Something for a rainy day

I had a Zoom meeting with a client last week to review and sign off some accounts. 

The accounts mainly covered ‘pre-Covid’ trading so it was a solid year. The current financial year will be a different story. They are a B2C or ‘Business to consumer’ service business. They were closed and had no sales during the period of lockdown and since then sales have been ‘fair but patchy’. Further restrictions on the horizon make the future uncertain.

But this business is better-placed than most. 

During the better trading years they chose to leave a reserve in the company in case tougher times arose in the future. Tougher times have now arrived, with knobs on and their prudence has been rewarded by having a reserve to fall back on to allow for the inevitable reduction in profits and cash flow this year.

How many of the rest of us showed enough foresight and self restraint to do a similar thing? 

Not many of us I suspect. 

Of course now is not the time for accumulating reserves. Some businesses are still fighting for survival and the majority are probably just ‘getting by’. 

The medium term priority for all businesses must be to return to profitability. Government financial support has helped but we know that this is unlikely to be sustained in the longer run.

Many businesses will have taken advantage of Bounce Back Loans or Coronavirus Business Interruption Loans so cash positions may be relatively favourable. Loan repayments will commence from next year however and it is profit rather than cash which will be the key measure of longer term sustainability.

In a post-Covid world, when it arrives and business fortunes begin to turn, the first priority for many of us will probably not be setting something aside for a rainy day.

One of the lessons of this crisis however is that we all need to become more resilient and prepare for the unexpected. 

Keeping a little bit in reserve, like my prudent and far-sighted client, is something we can all benefit from.

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When the dividends don’t work

Most owner/directors of private limited companies will choose to pay themselves with a mix of salary and dividends.

Usually the most optimal set up is to pay themselves a salary up to the National Insurance Primary Threshold and top up the rest of their income as dividend.

In the current tax year (1920/21) that would mean drawing an annual salary of £9,500. Drawing a dividend of £40,500 in addition to the salary would give a gross income of £50,000. The income tax due on this would be only £2,287. No employee National Insurance would be due but a salary at this level would count as a qualifying year towards State Pension eligibility.

In comparison, personal income tax and employee National Insurance contributions on a £50,000 salary would be £12,358. Some £10,000 higher than the combined salary/dividend option.

The tax saving is much reduced if the combined company and personal tax impact are considered. Dividends are paid after corporation tax (unlike salaries they are not a tax deductible expense) so every £100 of dividend paid instead of salary incurs an extra £19 corporation tax. The company would also pay employers' National Insurance on salary above £8,632 per annum.

Nevertheless, for modest incomes, if looking purely on the basis of tax efficiency the combined salary/dividend option works best and most accountants will recommend this route.

So why wouldn’t an owner/director always choose this option?

There are a some cases where I think the salary/dividend route may not be the best choice:

    1. Where there are a number of senior managers who may not be shareholders

Where there are a number of senior managers who are not shareholders there might be a case for the owner drawing a ‘market rate’ salary for the contribution they make and topping up with dividends if profits are sufficient to allow this. This enables the owner to be transparent about profitability and remuneration with their senior management team. They might also combine this approach with a profit-based bonus scheme. The benefits may outweigh the tax savings gained from the salary/dividend remuneration method.

    2. Where an owner is preparing for exit

As above a ‘market rate’ salary reflecting the owner’s true contribution to the business might be a sensible transition in the years before they exit the business. The remuneration can be easily flexed if they gradually reduce their involvement. As with 1 above a top up dividend can be drawn on top of the salary if profits allow. This can be an added incentive for a business owner to drive the business to generate ‘surplus’ profits after allowing for their management contribution. In this way the business may be more likely to become a standalone investment rather than a lifestyle business.

    3. Where there are several shareholders with varying levels of input

Using salary rather than dividend in this case allows greater flexibility. As with 1 and 2 above dividends can be used as a ‘top up’ on the salary where all the shareholders benefit in proportion to their respective shareholdings.

There’s a saying in tax circles, ‘Don’t let the tax tail, wag the business dog’. 

I think it can apply here. 

It's not conventional wisdom for an accountant to say this but, in some cases, less tangible, business and operational considerations may sometimes override harder tax savings.

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Knowledge is power

I like the TV programme where antique experts go on a road trip in a vintage car. They start off with a wad of cash and along the way they stop at antique shops and hunt out bargains. Their booty is sold at various auctions and the winner is the one with the biggest profit made on the trip. All proceeds to charity of course.

I really enjoy this, partly for adding to my limited knowledge of antiques, partly for the banter and mainly for the haggling. Yes, the haggling.

That, for me, is the essence of the show. Can the expert find a treasure and negotiate a price with the shop owner which leaves them with a healthy profit and the shop owner satisfied?

After watching a ridiculous number of episodes (I’m on repeats of repeats of repeats now) I’ve reached the conclusion that there are two main types of antique expert. 

There are the ones who have an uncanny knack for sniffing out the genuine treasures and noting with glee that they are under-priced. The shop owner has not realised they have a hidden gem in their cabinet and left it jumbled together with sundry bric a brac.

Then there are the less observant, or perhaps less able experts. They mooch around the shop for a good while and eventually settle on something shiny which catches their eye. Inevitably these items are fairly-priced, which makes turning a profit a little more challenging.

Then the negotiation starts.

Our savvy expert knows he has a bargain on his hands. He shares his thoughts with the camera and goes off to find the shop owner. Negotiation is simple and quick. ‘Is this the owner’s best price?’ or, ‘Can they knock a couple of quid off’ The deal is done and both the expert and the owner are happy. Both have achieved good value. The owner has achieved their target price (or thereabouts). The expert has achieved outstanding value - a result of their knowledge, acquired from years of obsession, research and experience.

Our less savvy expert takes his shiny object to discuss with the owner. He looks for flaws, “There’s a bit of a crack here’, ‘Did you pick this up for a song in a house clearance’ or, ‘Is this one you’ve had for a while’. He makes a ridiculously low offer. The owner is clearly not happy and is reluctant to drop. They eventually reach a grudging compromise. The owner’s body language shows disappointment. They accepted a lower price than they wanted to and have barely covered their costs. The expert has the chance of a small margin if all goes well at the auction. If not, they'll make a loss. It’s a functional and unsatisfactory deal with neither party terribly happy with the outcome.

My take-out from this is that the expert with the knowledge is the big winner in the profit stakes. Haggling skills alone are unlikely to result in a great outcome.

I think this has relevance beyond the world of antiques. 

Knowledge has value, particularly in professional service businesses.

If businesses can find ways of applying their knowledge to address customers’ needs and wants, at the right price, there lies the potential for healthy profits and satisfied customers.

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What's the point in a 'Break-even' point.

Accountants learn about the  'Break-even' point whilst studying for their professional exams. 

Many though will rarely, if ever use it during their working life.

I think it's a useful and under-utilised tool however, particularly for start ups and early-stage businesses but also to established businesses who struggle with achieving consistent profitability

So what is it?

Well, essentially it is the level of sales or sales units needed in a period to cover fixed overheads and break even.

It is traditionally used in a manufacturing environment where the number of units which need to be sold to reach break-even is a critical measure.

It can be applied however to any environment where the cost components of gross margin are relatively uniform and directly related to sales volumes.

Let's look at a restaurant business as an example:

• The  main 'direct' costs are drink and food ingredients (wet and dry stock) and the labour needed to prepare the food, greet customers, serve the food and drink etc
• Let's say the labour costs are 30% of sales value and stock is 20% of sales value. So the gross margin is 50%.
• Fixed overheads rent & rates, insurance, premises costs, directors' and admin wages etc are £20,000 per month.
• So in this example 'break-even' sales are £40,000 per month. They generate a gross margin at 50% giving £20,000 'quantum' margin which covers the overhead.

So what?

Well getting to break-even should be be the driving force for the business. Every fibre of management's focus and effort should be to getting there and then forging above it.

The main levers are price - is there scope to increase these and still deliver good value and maintain ( or only slightly reduce) volumes, and cost control - ensuring buying stock is effective and payroll and staffing schedules are well managed.

If £40,000 sales per month are needed management should be asking, how are we doing on a weekly basis, or every day? What do we need to change?

The break-even point can be a powerful motivator for change. Once reached, the sales above this threshold are all profit. In our example, every £1,000 sales above the break even puts £500 on the bottom line. That's the happy place where  all businesses should aim to be. The business then has surplus profit for investment or additional return to the shareholders.

So some of the things we accountants learned in school - like discounted cashflow, internal rates of return and correlation coefficients may not see the light of day that much after our studies.

Break-even analysis though is something that I believe should get regular use in every business accountant's tool box.

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