The Need For Financial Headroom

Managers should sense-test their business plans and financial projections to ensure they have the financial headroom that will enable them to cope with unexpected events.

In business it’s always wise to expect the unexpected. In the current economic climate no one can predict with any degree of certainty what the next six or twelve months will bring. At the macro level, we could be looking at modest growth or some degree of contraction in the economy. From the perspective of individual business, today’s solid order books might look a lot less healthy if a major customer goes into administration or a downturn in the sector leads to a sharp fall in demand.

But it would be wrong to see ‘the unexpected’ purely in terms of negative events. It’s not always easy to predict future sales, and business plans will often overestimate the potential in the market. Sometimes though, a business will unexpectedly secure a major contract, an event that confounds the pre-existing plan in a good way.

The paradox is, if a sudden downturn in sales or the loss of a customer can throw your plans into disarray, so too can an unexpected influx of new business. The reasons are different, of course. In contrast to a dip, a big order from a new customer is unalloyed good news in the longer term. In the short term, however, it often creates a need for upfront spending on stock or production capacity running several months – or longer – ahead of eventual payment by the customer. The result can be a cashflow black hole.

The headroom factor

This is why financial headroom is so important. When negotiating financial facilities with your bank – and particularly those that address cashflow and working capital issues, such as overdrafts and invoice finance – it is important to factor in headroom. Will your facilities be sufficient to allow you to grow when demand in your market picks up? Equally important, are the facilities sufficient to let you ride out a few downward blips?

Having headroom in place enables you to react quickly to events. For instance, let’s say a customer asks you to pitch for a major contract that will require increased production and upfront costs. If this kind of event has been factored into your financial plan, you can pitch with a degree of confidence. If not, you’ll also have to be thinking about finding additional finance to cover any cashflow gaps.

Testing your predications

It’s important to test your financial projections, using ‘what if’ scenarios. What happens to your cash situation should sales dip by 10% or 20%? What happens if a customer goes bust? What happens if you’re required to increase production by 20% or 25%? By looking at various scenarios of this type, managers can begin to understand the financial requirement going forward, not only over the fairly predictable near-future but also in the medium and longer term.

It’s also important to consider the most appropriate solutions. For some businesses, that might mean an overdraft. In other cases, invoice finance, perhaps coupled with stock finance may be the best solution. Regardless of economic circumstances, it is important for fast-growing businesses to be flexible and nimble enough to take advantage of opportunities and ride out difficulties. That imperative should be built into the financial planning process.

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John Carroll - Helping businesses achieve International success. Head of Product Management & International Business, Santander UK