The importance of cash flow management
Business owners usually evaluate financial performance based on profitability. Continuous efforts are made to improve the bottom line by generating new sales in addition to applying cost cutting measures. The common assumption is that to obtain financing from bankers and other key stakeholders, strong profitability is the only measure that counts. Unfortunately, while profitability is important, cash is the real king of business. The primary reason that most businesses fail is the lack of proper cash management. Business owners tend to spend their time building their business instead of placing controls on managing daily cash flow. Frustration occurs as profitability increases and yet there is no cash in the bank. If business owners obtain sufficient working capital financing when starting a business or as the business grows, many of their daily cash management issues can be solved.
Let’s look at some important reasons why net income and cash flow sometimes do not work in tandem.
The cash lag is the time between making payment for the initial receipt of goods and receiving payment from customers for goods sold. The time can be significant, especially for any type of manufacturer, as materials purchased need to be put through the manufacturing process, packaged, and then sold and shipped to customers. The sale is only half of the battle as the business needs to collect its accounts receivable. This can take time as customers want to stretch out their cash flow as long as possible because they face the same demands. It is not uncommon for a manufacturer to experience a cash lag cycle of several months. So, profitability may look great if the business has several new sales at good margins, and all the materials and processing work has been paid for, but no cash inflows are coming in for several months.
Companies that are in a growth mode tend to be cash strapped because of additional expenditures and working capital needs, specifically to finance accounts receivable and inventory.
Most growing companies invest in new talent, marketing, and capital assets and/or machinery and equipment at the beginning of a growth cycle. The cash outflow for these expenditures is made well in advance of receiving the cash inflow benefits. Business owners look for a return on their investment but need to be patient and understand that realization is not immediate. In addition, growing companies need to build inventory and receivables. Inventories are built to meet new customer demands and receivables are greater due to sales volumes. Although these assets are good working capital items, they need to be financed, either from the company’s bank operating line or business owner’s funds. If businesses do not have a good operating line from their bank (i.e. the margining of their receivables is very stringent on the aging, and inventory margining carries a low cap on the inventory levels), cash flow will be very difficult to manage for a growth phase company.
Here are three easy tips to help your business improve cash flow management:
Understand your customers
As the business grows, the number, sophistication and demands of its customers will also increase. Large box retailers such as Walmart, Home Depot, Loblaw’s and others recognize that they have influence and are important to suppliers since they represent a large volume of sales. Thus, these large retailers stretch out their payments as long as possible and reduce the margins for the supplier with the attitude that if the supplier doesn’t like it, they can go somewhere else. On the other side of the scale are the smaller customers, where the business’ biggest fear is customer bad debts or the non-collection of receivables.
Manage accounts receivable
There is only one thing worse than not making a sale: making a sale and not getting paid. If a customer is late on payment, it’s not enough to assume that they will eventually pay. There needs to be follow-up and active communication about the timing of receipt of payment. Managing accounts receivable should be a daily function. Although there are costs associated with providing customer discounts, it is a business tactic to help improve collections. A two per cent discount if paid in 10 days or one per cent discount if paid in 30 days will assist with predictability of cash inflows. In addition, if a customer is past due, offering them a discount if they immediately pay is a way of easing cash flow issues. This will negatively affect profitability now and possibly in the future as the supplier may want the same discount again in the future.
As mentioned earlier, payment for goods and materials occurs at the beginning of the cash flow cycle. The last thing that businesses want is to disappoint their customers with short shipments due to insufficient inventory levels or not having the product at all. The common thought is that carrying more inventory items (SKUs) and quantities than necessary is better for business. However, carrying too many inventory SKUs can be a detriment to the company. First it’s detrimental to cash flow, difficult to manage and the risk of obsolescence is high. Second, and usually forgotten, is the power of brand equity. The business wants to be known for something and have the product sell itself. Think about the most popular brand of ketchup or facial tissue – both are commonly known under a specific brand name. These companies are not worried about expanding the amount of product they carry. They are concerned with continuously promoting their core products and only creating and offering new complimentary products after the appropriate market need assessment has been performed. For successful inventory management, managing inventory turns is of the upmost importance. Don’t be afraid to tell a customer that certain products are not carried by the company. The “all things to all people” business model has proven to be unsuccessful. Bankers prefer to finance companies that carry fewer SKUs and have high inventory turns.
It’s important to note that the traditional thinking that business profitability matters the most is short sighted. Cash is truly king as it provides operational flexibility, the opportunity to enhance product lines and invest in research and development. Business owners will be reassured that they don’t have to manage cash flow on an hourly basis. It is common for investors and lenders to request cash flow reporting and forecasting, in addition to or even instead of, the standard profit and loss forecasts. In a low interest rate environment, many business owners believe increasing their operating line to manage their long cash flow cycle is easy and inexpensive. However, what they fail to realize is that bankers are becoming stricter on margining receivables and customer concentration. Also, we are seeing that many banks are advancing less and less against inventory levels, so increasing a line may not be too expensive based on interest costs. The level of financing available is reduced due to strict covenants on receivables and inventory.
Remember that every business decision should be evaluated from both a profitability and cash flow perspective.