forecasted
performance of your company across a range of criteria, as well as across a range of periods
(years), in order to recognise critical areas where the company may be at risk. These include:

Measure Explanation Ratio
Short Term Solvency / Can the company pay its • Current Ratio = Current Assets /
Liquidity due debts? Current Liabilities
• Quick Ratio = Quick Assets /
Current Liabilities

Activity / Efficiency How well is working • Asset Turnover = Revenue / Total
capital managed? How Assets
well do your company’s • Receivables Turnover = Revenue /
assets generate sales? Receivables
• Inventory Turnover = Cost of
Goods Sold / Average Inventory

Financial Leverage How does your financial • Debt ratio = Total Debt / Total
structure change over Assets
time? How much • Debt/Equity Ratio = Total Debt /
financial risk are you Total Equity
exposed to? • Debt / Capitalisation = Total Debt /
(Total Debt plus Equity
• Interest Cover = Earnings before
interest and taxes (EBIT) / Interest
Expense
• Profit margin = Profit / Revenue
• Return on Assets (ROA or ROI) =
Profit / Total Assets
• Return on Equity (ROE) = Profit /
Equity

Market Value Ratios If you are a listed • P/E ratio = market price per share /
company, what is the Earnings per share (EPS)
market’s view of your • Dividend Yield = Dividend per share
company? / Market price per share
• Market / Book = Market price per
share / Book Value

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7.3 VARIANCE

Simply forecasting your company’s finances is insufficient. You need to be continually
monitoring how your actual performance is comparing to your forecast.

Has your actual financial performance for the period lived up to the budgets and expectations
you set at the beginning of the period? The difference is simply the variance and is a key set of
statistics for presentation to the board, management and financiers.

If your company has not performed to expectation, how much of this can be attributed to:

• Unexpectedly high or low level of awareness or sales from promotional activity.
• Poor purchasing policies or efficiency
• Poor labour usage or efficiency
• Poor distribution policies
• Poor pricing strategy
• Changes in consumer behaviour or attitudes
• Unanticipated seasonal variations
• Reputation of the company changing.

And more important, what can be done to change this?

It is important to be able to track your actual overhead costs to that which you had budgeted
for. Costs have a way of spiralling out of control when there’s insufficient management
scrutiny.

The greater the risks and volatility in your overall industry, the greater the time and emphasis
should be placed on tracking your performance to budget. The more unpredictable the future,
the more often you need to be reforecasting and producing rolling forecasts in order to align
your operating needs with the general competitive environment.

Increasingly, board reporting is simplified by a series of pre‐developed digital dashboards
illustrating the performance of key variables. Here is one such example:

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Figure 27: Variance Analysis in Reporting

Finally, what kind of financial reviews take place, who undertakes and how frequently are they
undertaken. These reviews could include:

STRATEGIC: Is the company focused and focused in the right direction? Review by
performance to budget, sales to expense ratios etc.

PROFITABILITY: Where is the company making most of its profit? Review by product,
customer, territory or channel.

EFFICIENCY: How efficient is expenditures in different areas relative to results. Review by
production, R&D, marketing, sales, accounts, customer service and pretty well every business
function that has costs associated with its upkeep.

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7.4 SCENARIO ANALYSIS

A complete financial forecast will have alternate results reflects alternate outcomes that could
happen to the company. For example, they may reflect realism, optimism and pessimism in the
financial plan

The impact on a cash flow of a pessimistic forecast must be taken into account. Can the
company withstand the shocks, in terms of its current liabilities (interest to be repaid, creditors
etc) and reserves of one or more worse than expected reporting periods.

With the results of a pessimistic cash flow forecast, consider your strategies for the following:

• Would you seek to maintain or downscale future capital expenditures for subsequent
periods?
• Do you have the flexibility to adjust the debt repayment schedules?
• What changes would you make to the operational side of the company in terms of
subsequent forecast periods of revenue and cost? In the end this would depend on the
reason for the performance shortfall relative to base case.
• Has the overall market for your products and services changed? (How did your
competitors perform?) Are there structural changes in the way that your customers
have their needs met (Airlines v Video & WebConferencing) or are there changes in the
overall economy (downturns in consumer spending)

You may want to develop a more sophisticated modelling environment for forecasting:

• What would be the profit impact of delaying a product launch?
• What would be the impact on profits of offering discounts to increase sales volume?

Consider applications that provide sophisticated and powerful modelling and "what if"
calculations.

The following layout compares the financial outcomes under a range of alternate scenarios.

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Figure 28: Graphical Analysis of Scenarios

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7.5 SENSITIVITY ANALYSIS

Rather than creating alternative forecasts based on different perspectives on the future, you
could select one or a few variables and later them in order to assess their impact on financial
indicators such as earnings, cash flow or money‐in‐the bank.

Key variables for adjustment would include:

• Expected Gross Margin. You may assume 30% of the ex‐GST selling price for an
electrical appliance, but what if price discounting occurs because retailers are fighting to
clear stock?
• Expected Sales Penetration: You may believe that 5% of a particular population will
purchase your patented drug at the prevailing price, but what if viral marketing and an
overly successful PR campaign increases consumer awareness more quickly than
expected?
• Market Share: You may consider that 10% market share is a reasonable 5 year target for
your product, but what if a customer’s become aware of a quality problem with a
competitor’s product?
• Distribution Payment / Royalties: What if you have to increase the margin you pay
distributors above 15% in order for them to be prepared to stock your product?
• Marketing Spend: what if the 20% of revenue that you have previously forecasted as
appropriate marketing spend turns out to be inadequate and you have to increase the
proportionate spend in order to create additional awareness?

You may also wish to include various economic statistics in your forecasts. Interest Rates are a
good example. If they adjust upwards or downwards, what is likely to be the effect on…?

• Sales Revenues – as consumers have altered purchasing power.
• Your company debt – as interest on repayments may be higher or lower.

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7.6 RISK MANAGEMENT

A major component of forecasting is the understanding of risks that could adversely affect the
cash flows of your company, as well as a strategy for mitigating them, even if (like most of these
risks) they are outside of your control.

7.6.1 BUSINESS RISKS
There are a wide range of business risks to be considered when reviewing your business, your
industry and market fluctuations. Every industry will have certain similar operational risks, but
other different levels of risks depending on the nature of that industry.

Some common risks include

• Highly volatile revenues, perhaps related to the general economic cycle.
• Challenges at maintaining internal systems
• Capability of management to handle growth
• Capability to integrate operations when expanding
• Market power of one or a few large customers
• Unproven revenue potential for new products
• Capacity constraints, particularly with manufacturing, R&D and skilled personnel
• Dangers of acquisitions / strategic alliances between competitors,
• Growing the business globally
• Loss of key personnel,
• Legal liabilities
• Capabilities to adopt changes in technology, or international standards
• Possibility of another company’s IP infringement
• Long lead times for commercialisation of new developments particularly in
biotechnology

Increasingly uncertain times, greater competiveness and greater industry volatility calls for Risk
Management processes even in the smallest of organisations.

7.6.2 FINANCIAL RISKS

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Components such as interest rate fluctuations (both in Australia and overseas), changes in
exchange rates and changes in the commodity prices, are all inevitable issues when doing
business. They create an unanticipated mismatch between prices, costs and debt and most
significantly affect trading margins and interest repayments.

You need to

a) considering where you are exposed to risk
b) understand the size of that exposure
c) Consider how this risk may be mitigated.

Risks may be classified as follows:

TYPE OF RISK EXPLANATION DETAIL MITIGATION
Liquidity Risk Insufficient funds Borrowed funds Maintain unused funding sources in view
to meet due not available at of factors such as future debt repayment,
liabilities. acceptable terms. capital expenditure, seasonal fluctuations,
Loss of credit line potential acquisitions and contingencies
from funder.
Interest Rate Risk Movements in Include sensitivity analysis in your
interest rates will forecasts.
affect financial Use of pre‐agreed fixed and locked in
performance by interest rates.
increasing interest Offsetting the increases in interest paid in
expenses one part of business with interest
received on another.
Use of swaps – exchanging a floating rate
obligation for a fixed obligation.
Foreign Exchange Risk that exchange Risk that these Forward planning including buying
Risk rate used to movements make forward currency
convert foreign your company’s Other hedging against currency moves
revenues and products or e.g. foreign currency bank accounts.
expenses and services
assets / liabilities uncompetitive
to Australian internationally.
dollars causes
shareholder
wealth to decline
Commodity Price Risk that a change Reducing reliance on specific
Risk in the price of a commodities
commodity that is Forward buying
a key input /

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output of an
organisations
business will
adversely affect
financial
performance
Credit Risk Risk that the other Could also be the Assess counterparty risks prior to
party in a consequence of involvement. Use of prompt payments.
transaction will international Avoid creating an undue dependency of a
not be able to government limited number of suppliers, distributors
meet its financial directives and or customers
obligations. policies or a
settlement
delivery risk that
destroys future
business dealings

Here’s where the key risk elements may be create:

• Who are your customers? How much of your total revenue is made up by the top five
spenders? Top ten? Top twenty?
• Where are your customers located?
• Where is your manufacturing done?
• How much are your interest expenses, are they fixed or floating and in what currency
denomination?
• What is the main currency denomination of your payables and receivables?
• What are the main currency denominations of your major competitors?

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7.6.3 RISK MANAGEMENT FRAMEWORK
As part of a business plan, you may include a Financial Risk matrix, outlining the main financial
risks, the probability of them occurring, their impact and what you would do to mitigate them:

RISK PROBABILITY IMPACT RISK SCORE PLAN OF RESULTANT
(1‐5) (1‐5) ACTION FINANCIAL IMPACT
Increasing 2 3 6 Dual source Lower quantities
costs of raw raw materials ordered means higher
materials cost price and longer
lead times – see
model (b)
Competitor 2 2 4 Bring forward Access to new
XYZ plc enters Australian revenue stream
Australian launch of new earlier,
Market generation cannibalisation of
product existing revenue and
high costs required for
QA & customer
service – see model
(c)
Failure to 1 4 4 Ramp up Reduce unit sales by
interest direct online 10%, but increase
distribution presence gross margin from
channels 30% to 40% ‐ see
model (d)

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8. ACQUIRING OR SELLING – VALUATION & OTHER
CHALLENGES

You may need to value a company for a whole range of reasons. These can include anything
from a buy / sell proposition or an employee share option plan to a capital raising or a marital
dissolution.

Your prime business goal will probably be for you to maximise both the current value of that
company and its future potential value.

An updated cash flow forecast allows you to be able to use one of the more sophisticated
methods of valuing a company, Discounted Cash Flow (DCF) to calculate your company value.
This may also be appropriate when looking for additional shareholders or equity partners, or
buying out existing partners in the company. It is particularly relevant for high growth
companies where their current trading profit does not reflect their potential.

A discounted cash flow simply values your company based on the expected future cash flow
streams generated, adjusted for the level of risk inherent in achieving those forecasts. Reams
have been written on this methodology, its applications and its limitations that would be out of
place in a document of this nature, but simply stated, models that incorporate a valuation,
require as inputs:

• Around five years of forecasted cash flows.
• A risk percentage rate required to discount these forecasts by – the higher the percentage
risk rate, the riskier the business proposition. (Stable cash flows in a stable industry with
high capital requirement and higher barriers to entry attract a lower discount rate than
more volatile organisations and industries.
• An overall per annum anticipated growth in cash flows of the company, relative to the
overall growth in the economy.)

An alternative method for valuing a business with more stable revenues is applying a
multiple to the normalised earnings (EBIT, EBITDA, PBT etc) of your company to arrive at a
nominal value. Normalised earnings would exclude extraordinary or exceptional items, one
off non recurring items and discontinued divisions or product lines.

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The following chart illustrates the average value of a business in different industries in the
first quarter of 2008 as a multiple of their EBIT:

Figure 29: Average Business Value by Industry. SOURCE: BizExchange Index March 2008 Quarter Results

Generating forward cash flow figures and discounting them at the cost of capital enables you to
calculate the present value of your company. Your software is a useful valuation tool, as the
software helps you look ahead at those future cash flows and allows you to see what steps
need to be taken to increase the valuation. Valuation is particularly important where future
profit may be a long way out, or where your cash flows are irregular.

Valuation is a versatile tool appropriate for buying or selling a company or as an important
management focus and motivation tool. Agreeing and targeting a stream of anticipated future
cash flows, is a far better measure of business value that accounting statements!

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8.1 INCREASING YOUR BUSINESS VALUE

Your financial forecast should display numerical evidence that many of the following strategies
are being adopted as you grow your company:

• Implementing a marketing strategy based on differentiation, quality, cost leadership,
innovation or extreme focus.
• Create entry barriers through economies of scale, product differentiation.
• Access to distribution channels.
• Design a strategy to maintain market share
• Reduce costs in line with industry demand reduction
• An effective relationship between total cumulative output and unit cost of your
production of products and/or services.
• Attempt to identify profitable niche
• The effective use of possible alliances/partnerships.

The valuation of your company will adjust in accordance with general market conditions (boom
versus slump), the prevailing value of similar enterprises, your forecasted and risk adjusted rate
of growth and the degree with which your company possess the following capabilities.

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Figure 30: Increasing Business Value

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8.2 ACQUISITIONS

It is estimated that only 17% of acquisitions add shareholder value, while 53% actually lose
shareholder value and the remaining 30% produce no added value.

An acquisition may be part of your “roll up” strategy to consolidate the number of players in
your industry. The advantages of this may include:

• Revenue enhancements from improved marketing, less competition, capacity to enter
new markets and greater muscle when seeking large corporate or government
customers through tendering opportunities.
• Cost reductions from economies of scale, economies of vertical integration, elimination
of inefficient management, purchase economies and the capacity to make better use of
existing resources.
• Utilise the research and development capabilities of the acquired company.
• Risk diversification through having either a broader geographic operation, the capacity
to diversify into different customer segments
• Tax gains from transfer of operating losses, unused debt capacity and lower cost of
capital.

A longer term strategy may also be the increase overall valuation of the combined company
through obtaining the higher valuation multiples that a corporate will achieve relative to an
SME. However undertaking an acquisition for this purpose alone is risky as economic boom /
slump cycles also play a significant role in the determination of multiples.

In addition, many of the more successful “roll up” acquisitions are under the guidance of a
Private Equity team. While Private Equity clearly has its role in strategic planning, driving
processes and financial structures etc, investors may well have different time horizons to
owners and may be motivated more by the financial engineering than the long term business
opportunities.

With potential acquisitions, you should be able to see a financial opportunity through
underperforming assets or bad management. But they may be more than offset by the Control
Premium, the costs of acquisition, and post acquisition challenges such as potential
diseconomies of scale including loss of key staff dissatisfied by the acquisition etc.

Acquisition is only one of many alternatives for growth. Other quasi‐ integration strategies
include technology licenses, strategic alliances, franchising, joint ventures or asset ownership.

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The chart in Chapter Three reviews the partnering and alliance process and argues that you
could achieve similar objectives at a lower risk by considering this route.

Acquisitions may also involve a Management Buy Out (MBO) of your company, where your
incumbent management team raises capital to buy your company. Alongside your
management team, an investor or VC will take a stake in the company, and arrange debt
funding for the management team. The advantage of this is that the management team is now
focussed on the same goals as the shareholders.

8.2.1 VERTICAL INTEGRATION
Vertical Integration is a means of co‐ordinating the different stages of an industry supply chain.
Here your company may seek to own its upstream suppliers and its downstream buyers. It’s
however a risky strategy, complex, expensive and hard to reverse.

The main circumstances given when it can be good to integrate are:

• When the vertical supply chain “fails”, transactions between the players become too
risky and too costly, and there needs to be some “control” or market power in its place.
• When you can create an exploit market power, usually be creating barriers to entry for
other companies looking at competing in this space.
• Where the industry life cycle is either too young – and you have to forward integrate to
develop the market, or too old e.g. you have to fill gaps by others leaving market. (You
may need the reassurance of product supply from a company considering exiting the
industry).

There are also spurious reasons for integration e.g. reducing cyclicality and assuring market
access.

In the end long‐term contracts, joint ventures, strategic alliances, technology licenses, asset
ownership, and franchising tend to involve lower capital costs and greater flexibility than
vertical integration.

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8.3 DUE DILIGENCE

Due Diligence is a process undertaken by a buyer of a business in order to determine the
attractiveness, risk and issues of that potential acquisition. The due diligence can be either
external (assessing the future potential of that company in a competitive marketplace) or
internal (assessing the key legal, financial and managerial issues within the company).

If you are considering selling your business in the future it helps to address the key issues that
buyers will look for when the sale time comes. Conversely, you may be looking at acquiring a
business, in which case the MindMaps below can act as your checklist for what you should be
looking out for.

As part of the negotiation process it is also important to ascertain what the motives are of all of
the other parties involved. In particular, why is the owner selling? What does the owners’
management want to get out of this? Why does the owner want cash rather than shares? What
are the motivations of the other parties?

Due diligence is a large & complex subject in itself, but this series of MindMaps will graphically
list the key areas that you need to be aware of:

8.3.1 DUE DILIGENCE – ORGANISATIONAL & FINANCIAL
A seller will necessarily provide financial projections through rose tinted glasses in order to
maximise the value of their business. It’s important to compare these projects with actual
trading history. If there is a major discrepancy, ask yourself, if the seller is so confident of this,
why would he or she wait a couple of years until those projections had been realised and sell
the business at that point?

Ownership may not simply be a case of transfer 100% of a company over from one party to
another. There may be other issues clouding the transactions including minority shareholders,
commitments to management staff and suppliers, ownership of technologies and lender
covenants.

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Figure 31: Organisational & Financial ‐ Due Diligence

8.3.2 DUE DILIGENCE – MARKET OPPORTUNITY
Assessing the market opportunity for a venture involves strategic due diligence, and in order to
undertake this successfully, you will need to source more opinions than those of the owners.
This analysis involves the size and growth potential of the market, the customers and potential
customers accessible and the major current and potential customers.

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Figure 32: Due Diligence ‐ Market Opportunity

8.3.3 DUE DILIGENCE – LEGAL, TECHNICAL & MANUFACTURING
The incumbent management team of an existing company is frequently cited as being a major
reason for the success of that company. If you are purchasing a company, will those individuals
stay with the company, and if so, do you need to offer them incentives or “golden handcuffs”?
Alternatively, you may not want them to stay, particularly if you are purchasing a company
believing it to be undervalued because if the ineptitude of their current management?

Technology also may or may not be important. For technology companies, technology will be
the cornerstone of its competitive advantage, but you will need to look at most companies with
a manufacturing facility to determine the state of their processes. How efficient are they?
What capital expenditure may be required to ensure that obsolescence is not an issue?

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Figure 33: Organisational, Legal, Technical & Manufacturing Due Diligence

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8.4 EXITING YOUR BUSINESS

Rarely do company owners consider what their exit strategy is while in the early stages of
building their companies, yet it is one of the key factors that determine the value of their
company. How you intend exiting from your business is fundamental to the way that you grow
your company. Ask yourself the following:

• What large company has a significant customer base who would buy my products?

• If I develop a large customer base, what large company has a portfolio of products or
services that could be readily sold into my customer base?

• Could my products or my underlying technology be used to open up new markets for a
large company with the resources to fund market development?

• Can my products or services be easily modified or extended to create new products that
could be sold to the customer base of a large company?

• Can my company provide the catalyst for a large corporation to break into a new growth
market?

Whether your exit is via a trade sale or via the longer process of a listing on the Australian
Stock Exchange (remember with the latter, your remaining post‐float shares will likely be in
“locked up”), the laws of supply and demand apply. The greater the number of potential
purchasers, and the lower the number of similar company’s offering your range of products /
services, the higher the valuation.

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9 REVIEWING YOUR FORECAST
How good a shape is your company in at the end of your forecast period? Have you costed in to
your forecast, expenses that ensure the following are covered:

• Your manufacturing plant remains effective, productive and not facing technical
obsolescence.
• The next generation of those products have been developed to replace and enhance
your current revenue streams
• There is the potential spare capacity in manufacturing, or the flexibility to outsource in
order to cater for an upsurge in demand.
• You have the right skill set in your development division to respond to or create new
developments in your chosen market.
• You have made the right investment in environmental safeguards both
o Positively ‐ "green" products that will appeal to a more concerned public
o Negatively ‐ limit the potential for litigation for environmental damage caused by
products, manufacturing plants etc or via public opinion ‐ packaging etc.

The final words go to Woody Allen:

“More than any time in history, mankind faces a crossroads. One path
leads to despair and utter hopelessness, the other to total extinction.
Let us pray we have the wisdom to choose correctly”

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Forecasting, Financing &amp; Fast Tracking Your Business Growth

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