All on Board: Positioning your SME in 2012

Shaun Fraser and Jason Ireland review the business landscape for SMEs in 2012 and identify six strategies that will help them to flourish during the year.

Australia has demonstrated remarkable resilience to an unprecedented period of global volatility spanning four years since the onset of the global financial crisis. A solid and reliable banking system and a strong resources sector have helped Australia avoid recession and have contributed to a gradual strengthening of conditions in some parts of the business sector in the past 12 months.

However, this economic recovery continues to be tentative and is likely to remain so in the coming year, especially in light of a recent intensification of concern around the European debt crisis, US recovery and a slowdown in China. Furthermore, headline indicators continue to be distorted by the strength of mining and related industries. Rising profits in this sector have masked continuing difficulties in most other industries, particularly manufacturing, construction and retail. There is also evidence of increasing levels of stress in small to medium-sized enterprises (SMEs) as profitability has to date failed to keep pace with larger businesses in the economy. SMEs constitute a flexible, innovative and responsive section of the Australian economy and are therefore well equipped to quickly respond to challenges presented by the economic uncertainty.

Challenges faced by SMEs

Macro economy

Australian households continue to adopt a cautious approach to spending, leaving the profitability of many non-mining businesses challenged. Accordingly, we can expect to see a continuation of the competitive conditions witnessed over the past 12 months, translating into pressure on sales and margins across Corporate Australia. Relatively high employment, volatile interest rates and the continued rise of energy and commodity prices present an inflationary risk to key inputs, so margins may not just be at risk from lower demand, but also from increased costs.

Access to funding

Because SMEs generally do not have access to the capital markets, they are particularly sensitive to the cost and availability of bank funding. Although lending conditions have improved over the past 12 months, the global credit markets where Australian banks source much of their funding remain unpredictable and expensive, and businesses securing new funds or refinancing have found pricing to reflect this. Furthermore, many traditional sources of SME finance have dried up due to structural changes in the Australian lending market, for example, the withdrawal of many international and non-bank lenders from the market and the consolidation of smaller, regional banks.

Although we expect these market challenges to continue into 2012, the Australian banks have maintained relatively strong balance sheets and we have seen growing competition between domestic lenders for new business and retention of quality clients. SMEs must therefore ensure they are well positioned to respond to this "flight and fight" for quality among lenders. Well performing companies that can demonstrate good strategies, reliable cash flow and strong management will be best positioned to minimise the cost of funding.

Responding to globalisation

The continuing trend of globalisation has allowed many larger organisations to generate significant savings from outsourcing supply chains and other activities to lower cost regions. As a consequence, many areas of the Australian economy are exposed to an unprecedented level of overseas competition and cost structures. This particularly affects the SMEs that have traditionally served as downstream suppliers to larger Australian companies or Australian-based internationals. This threat to SMEs has become increasingly difficult to combat because of recent domestic challenges such as volatile interest rates and input cost inflation. Furthermore, resource constraints mean SMEs struggle to step up and take advantage of the benefits of globalising themselves.

Exit planning

The equity markets have continued to demonstrate high levels of volatility, due in part to fluctuations in commodity prices, rising energy costs and unresolved issues in the global debt markets. Investor caution has significantly diminished merger and acquisition activity in the SME sector, which is now a strong buyer’s market. Many SME owners this year have delayed exit plans due to the effective shelving of initial public-offering options and as referred to earlier, the problems of prospective purchasers raising appropriate debt finance. This has forced many business owners and managers to rethink strategy around exit planning and succession, an area of particular vulnerability for SMEs that may be reliant on a few key individuals or have limited exit options in the niche in which they operate.

Positioning for success

Here are six initiatives for SME owners and managers to consider to better position their businesses in 2012:

Focus on strategy

The competitive position of Australian SMEs is under threat from low cost competition overseas and at home, and by the creeping expansion of larger and well-resourced businesses into niche markets. Accordingly, it is becoming increasingly difficult for SMEs to flourish without a genuinely unique selling proposition or other basis of differentiation. Existing competitive advantages have, in recent years, become more difficult to sustain, due to the ever-increasing availability of information and technology to rivals. To prosper in 2012, SMEs need to exploit their natural advantage of innovation and responsiveness to change through frequent reviews of core strengths and competencies and regular reassessment of strategic plans. Strategic plans must be accompanied by a clear series of management action points allocating responsibilities, timeframes and milestones. Plans must be actively tracked and progress critically assessed.

Manage for cash

Restricted access to capital is necessitating a greater focus on cash flow as a source of internal funding. It is therefore critical that directors understand how cash flows through their businesses. SMEs able to release cash from working capital or other areas will have a greater flexibility to respond to unforeseen or adverse developments. A cash flow forecast, including a clear and understandable mapping of the process and timing of the conversion of profit into actual cash flow, shows management teams a lot about how their businesses actually work, and the priorities for improvement. A starting point is a robust discipline of business planning and forecasting that should include use of an integrated profit and loss, balance sheet and cash flow forecast, as well as more detailed short-term cash forecasts to manage intra-period cash peaks and troughs. A comprehensive forecast, sensibly broken down into its component parts and assumptions, enables boards or management to quickly recognise potential "weak" points and ensure they have contingency plans ready to go to mitigate underperformance or take advantage of changed circumstances. Management must spend time with operational and finance staff to formulate the forecast so theory and practice are considered.

Protect and plan for capital needs

As mentioned, credit is more difficult to access, or more expensive due to simple supply and demand metrics. SMEs should therefore be considering their debt obligations, the strength of their relationship with lenders and future capital needs. It is important for businesses to go to their lenders early and well prepared. More than ever, lenders need to find a point of difference between customers before committing capital. Management teams that present clear business and financial plans, integrated profit and loss, cash flow forecasts and a clear explanation of funding requirements and debt capacity, will be better placed to negotiate support on better terms than competitors.

Governance

An increasing number of company directors and senior management teams are reviewing their corporate governance models, partly due to current economic uncertainty combined with the continued strengthening of obligations and standards that directors and management teams are held to. It is typical for larger organisations to seek independent input in their businesses, for example, through non-executive director appointments or the ad-hoc use of specialist advisers. The benefits of independent contribution are often overlooked, yet particularly relevant to SMEs, where boards are typically smaller, delineation of duties less defined and director and shareholder interests overlapping. SME owners should welcome independent advice as a means of accessing specialist skills, managing risk and promoting accountability and transparency to external stakeholders of their businesses.

Dashboards and reporting

We often see SME decision making based on "gut instinct" or intuition, rather than clear financial information. Management should have a flexible and reliable financial reporting system to help assess performance and flag signs of opportunity or underperformance, and it is essential that management produce reporting packs that show the key lead indicators of performance in a concise and timely manner. Nearly all SME managers and owners are able to identify the three to five key business drivers they watch to gauge a company’s health. However, very few reporting packs highlight those issues and measure them clearly. Focusing on trends in key business drivers highlighted in management reporting will identify levers that management can pull to guide the business towards achieving its strategic plan.

Plan for exit or succession

SMEs should be continually refining exit strategy or management succession plans. A suitably developed plan will mitigate such risks as a sudden change in management or economic conditions that may otherwise precipitate a fire sale disposal or failure. In reality, only a minority of SMEs have commenced planning for exit events, yet in the current uncertain environment, taking the time to plan for transitioning leadership or ownership is more important than ever. The process from identifying the roles and competencies required in future management teams or leaders, through to selecting and developing the relevant individuals, may span a number of years. Similarly, grooming a business for a successful sale requires a significant investment of management time, the development of strong systems, robust value drivers, and a clear strategic footing. The five other initiatives discussed above are also essential in preparing a business for a successful sale.