Ask The FD – Previous Questions

The short answer to “should I be worried” is an emphatic “YES”!  Unless, that is, you are a one (wo)man band with no employees (other than you).

Put simply, if you are running a business it is the biggest shake up of the pension world in your lifetime.

To give you some context – over 5.5 million UK workers are already enrolled.  And – for you and your business – it is a legal requirement.

And you need to do something – NOW.  Inaction on your part could result in a hefty fine

We suggest you quickly find answers to these questions:

1. How will it affect me?

2. What do I need to do?

3. When do I need to do it?

4. How can I use these changes to my advantage?

No two businesses are the same and you need to talk to an expert very soon.

Contact Tectona to let us help you on the first steps of this journey.

Logic surely dictates that if you raise prices (and don’t change anything else) that you will make more profit; in fact, every penny more you charge goes straight to your bottom line – happy days!

So how much volume could you afford to lose and still have the same profit before that price increase?

Surely it would be fair to assume that if you put your prices up by say 5% then you could lose 5% of the volume and be back where you were before – WRONG! Every business is different – but the rule of thumb if you are a manufacturing business making a Gross Profit of, say, 30% is that you can “afford” to lose 14% of your volume.

And it gets better! If you were working at a 15% gross profit % and increased your prices by 5% you could “afford” to lose a whopping 25% of your volume – that’s a quarter of what you are doing now!! Or, in other words, you could be working at three quarters your existing level and still show the same profit – goodbye, busy fool!

Tectona Tip:

There is, however, a sinister flip side to this coin: in these competitive times your sales team might quite possibly suggest (very persuasively) that “we must reduce our prices to get business to keep those new machines humming”. Before you do anything – THINK! If you are making a 15% gross profit and you followed the advice of your sales team and reduced prices by, say, 5% – then you would have to sell 50% – YES, that is 50% – more stuff (units/hours etc.) just to stand still. Have we got your attention now??

If any of this is meaningless gobbledegook or you see this as nothing more than a theoretical exercise – please think again.

You simply must understand this dynamic and how it affects your business – especially if you are contemplating reducing prices.

Contact Tectona now if you want to learn how this affects your business.

The obvious – but wrong – answer is to look immediately for another bank that will lend. The danger is that your bank has made the correct decision on the information you gave it, and by simply reapplying elsewhere you are condemning yourself to another refusal – and a waste of your valuable time.

The correct answer is to ask your bank why it refused your request and then to act accordingly. Broadly, there can be three answers:

1. The request was badly written in that it did not clearly state the requirements, describe your situation, present the economics, or identify and address issues.
2. The request was well written, but the underlying economics or risks were unsatisfactory.
3. The request was well written and economically sound, but the bank has a limited appetite to lend in the relevant area.

Now you have the starting point for sensible action.

If the feedback is that your request was badly written, then you should get as much clarification as you can and consider how you might rewrite the application to make it clear. No one is going to lend you money if they can’t understand what you need it for and how you are going to repay it. Test the document with friends and family – not for their lending decision but for whether they think your writing makes sense. Rewrite your application so that it tells your story clearly and anticipates questions. Then you have a starting point for re-opening the conversation with your bank.

If the bank is telling you that your request doesn’t make economic sense, remember, there is always a possibility that they are correct. So again, try to get as much feedback as possible and, without arguing back, make sure you understand their point of view. If you are not convinced, find someone you trust and discuss the request with them, making sure that you give an objective report of the bank’s opinion.  If you still think the request should fly, then again jump to point 3. If not, then you have to go back to the drawing board to get a better idea. Every situation will be different, but some areas to look at are:

1. Reduce fixed costs – even if this increases variable costs (e.g. outsource some production rather than hire new staff). This reduces risk at the expense of reducing return.
2. Look at locking-in customers – for example by offering a lower price for fixed larger volume – again lowers net profit but also lowers risk.
3. Change the speed of roll-out or the mix of products etc. – this will depend on your individual circumstances but there may be a subset of your plan which is attractive even if the overall plan is not.
4. Find some asset to put up as security – this reduces risk from the bank’s perspective but increases yours.

If the bank says “great idea – but not for us” or if you have confidence that you are right and they are wrong in turning you down – and you are prepared to put your valuable time into it – then it becomes worthwhile enquiring with other banks. Be prepared to persevere – banks are herd animals at heart and don’t like being out on their own where the lions might eat them. Nevertheless, if the idea is good you have a reasonable chance of finding success.

If all fails with bank lending, there are other sources of finance – both bank and non-bank. But that is another story.

This is the sort of area where having someone who knows the ropes and expectations of funders can really save you time and effort.  Contact Tectona if you want that unfair advantage.

This is a complex area.

For accounting periods beginning on or after 1 January 2015 you will probably need to change your reporting.  In essence, you will need to decide whether you are going to opt for one of:

• New UK GAAP (Generally Accepted Accounting Principles)

or

• IFRS (International Financial Reporting Standards).

For some, the decision will be easy; others need to take a number of factors into account.  Whichever camp you are in you need to talk to your accountant to make sure you get it right – adopting a new GAAP means changing more than the numbers and decisions taken now will affect your future financial position.

Let’s cover off the easy one first – FRS 101 applies to subsidiaries of listed companies that have adopted IFRS (International Financial Reporting Standards).  If you are in that category you would most likely have already received direction from your holding company.

The adoption of FRS 102 is potentially far more complex and will lead to some changes to the format of the financial statements and the disclosures required, but for many businesses there will be changes to the numbers as well.  FRS 102 will change:

• the recognition criteria for various assets and liabilities
• the basis on which some items are measured
• the treatment of certain gains and losses

compared to current UK GAAP.

The starting point for applying FRS 102 will be to restate the opening balance sheet at the start of the comparative period for the first accounts prepared under FRS 102. This is known as the date of transition.  So, if a company prepares its first accounts under FRS 102 for the year ending 31 December 2015, its date of transition will be 1 January 2014.

The important point, therefore, is that if you are adopting FRS102 from 1^st January 2016 you actually need to go back to restate the balance sheet as at 1^st January 2015 so that you can do comparatives and work out prior year adjustments.  This can be pretty time consuming and to assess how long it will take you will need to consider each of the following categories and work out whether or not adoption of FRS102 would produce different answers from existing UK GAAP.

To simplify things we have produced 2 answers – this, the abbreviated one.  If you have any of the following asset/liability categories you might want to read the “full fat” version – which we have incorporated in our Blog No.72.  Click here to be taken to the blog.

1. Investments in listed shares
2. Investment property
3. Financial instruments  
4. Accounting for business combinations  
5. Intangible assets and goodwill 
6. Defined benefit pension schemes   
7. Lease accounting 
8. Deferred tax
9. Foreign exchange

Do feel free to contact Tectona if you need more guidance on this complex topic.  Contact Tectona.

Shares acquired through purchase or subscription are eligible for ER (subject to the lifetime limit) on sale of the business if the shareholder has:

• more than 5% of the equity and more than 5% voting rights;
• is an employee or officer of the company at the time of sale; and
• has held the shares for over a year.

With effect from April 2012, ER was extended to the holders of shares acquired through an EMI option scheme irrespective of the % of the shareholding or voting rights of the shares; provided the option was granted over a year before the share sale and the shareholder is still an employee of the company.  So the exercise of the EMI option could be on the day of the sale of the shares, but the option must have been granted at least a year earlier for the capital gain to qualify for ER.

There are detailed rules about qualifying businesses and situations in which ER may be withdrawn.

The simplest way to reward your people for achieving targets is to pay a bonus or maybe offer an incentive like a holiday.  It gives them instant gratification, will be appreciated and is easy to administer.  The only downside is the amount of money the tax man will take in PAYE and employer and employee NI.

Enterprise Management Incentives or “EMI” options are a terrific way of bringing employees into the ownership of the business, making them feel valued and more generally aligned to the long term success of the business.  Options can be linked to achieving targets, such as beating £5m turnover, so they can bring specific performance focus as well as encourage more general ownership behaviour.

Options only really work if employees can see the potential benefit.  If your business is being built up and groomed for a sale, then allowing key employees to have access to a bit of equity is a powerful incentive.  If it’s a family business with no ambition to grow and exit, then dividends would be the only benefit to an employee of owning shares.  If the options require the staff to pay a significant amount of cash to get hold of their shares, this can be something of a disincentive.

The benefits of EMI options include:

• Long term incentive with ability to create short term performance focus
• Very good tax treatment on any profit made from selling shares acquired – all profit taxed as capital gains (i.e. no PAYE and no NI) and for most employees this will be at the 10% Entrepreneur’s Relief rate
• Employees who leave don’t take option rights with them – unexercised options lapse
• The options price can be heavily discounted (possibly up to 95%) for small employee option grants with no immediate tax consequences.  For example an employee could be allowed to acquire a share for £1 that has an open market valuation (were the business to be sold) of £10 – giving an immediate paper profit.

The downsides of EMI options include:

• If no exit is ever planned, options have limited incentive/reward value
• Some staff can have difficulty grasping the value of an option – cash may still be king
• They involve giving equity away – are you prepared to do that?  If you are not; ask yourself if your greed might mean you are missing a trick.  10% is a normal option pool size in many businesses
• You may need to revisit your Articles of Association to ensure your capital structure is correct (especially if you regularly pay dividends and may not want to do that for staff shareholders every time)
• It is preferable (though not essential) to get HMRC to approve the option price you are going to grant your options at.  That way there cannot be a challenge later that the options were granted at a discount.  Any such discount is taxed as a benefit in kind and has the old PAYE and NI consequences.

So to sum up – EMI options are a great tool and should be considered very seriously.  However, they don’t suit all businesses and you will initially need to engage a professional to help you navigate the legal issues (Articles) and the share valuation and set up.  Once a scheme has been established it is much easier and cheaper to make subsequent grants of options.  With the help of a Tectona FD, you will be able to do the planning more effectively and so save quite a bit a cash on the valuation and legal structure.   This is one area where a DIY approach could turn out to be costly.

Sweat equity has no real monetary value until you either get a dividend from it or you can sell the shares in an “exit”.

Less tangible value comes in the form of having “skin in the game” or a sense of ownership or superior status to other employees. Warm fuzzy feeling value, not hard cash value.

The opportunity cost is probably easier to quantify if you have to give up a better paid job to join the business our have a good measure of your market value to more established employers who pay their senior people solely in cash.

It’s still an important decision when you take sweat equity in lieu of salary and there are ways of getting at a value. If you are being given shares alongside or close to a cash investment round, there will be an agreed value for the business at that point in time. So a cash investor putting in £2m for 25% of the equity must think the business will be worth £8m after the cash goes in. If your sweat equity offer is 0.1%, you would have £8,000 worth of equity at that valuation.

No one invests for sweat or cash equity purely on the basis of an assumed valuation of the business now. It might be a loss making start-up and need to secure some big contracts to reach break-even. Equity is all about possible future value and that, by its very nature, is an unknown. Serious investors have a feel for the size of the market opportunity and how big the business might become, if successful, and how attractive it might be to trade buyers or the stock market. Institutional investors will want an exit in three to five years and they won’t be looking to make a10% return.

So think about what the business might become and what it might be worth on an exit. Look at similar businesses and see how they have been built and sold. 0.1% of £50m is £50k. Not exactly “beach money” as the private equity world terms it, but maybe a good return for the sweat.

But beware. Sweat equity in a family-run business with little prospect of an exit or dividend stream would probably be better termed “mug equity”.

In the current financial climate, the most obvious answer to this question is quite possibly why?

With the base rate still at 0.5% there’s little point leasing a piece of equipment if you have the cash to buy it.

Asset backed lending – a fancy term for leasing – can be relatively cheap if the asset in question has a good and easily realisable second hand market value. The lenders used to love fancy IBM mainframe computer hardware as it could be repossessed and sold-on if the lease went bad. It’s not quite the same these days with £500 servers, but the principle remains.

The interest rates you get charged on a lease can vary wildly depending on the asset security, term and risk the lender sees in you the borrower. Rates will often exceed 10%, which is easily achievable when customers have no option but to lease and the lease values are small and relatively expensive to administer.

Modelling a lease-buy scenario is quite easy with a bit of Excel know-how and each case is probably best looked at in isolation. YouTube has quite a wealth of content on the subject, some of which looks pretty daunting and probably confusing.

The bottom line is buying involves cash outlay now with a VAT recovery (for equipment not cars) a month or few later. Leasing (HP or rental) involves payment of a deposit and fees now and then a rental stream over a period and maybe a balloon payment at the end. Ownership may pass to you or not and this will impact the VAT treatment. You are trading one set of cash flows for another.

A business we know has an HP agreement for an industrial floor cleaner which helps illustrate this. The cleaner cost £5,800 plus VAT of £1,160 (recovered by the company). The business paid the lease company a deposit of £1,496 and now has 35 rentals to pay of £185.60 each with a final purchase payment of £75 at the end.

If you do the sums you will see the finance cost is £1,107 (an extra 19% on the cost of asset) and the annual rate of return for the lender is 13.4%. For a business sitting on cash at the moment, it’s not quite clear why they took the lease option. They certainly did not consult Tectona at that time.

There are other tax related considerations in a lease-buy decision which depend on the type of lease and the business tax allowances you get. Buying could bring a 100% tax deduction in the year of purchase but you might not see the cashflow benefit of that for well over a year. With a lease with no change of ownership at the end, the rentals themselves are tax deductible.

There will be spreadsheets out there that will do a calculation for you, but beware. They may not be detailed enough to cover all aspects of your lease option and they may not cover the tax properly. If it’s a big decision for you, come and talk to one of our FDs.

The simple answer is that the price of loans is set by the balance of supply and demand, as for any other commodity.  The problem for small company borrowers is that their loans are set in an oligopolistic market, with only a few major suppliers.

As a result, a small company is often faced with a “take it or leave it” decision. You can improve your odds by structuring your loan requirement to demonstrate that your business is well run and you have identified and are managing all risks.  The more you understand the banks’ requirements – and the better you explain your business to them – the better your chances of getting the right answer (approval for a loan at a lower cost). Ideally, if you can get multiple quotes you may be able to play one bank against another.

But in the end, an interest rate makes sense to you if it lets you fund your business and there is no better alternative.  Therefore, you should be constantly looking at ways of financing instead of bank borrowing. Try leasing rather than buying, changing your terms of trade, changing your business model, or hiving off part of the business into a joint venture with an investor.

An organisation should project its cash requirements on a rolling basis assuming a “reasonable estimate of the worst case” and ensure that it has sufficient cash reserves to see it through. Remember that banks are not going to be sympathetic to borrowers who are fast, or unexpectedly, running out of cash.

A rule of thumb is to have cash (or overdraft facilities or other guaranteed liquid resources) to cover three months of normal expenses. If your projection gives a requirement less than this, question strongly how you expect to pay the salaries and the rent – not to mention any cost of business activities – until money starts coming in.

Even if you have three months’ costs covered, you should be planning on a broad brush basis for 6 months, a year, and longer.  If your business is going to expand, your working capital needs are like to expand at the same time while the increase in income is likely to come a few months later.  You do not need an exact calculation, but you should aim to quantify your approximate cash needs in each period and ensure that you have cash or borrowing capacity to cover.  If you do not, then you need to start making alternative arrangements now.

Top Tip: One to be avoided (and a classic route to bankruptcy) is to grow a business rapidly without adequate cash in hand; this is called “overtrading”.

The first point to note is that Research and Development (R&D) tax credits are a specialist area and if you think that you may be eligible the best advice is to work with your tax adviser to ensure that the claim is presented correctly to HMRC.  As your Financer Director, part of our role at Tectona is to enable this to happen.

R&D tax credits are a company tax relief that can either reduce a company’s tax bill or, for some small or medium sized (SME) companies, provide a cash sum.  They are based on expenditure on R&D for companies carrying out projects seeking to advance science or technology.  You need to be able to state what the intended advance is, and to show how, through the resolution of scientific or technological uncertainty, the project seeks to achieve this.

The actual R&D expenditure for tax purposes is the costs of those activities within the project that are accounted for as R&D using generally accepted accounting principles and that fall within the definitions set out by the Department for Business, Innovation and Skills.  The type of project advance being sought must be one of advancing the overall knowledge or capability in a field of science or technology, not a company’s own state of knowledge or capability alone.

In making any claim there are two schemes available; one for SME businesses and one for large companies (which may also in certain circumstances be available to SME’s).  The amount of relief available varies dependent on the year in which the expenditure took place, and whether the business is loss making or otherwise.  It is best to seek clear professional advice when making any R&D tax credit claim, and we at Tectona can help you achieve this first by helping identify if you have a potential claim and then maximising that claim.

At Tectona we are often asked to comment on margins of our client businesses = especially new clients.  As we work with businesses in many sectors we are in an unenviable position to make such assessments.  So, that said, what are our comments on retail?

The short answer is that there is no uniform margin in retail.  There are many facets to retail trade and margins will be different in Bond Street to Bicester Outlet Village.  One has to refine the question to “what is a good overall margin in a particular retail sector”.  This is ultimately driven by the need to cover all other operating costs and overheads of the business and to allow a net profit after tax that represents a good return for the risk involved.

So if we compare a supermarket to say, Jimmy Choo shoes, which has the better margin?  One thing is for certain the margin on a pair of Jimmy Choo’s far exceeds that on a tin of baked beans!  However looking a little deeper, the supermarket has huge stock with many product lines over which varying margins can be made and a huge customer base to which sales are made.  On the other hand, Jimmy Choo shoes are only affordable to the wealthiest in the world and the product range is limited by comparison.   Looking at recent financials the relative EBITDA (earnings before interest, taxes, depreciation and amortisation) for each business as a percentage of turnover is around 17% for Jimmy Choo and 3.3% for Sainsbury.  That is only part of the story and you might therefore think that Jimmy Choo wins the margin race.  However Sainsbury’s makes around 16 times for absolute EBITDA at c. £790m compared to Jimmy Choo’s £50m.  Whose profit/margin would you prefer?

We at Tectona are skilled in financial analysis and planning, with commercial business knowledge across many sectors.  If you would like to discuss your particular margins further, please contact us.

There are 2 separate (yet linked) points you are raising:

1. Day to day management of cash; and
2. Having a broader suite of management information (MI) to help you really manage the business proactively.

Accurate cash flow projections are a vital element of the day-to-day financial management of any business – one could even go so far as to say they are the MOST vital element.

A business might be running at a profit – but if there is insufficient cash in the bank payments cannot be made.  The trusted spreadsheet is used by many trained accountants.  A weekly rolling cash flow projection will show projected receipts matched against outgoing payments.  If the projection covers a calendar quarter (13 weeks), rather than just one week for example, it will capture major quarterly outgoings such as VAT and rent.

As the name implies, the main components of the cash flow are the receipts from your sales and the payments that need to be made, including VAT where appropriate.

Once you have established when you expect funds to come in and go out, the pinch-points in your cash flow will become apparent.  You will then be in a position to manage them more effectively.   If your cash flow position is critical and an unauthorised overdraft is predicted, you must take urgent action to address – your banker will not like surprises.

Here are 7 actions to consider – and these are equally applicable to most other types of business-to-business consultancy firms too:

1. Contact your major clients to determine whether their payments can be accelerated. You need not direct your enquiry to your business contact, but a discreet call to the client’s accounts payable department may elicit funds more quickly;
2. Approach your bank to see whether they might be prepared to provide additional (possibly short term) facilities. This process will take some time while the bank conduct their underwriting.  The bank may well require security.  This may take the form of your debtor  (or receivables) book and a personal guarantee;
3. Investigate other sources of finance, such as invoice finance, crowd-funding, or have a look at the various Government funding schemes;
4. Seek to delay or spread major payments. Approach HMRC to request a “time to pay” arrangement for VAT and/or PAYE/NIC.  HMRC have been known to take a sympathetic approach to a one-off request and may even agree to spread a particular liability over 6 to 9 months, as long as subsequent liabilities are met on time;
5. Approach your landlord to see if they might be amenable to changing a quarterly rent commitment to a monthly commitment, on a temporary basis. They are not under any legal obligation to do so and may well refuse, but if you do not at least try, you will never know.  They are most likely holding a rent deposit after all;
6. If suppliers of services work to a frequency other than monthly, e.g. quarterly or annually, approach them to see if they will enable you to spread payments over a shorter timetable;
7. Embark upon a cost saving programme by cutting unnecessary costs. Bear in mind however that cutting staff may incur additional cost due to termination payments including the payment of notice periods.

Remember, the more accurate and reliable your cash flow projection is, the fewer surprises or unpredictable factors there will be in your business.  And, incidentally, the easier you (and your bankers) will be able to sleep at night.

Tectona’s FDs regularly help prepare cashflow forecasts and management accounting reports which “take the pulse of your business” and give you an unfair advantage.

If you need a bit more bandwidth on this then contact Tectona.

And if, perchance, you are hungry for more on the whole area of MI, we have recently published our Entrepreneur’s Guide to “Measuring what Matters”.

Thinking favours holding personally:

Assuming both the individual and the UK limited Company have a strong initial cash position, then purchasing the shares in the individual’s name makes sense.

In short, this is because:

• If the shares are held in the Company and they are worth a considerable amount of money then this can change the underlying nature of the Company to that of an investment company. This can have consequences for inheritance tax and how the Company is taxed now;
• From a Capital Gains Tax perspective, if held personally,you then get the benefit of the £11,100 (your spouse too) annual exempt amount on any capital gain each year – even more useful if you can sell the shares over a period of time.  (Companies don’t benefit from this arrangement);
• There would be a tax relief in the UK on any tax paid in Australia on the gain when the shares are realised via a foreign tax credit;
• If the shares are held in a limited company and that Company has losses carried forward, then those losses cannot be used to offset alternative profits;
• You would have to do a share transfer to retain the value of the shares if the individual wants to shut the limited Company down for any reason;
• It wouldn’t harm taking specialist tax (and Australian duty) advice if the investment is significant.

Also:

• Should the shares pay dividends, or you make a capital gain on the sale of some shares, then the company will pay Corporation Tax at 20% (or whatever the prevailing rate) with no allowances or exemptions.

• And of course when the tax has been paid in the Company, the money is still in the Company and a further layer of personal tax needs to be considered when withdrawing the money from the Company into your personal account.

So summary is hold personally:

• The tax rates for 2016/17 on capital gains is 10% if your taxable income is less than £32k, and 20% if it’s more.
• And this is money that is now in your hands and can be put to whatever purpose you want – be that personal or lending money to that original company so it can do the next big thing.

And for those who want the full picture – there is a counter argument:

There is something called the Substantial Shareholding Exemption (SSE) which would apply to a foreign company.  If it does apply then essentially if the investor holds the shares (more than 10% of total shares to qualify) in his Company for more than 12 months any capital gain on the sale will be exempt of tax.

See https://www.gov.uk/hmrc-internal-manuals/capital-gains-manual/cg53000.

Clearly there are conditions that need to be met but if the investment qualifies this is a tax efficient way of holding the shares. The regulation is out for consultation and therefore subject to change so one would need to do some research and take specialist advice.

We originally thought that the foreign status of the investee company muddied the waters. We checked it out and apparently it’s fine. The legislation was originally designed for corporate restructures (and we think to make UK holding companies as attractive as some of their offshore relatives).

There are a few requirements as noted above – for example, the investee company has to have been trading for 12 months before the sale etc.

And there is still the point that the money is in the Company and would be taxed when extracted.

This is not advice or recommendation; it is intended to be practical, useful guidance on what to consider, what steps you may wish to take and/or where to look further.

Tax relief for business expenditure on cars is given by way of capital allowances which are the equivalent for tax purposes of the depreciation charge made for accounting purposes.

Expenditure incurred on a car is normally allocated to one of two main capital allowance pools for plant and machinery.  Expenditure on cars with emissions of up to 130g/km go into the main pool attracting capital allowances at 18% per annum.  Cars with higher emissions attract allowances at 8% in the special rate pool.  From April 2018 the CO₂ threshold for the main pool will be reduced to 110g/km.

100% first year allowances (FYAs) for new cars with very low emissions are available until 31 March 2021.  The current threshold for low emissions is 75g/km but this is set to be reduced to 50g/km from April 2018.  So a business will get faster tax relief for a low emissions car if it is bought through the business.

For a sole trader or partnership cars with private use are kept in a single asset pool but the rate at which capital allowances are given is still determined based on the emissions.

When the car is sold the disposal proceeds are deducted from the appropriate capital allowances pool.  If that car had been fully written down (100% FYA claimed) then tax would be due on the amount the vehicle was sold for at that time.

This is not advice or recommendation; it is intended to be practical, useful guidance on what to consider, what steps you may wish to take and/or where to look further.