Our experience has been that the majority of SME businesses undertake their capital investment (capex) planning on a reactive, needs based basis. The need to meet growing capacity demands, the need to replace ageing equipment, or the need for additional facilities may be pressing demands and require near-term responses. Alternatively, the need for better systems or the goal of reducing costs through automation or other means may seem more optional but are likely to improve business performance. Many SME businesses don’t commence the review and planning processes until the investment is planned to be undertaken in the next 12 months.
Capital investment is a risky business for the following reasons:
- It often includes new processes or new technologies
- A range of assumptions are relied upon, and these assumptions may need a lot of testing
- There are often alternative options that should also be investigated
- A range of implementation plans might provide differing returns on investment
- Qualifying criteria such as the internal rate of return (IRR) and payback periods may not be well enough understood in terms of what the appropriate hurdle rate is for the business
The ceefo Wealth Engine program provides a platform to develop a longer-term, strategy driven, planning process that will reduce capital investment risk and improve returns on investment. The core elements of the Wealth Engine program are:
- 5-year return on equity planning (forecast profits and reinvestment levels)
- 5-year capital investment budget
- 5-year capital investment plans, and
- 5-year funding model
Strategy driven, proactive capital investment planning
The ceefo Wealth Engine program includes a rolling 5-year planning cycle for capital investment planning. This targets the different phases in the following manner:
- Year 1 projects – all plans fully developed and approved by owners/board – focus now on implementation planning
- Year 2 & 3 projects – consistent with strategic plans, in the process of being fully qualified and supported by the owners/board
- Year 4 & 5 projects – consistent with strategic plans, documented as potential projects to enable full context of how the business will achieve it projected performance levels in those years
By matching the capital investment plans to the strategy of the business and by quantifying the overall performance targets for the outlook period, approved investments will be fully aligned with the direction of the business and better support the achievement of the targeted performance levels.
Establishing the capital investment budget?
The models used in the program will establish the capital investment budget over the 5-year outlook period through the following considerations.
Reinvested earnings
The 5-year return on equity planning process projects the profitability over the next 5 years and the reinvestment ratio then allocates a proportion of net profit to go to retained earnings.
Sustaining capital
This is the equivalent of depreciation and amortisation being expensed by the business each year. In theory, if appropriate useful-life measures are being used to determine these expenses, an equivalent amount needs to be invested each year just to sustain the operating capability of the business. And, as these are a non-cash expense item, the cash will be there for investing back into the business.
Working capital demands
Some of the planned capital investment will need to be allocated to funding increases in working capital. There is normally a strong correlation between sales and working capital so the model can readily forecast the increases in working capital over the outlook period.
Debt capital principal repayment commitments
The principal reduction commitments of the business are not captured in the profit and loss accounts. These commitments must be funded out of the company balance sheet. Therefore, these commitments will also use up funds from the capital investment budget.
New debt funding
Capital investment budgets can be increased through the judicious use of debt funding. The lower the risk of the capital investment plans, the higher the level of debt funding that can be used (whilst always maintaining a comfortable gearing level). Debt funding is also very useful in increasing the investment returns.
Minimising implementation risk
The longer time frames enable the business to do more planning and more review. The key to reducing risk is often “planning, planning & planning”. Within the Wealth Engine program, the key focus is on:
- Detailed planning of the implementation process
- Ongoing review of investment returns and seeking ways of increasing the ROI (like a quantity surveyor role)
Most SME businesses also deal with resource constraints where management and key operational staff are often fully extended in their work demands. This is another area where planning is important and where the implementation of projects involves high workloads, high levels of complexity, or specialist knowledge, we will always encourage businesses to use specialist resources for the project management/implementation management functions.
The ceefo Wealth Engine program will generate a plan that brings a higher level of vision around a realistic growth plan. It puts it in the context of achieving or maintaining high levels of return on equity and grows the net asset base on which the return on equity is calculated. This leverages the levels of profit and business valuations. This is why we call it the “Wealth Engine” program.
Ask your CFO or advisor to implement the “ceefo Wealth Engine Program” and support you to establish and maintain your own WEALTH ENGINE.
