Business health checks

Motivations for undertaking a business financial health check are almost as numerous as the firms offering the service and are not always purely commercial.

While the purpose of the exercise is to identify areas where the business can be more efficient, it is not uncommon for requests to come on the back of a change in personal circumstances.

Health or relationship issues or an application for non-business finance, such as a mortgage, can all be factors, according to Rob Ellis, managing partner of Welch & Ellis.

He says that once the objectives have been determined, the next step is a fact-finding process to establish the current position: “Ideally I would want to be able to look at two years of accounts, but the more information the better.

“It’s also important to listen to a client’s concerns as only then do you pick up on what is needed and where their priorities lie – I often say that part of this job is being a therapist.”

Ellis reckons many businesses fixate on accounting ratios, rather than looking at the big picture and remembering that, in order to facilitate growth, costs will increase in the short term and it may take a while to see a return on this investment.

“Costs often have to jump up significantly, which may cause unnecessary concern,” he adds. “On the flip side it’s fair to say that many businesses underestimate the significant ‘sickness’ that may come with growing too rapidly or over-trading. Growth is sometimes wrongly seen as a positive as long as the money is coming in. Don’t be a busy fool.”

According to business consultant Nigel Moore, the most common reason for a business undertaking a financial health check is a general lack of understanding of what the year-end accounts actually show.

“Many accountants send out the year-end accounts with their invoice and a letter stating how much tax the business needs to pay,” he says. “Most businesses – if they do make money – find it extremely difficult to understand where the cash has gone.

”He describes the key elements of the process as face-to-face fact-finding and collection of the full set of accounts from the last three years, along with analysis of the numbers and the information gathered at the meeting, a presentation of the financial assessment and an action plan of what the business needs to do to improve its cash generation.

Moore argues that most businesses that turn over less than £50m overlook regular key performance indicator monitoring, especially cash generation post profits, dividends, Capex and loan repayments. “They often forget what cash is needed to run their business and service debt, and simply go ahead and spend on capital items without thinking about retained cash levels,” he says.

Gary Jesson is group managing director and co-founder of EFM, which provides ‘pay as you go’ financial management services to businesses. He explains that investors often request a financial health check on a business they have just acquired.

“They may already have had a professional firm do some due diligence, but they are looking for some real under-the-skin commercial due diligence,” he says.

Requests from business owners may be prompted by concerns about the efficacy of their finance director, especially entrepreneurs who don’t feel able to benchmark financial performance.

“Most of the health checks we get involved with tend to focus on cash, profit and risk,” says Jesson. “In one case we found that the client’s data measurement was inaccurate – it was mixing up one-off payments with day-to-day payments, which skewed the numbers substantially and meant it did not understand when cash was coming in against when it went out.”

He says the results of a business health check can come as a surprise: “We often find that a perceived cash problem is actually a profit problem. I was doing this with a company recently and when we analysed the business they realised they just weren’t making enough money.”

There are some tried and tested metrics around monthly recurring revenue, average recurring revenue and costs of acquiring clients, but what entrepreneurs sometimes forget is that underneath that there are costs and overheads. Businesses see revenue going up every month but don’t increase profits because as they scale they are taking on too high a cost for their relative sales price.

“I have worked with businesses that are achieving a gross profit of 30% and think they’re doing OK, but when you break it down they find they’ve got issues in some parts of the business,” says Jesson. “One of the things I like to measure is the liquidity ratio. Anything north of one means you have more cash and debtors than liabilities. It’s a very simple metric, and yet I hardly ever see it done.”

He suggests that non-financial metrics are also frequently overlooked. “Businesses don’t look enough at operational data, and when they do they don’t link it to profit, risk and cash,” adds Jesson.

Richard James is a director of Jolly Good Communications, a not-for-profit PR agency with clients throughout England and Wales. “As the business was approaching its fourth anniversary, we decided to carry out a financial health check as we thought it was a good chance to take stock and see if there was anything we could be doing better,” he explains. Following a personal recommendation, Rob Ellis from Welch & Ellis was asked to undertake the review.

As a community interest company, making money is not the primary objective. However, its directors were keen to ensure it was operating as efficiently as possible. “Both my business partner and I are parents to young children and Rob was able to help with efficiency through utilising childcare vouchers,” says James. “He got us to look more closely at our costs and examine how much of the hourly rate we charge is actually spent on basic running costs and banking expenses.”

“He also gave us advice about the best way to structure shares and dividends and talked about business valuation and estate planning. The thing we had never done for ourselves was to think about projections for the business and future turnover.”

Jolly Good Communications may not have overheads such as offices (its founders both work from home), company cars or a large marketing budget, but maximising its profit enables it to continue to support small and micro-charities for free, adds James.

“It’s an added incentive to keep our business as healthy as possible, something we will continue to do through regular checks,” he concludes.

Which business indicators are measured during the financial health check – and over what timeframe – very much depends on the size of the company and where it is in its lifecycle, observes Ashmax Associates founder Martin Millen.

“The business needs to have positive cash flow and it is important to maintain cash reserves as an emergency fund,” he says. “After this it’s about financial protection and then ensuring surplus capital is working for the business. There is too much focus on the short term, often with a quarterly view as opposed to balanced planning, which deals with longer term stability and investment.”

Stephen Lane, finance director of automotive and motorsport engineering firm Xtrac, reckons the financial health of a business and putting in place appropriate controls and governance is ultimately the responsibility of the chief financial officer (CFO).

“However, in an organisation that doesn’t have a full-time CFO but perhaps a financial controller and an assistant, I can see it would be an area in which they would look to seek assistance from an external supplier who might come in and undertake a governance review as to whether some of the key controls are in place and operating effectively,” he says.

Lane adds that if a medium- or larger-sized business was in a particularly distressed state, there may be grounds for asking a specialist to perform some diligence over the financial performance and controls.

An organisation where the numbers were continually going backwards might have someone come in and take a look as a standalone exercise or ask its auditors for feedback on certain aspects of the business, he continues.

“Many firms now are trying to differentiate themselves by offering a health check as part of the audit process,” says Lane. “While their overriding objective is to give their opinion on the financial statement, auditors frequently offer a service where they come back with recommendations for improvements. That is a useful conversation to have.”

Ryedale Printing Works undertakes regular financial health checks as part of its accounting routine in addition to gathering external views and expertise from non-executive director appointments, explains managing director James Buffoni.

“We currently have a non-executive director with a very strong financial background who provides insight and advice,” he explains. “In simple terms, if you don’t know your numbers you don’t know your business and that is clearly a significant risk.”

Buffoni lists three key characteristics of a business’s financial data:

1. 1. Level – am I happy with this level of performance?
2. Trend – is it improving or worsening?
3. Variance – is it predictable and stable?

Decent measurement and analysis always involves relativity, he continues: “Is the number important? Is the data good enough? How does it compare? Ratios can help here. Typical measures might include revenue growth versus expectations/market; profitability; solvency; working capital; and cost structure.”

If you are looking to sell the business and want to achieve maximum value you will need to be in control of every element of risk, adds Buffoni, who refers to people who have been through this process – and succeeded above the average rate of return – as a useful source of advice.

Questions from corporate turnaround, recovery and insolvency professionals Tri Group:

• Do you know how much revenue you need to make to break even?
• Do you use cash flow forecasts to manage your business?
• Do you have enough cash reserves or forward orders to survive the next quarter?
• Do you review your debtors monthly to chase late payments?
• Do you monitor your own debts on a monthly basis?
• Are there any financial threats that you have yet to plan for that could/ will affect your profitability?
• Are all the products or services that you sell profitable?
• Do you monitor all your business operations for early warning signs?
• Are your sales seeing year-on-year growth that is keeping pace with – or higher than – inflation?
• Do you consult with business advisers when you need to?

WR Davies’ finance director, Len Jones, agrees that there can be value in the observations of someone within the business who has broader experience.

These may not be financial insights but rather recommendations about the business model, quality of earnings, the strengths and weaknesses of the management team and – most importantly – the culture of the company, he says: “In my experience, health checks tend to draw out underlying issues about leadership style, quality of workforce and general attitudes towards learning and training.”

Jones suggests that consultants will more than likely duplicate recommendations that a good finance director would already have considered, so they may ask why these steps have not been taken and what organisational barriers there are to prevent change or improvement.

“When I see recommendations about measurement and performance indicators then there is usually rationalisation around blips or longer term trends and a bit of defensive posturing about the suitability of the performance measure,” adds Jones.

“Outside consultants can break down these arguments, which verge on political infighting when finance functions continually report poor performance. The discussions have broken down into questioning the veracity of the figures rather than the underlying causes.”

He recommends working with consultants who look at people and processes and the broader culture of the firm as well as the numbers, but also warns that if the organisation is resistant to advice (financial or otherwise), health checks are a waste of money.

“It’s a bit like making the first step in getting help and recognising that something has to change,” Jones concludes. “It’s an initiative that has to come from the top.”

Download pdf article:

• Business health checks
  Business & Management Magazine, October 2018

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