The value of scenario planning: What Jazoodle can do for your business.
A practical guide to the value of scenario planning.
Throughout our lives, we are faced with difficult choices or decisions. As a business owner or director, these are often amplified as the outcome of them can mean significant personal, human, business and societal outcomes. Often, the data needed to justify these decisions, may not be readily available, and they may be taken based upon conjecture and/or gut feel. The other problem is that even if the data is available, cutting through what is important and what isn’t is equally difficult or expensive in having a professional assessing the data for you. In business, you are presented with an over-abundance of data at times, and from many different perspectives and professionals. Scenario planning is about making sense of uncertainty.
When it comes to taking financial decisions for your business, how do you know what the outcomes would be? Should you invest in new plant and machinery, or you cut overheads by 20%? What downstream effects will occur by making these decisions and will they add value to your business overall; will they contribute to your overall hitting of your objectives? Many business owners create their own business in order to make money, from something they’re interested in or passionate about, or through maybe wanting a little more flexibility in their lives. Many also start a business in order to plan for its exit and generating enough value from the business sale that this funds retirement plans, a new business or whatever. No matter what reason motivates this, our experiences and those of many of our accountant and advisory colleagues, is that there is not enough thought, if any, going into these plans, let alone modelling different scenarios in the achievement of these plans.
Let’s take an all too common scenario. When running your business, it is a usual goal to minimise, legally, company taxation based upon net profits earned within the business. This is a common and valid aim whilst not thinking about exit. But not, arguably, when looking to exit. Please note, the following is in no way intended to give you specific advice as to your taxation strategies, let alone whether a particular strategy is right for you. You should always consult your accountant or business advisor and establish the optimal strategy for you and your particular business.
As mentioned a tax minimisation strategy is not often conducive to a business sale optimisation strategy, as often the starting point in business valuation is made from either the asset base of the company, or its historical sustainable reported earnings. A tax minimisation strategy does just that, and therefore lowers reported earnings via various legal methods. A business sale strategy, will need to maximise reportable sustainable earnings – the two strategies are in effect, arguably mutually exclusive.
So, in returning to our original question, how do you know that the decisions you are taking now, don’t have downstream and unwanted effects on the wider areas of your business, and therefore counter-productive to your current business goals?
Jazoodle’s application simply allows you to take a look at your business and its possible financial outcomes, try different tactics out and assess what these plans may mean to your current business objectives. As a case in point, and to give you a little more understanding as to what Jazoodle can do for any small and medium business, here’s an interesting and hypothetical case study for you. Please note, the names of both the director and the company have been changed to protect the innocent!
Jessica Jazoodle is the director and majority shareholder of “The Luxury Emporium”, a retailer of luxury household furniture and household goods. The business has been trading successfully for about 15 years, although as is the case with luxury goods, has been reliant on economic conditions being favourable. When times are good, their clients are willing to spend more of their disposable income on Jessica’s luxury goods. Jessica knew there was a problem looming in her business but couldn’t understand where it lay, and what to do about it.
The Jazoodle application integrates with Xero, and instantly provides a dashboard of key performance indicators, business valuation, and scenario modelling tool – that is both easy to read, and visually stunning.
On creating the Luxury Emporium’s dashboard, via connecting Jazoodle to her Xero accounting package, Jessica first assessed profitability.
Gross margins were seen to be consistent at around 30% over the past 5 years. Being luxury goods, she knew that discounting was not a key factor in her business’ performance, and also the cost of goods sold and supply of inventories was also consistent both cost wise as well as supply wise, with long standing relationships with her key suppliers.
Net margins have been negative and still weak but were recovering. The negative margins were related to a large write down of exceptional items over the past few years. She knew that these were not now a factor moving forward and expected net margins to continue growing in the coming years, so long as sales activity remained consistent.
On closer examination, of her profitability drivers, she saw that the ratio of expenses to net profit is extremely high at 63 times net profit. This has therefore given a very high Cost of Goods Sold to Net Profit figure, as below the line expenses (such as the earlier write downs) have eroded net profits, whereby direct costs and general expenses have remained fairly constant. This has, in effect, minimised taxation for the past few years. Jessica was now looking with one eye on selling her business in the next few years, thus knew changes had to be made.
Jazoodle incorporates an easy-to-read health check barometer, which, is a simple and clear indicator of any underlying problems within the business that could create problems in the next 1-2 years. She could see that her company was sitting in a comfortable area with a score of 3.08 and growing, therefore the business was not in imminent danger of financial distress:
Jazoodle also has a number of measures which help assess the underlying efficiency of a business, and how well a number of client, internal, and asset measures are performing. Assessing how efficient the company is being, she saw the following:
Immediately, there are two problem areas apparent. The number of days it takes to collect clients’ monies is huge. This will put pressure on cash flows potentially in the future if this is left to continue. Equally, the number of days stock sits in inventory at 123.22 days is far too long and creates issues with the following: cashflow, risk of stock obsolescence, and possibly, the company is needing far greater area for warehousing this stock than need be.
Another area for a potential future problem, is in the levels of retained earnings creating reserves (or resiliency):
Both retained earnings to total assets is critically low, as is EBITDA to Total Assets. In time, both these will reduce the asset base of the company. Looking at the time series for both these measures:
Retained earnings to total assets have been negative for the past 4 years, although there is some improvement with the improvement of net profit over the past year. This needs to be maintained in order to keep the overall health in the 3+ range.
We’ll now look at what the company needs to do in order to shore up its future, with the use of the Jazoodle modelling tool:
Jessica has identified two key areas for improvement:
Collect client debts more promptly, thus shoring up cash reserves. You will recall that currently, it takes 53 days to collect client debts. Jessica should aim to reduce this down to 30 days. She then moves the receivables slider to the left in the modelling area to reflect 30 days sales in receivables figure:
Now, in order to basically halve the days in receivables, Jessica needs to employ two more full-time accounts receivables officers (assume total costs including super of $70,000 each plus $10,000 additional IT and other costs). She therefore then increases her general expenses amount by $150,000.
Now, let’s assume that Jessica expects sales to increase over the next year by 2%. She slides the sales slider to the right to 2%. She sees that her cost of goods sold also increases slightly, as Jazoodle calculates this for her. She notes that profits will rise as a result to $413,000 despite the additional staffing costs.
She also sees, when switching to the balance sheet view, that her cash position will increase from $948,000 to over $4,000,000 – a massive turn around, and is a great indicator of both the increased revenues, plus concentrated effort in collecting client receivables:
She also notes that the company’s overall health has now increased by about 10% and company value has also increased. With a view on selling up and retiring in 2 years, this is a good result.
Finally, in understanding what the changes mean to the rest of the KPIs, we can see that net margins have increased slightly (due to the increase in sales relative to increase in expenses), along with improvements in most other measures, including earnings per share and the relative costs and expenses measures to EBITDA and Net profit respectively.
Note, the overall health has increased. Overall, this could be a positive scenario and strategy to pursue:
One thing then occurred to Jessica. If the amount of cash collected has significantly increased, it may be worth looking at utilising that cash more efficiently than if it were to remain in the bank. She saw an opportunity opening up for her based upon this model. We see that the company has cash in the bank now of over $4 million, but with long term debt of $220,000. She may also consider investing some of this additional cash in another premises, and nearer to the city centre with better parking. She wondered, “what would happen if I pay down my debt, and invested a maximum of 10% of my cash reserves into another showroom? How would that affect me?”
Jessica first moved the Long Term debt slider to the left all the way to remove debt in the company:
Cash reserves reduce to $4.592 million:
Overall health changes by about another 10% positive and stands at 3.3373 after paying down debt:
Next, we model the purchase, fit out and staffing of a new showroom.
Let’s assume sales revenues will rise by 19% in the first year
Expenses will increase to accommodate additional sales and management staff but overall economies of scale can be achieved from support staff. Let’s assume expenses increase by $4 million per annum. Cost of goods automatically rise accordingly. In this scenario, we see the company increases its value, the overall health of the company increases to very solid areas, while net profits increase ten-fold.
Returns increase significantly too:
All efficiency measures increase too, and with a more efficient outlet for stock control, inventory turnover increases:
From this Jessica decides that based upon all of these measures, and of course leaving a cash reserve in place that is more than adequate, and also utilising some of that cash to increase her business opportunities, then the increase in sales, and therefore cash generation, will leave adequate reserves in place should there be a downturn in sales.
Now, the final thing that Jessica needs to assess is how resilient her business is to a downturn, given the investment she is proposing. Moving the sales slider left, she sees that her break even on the project shows her that if sales increase by less than 7%, she will be facing a loss in the coming year. Cash would remain at about $4.5 million should this happen. Now, if sales were set at zero, she would see that cash depleted to $3.2 million next year.
The final piece in the puzzle and resilience of the strategy is to understand what would happen if there were zero sales increase, she invests in the new showroom, but her new team members only make slight inroads into the client debt collections. We modelled reducing the collections time to half. What if they only shave 5 days off of the average collectables period? We can see from the model that cash reserves then get to near zero:
So, in this scenario, it is seen that overall company health has started to decrease from the original score.
In conclusion, so long as the investment in people, new showroom, and paying down debt means a minimum of 0% sales increase, and that client debts are collected 5 days more quickly as a minimum, then the project is worth considering but with these limits in mind.
Jessica decides, after discussing with her accountant, that this is a risk worth taking and decides to invest in a new showroom and two new staff to collect client debt. Her last decision, is whether to pay down the long-term debt. This would bolster cash reserves should the lower case scenario be achieved. She decides to pay down half the debt as an interim measure now and review after 6 months. That will give her a cash buffer of $239,000 should the worst case scenario be realised. Still, that only gives her a 4 day buffer on expenses at the end of the financial year, and inadequate short term buffers planned and put into place should they be needed. She is advised that she should aim for a minimum of 30 days cash buffer of outgoings:
Remember, this is the kind of value that Jazoodle can bring any small business!