Is holding 3 months worth of overhead costs enough to protect me from risk?

Is holding 3 months worth of overhead costs enough to protect me from risk?

Business coaches and consultants often advise a small business, to always aim to hold 3 months worth of their overhead costs. This is to mitigate the risk of some down turn in the business.

In fact, this could apply to any unforeseen event occurring, This would mean you were unable to generate sufficient sales to cover your fixed costs.

Obviously, overall this is a good metric to have, but I was recently asked this question by a business owner. He still didn’t feel assured and satisfied that he had risk covered.

The problem is, that using an arbitrary figure like this, does not really relate directly to the specific level of risk that the business is facing.

Using this measure is fine if you are a business with moderate growth. Also, if you have a foreseeable pipeline of sales and a good insight into future potential environmental factors which may affect your business.

Just concentrating on holding a reserve only buys you time, actually 3 months in this case.  You need to consider, if there were an unforeseen event, how would that impact on your business financially?  An unforseen event may be the loss of a major customer, change in law or perhaps the loss of a key employee. Having considered this, how long would you need, to put in place an alternative plan? Furthermore, how long would it take for “business as usual” to resume?  This then leads up to think that we would need a much longer period of time, perhaps more like 6 months. So, think about the amount of time you will need and now consider if you are actually looking into changing something about your business.

Specifically then, if you are thinking about undertaking a significant investment to grow your business. In this case your potential risk will rise as the return from the investment into growth activity is still to be proven.  Spending out on more investment for growth will, in the short term, lower your margins and available cash. This can feel daunting as you realise your healthy profit margin is going to be eroded and in fact with it, any cash reserves you have built up.

So, I always recommend that in this case, further projections should be made. This will give you peace of mind that eventually, you are going to see the results you are anticipating. More importantly though, having some sort of forecast of what you expect to happen and measuring against this every month, will flag quickly to you, where your plans are not playing out the way you expected. This will give you sufficient time to look at this, think of the actions you need to take and make the necessary adjustments to your action plans to try to bring your results back on track.

The key report required to help with satisfying yourself that the new investment is viable is the Cash Flow Forecast.

I always suggest starting with your current situation and financial shape. Hence at this point it is crucial you understand your current position in terms of some key components.

  1. What is your current Sales Projection based on hard data. We can all dream, but sales forecasts should be based on some credible extrapolation of the past or last year’s actual data achieved.
  2. What profit margin are you currently making, often referred to as your gross profit?
  3. What are your overheads and what is the average run rate for your overheads? Overheads will naturally fluctuate due to the timing of supplier invoices. Marketing, administration, repairs and travel are good examples of this type of spend.They reflect areas where the timing of spend is discretionary and not fixed as a monthly fee. Breaking out spend where you have some flexibility on when to spend, gives you a view of what overheads are absolutely fixed and have to be covered month on month.

So, armed with these 3 areas of information, you should be fine now to create a time based cash flow forecast. This forecast should be drawn up as a monthly forecast, (or even weekly depending of the nature of your investment spend). Plot it forward until the point when you expect your business to be seeing the benefit from your investment. This is often longer than you realise. The cash flow forecast should show the benefits materialising, which take your business to the next level. Ensure that the forecast covers this full time span. Many business owner stop short of this point. They only project across the time of when the spend is actually taking place. You need to see what happens to your business shape post the spend. you want to see if and when your business shape returns or even improves versus its original shape. This will often result in a forecast for at least 1 to 2 years out.

Having created the forecast, the most crucial action is to measure against this monthly. Failure to do this, may mean that your forecast is not delivered. You will need a flag to alert you where you are moving off-track. Ensure that you consistently and methodically track each of the key components of your cash flow forecasts. This data can be pulled out from your bank statements and other areas in your accounting system.

Planning and then measuring, will help you satisfy yourself that your growth investment decision is the right decision. Where it is proving not to be, this early warning flag should give you sufficient time to plan how to mitigate the costs by stopping the things that are not working and reinvesting in other areas.

Protecting your pot of cash is as important as building that pot of cash, whether it relates to 3, 6 or 12 month’s worth of overheads. Take these necessary steps to ensure your hard earned cash is not eroded because you have failed to forecast and consistently measure progress in this way.

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