Why cash flow matters in your business (more than you think)
Business owners traditionally evaluate the financial performance of their company based on net income, making continuous efforts to improve the bottom line by generating new sales and trimming costs. The common assumption among business owners is that in order to gain approval from bankers and other key stakeholders, strong profitability — in the form of net income on the bottom line of their earnings statement — is the only measure that counts.
While profitability is important, cash is the real king. The primary reason that most businesses fail is due to a lack of proper cash management. In essence, if you don’t have the cash to pay your bills or your employees, you will be out of business. Naturally, bankers watch a company’s cash flow carefully to determine their viability now and in the near future.
On the other hand, business owners tend to spend their time building their business by focusing solely on profitability through net income, without placing controls on managing daily cash flow. The danger in this scenario is increasing profitability, yet no cash in bank to sustain the business through its growth period.
The message here is cash flow and net income are NOT the same. Net income does not mean that money is sitting in the bank.
TWO CONTRIBUTING FACTORS TO LOW CASH FLOW
Cash Lag 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 manufacturers, as materials purchased need to processed, packaged and then sold to customers. Shipping time is only half of the battle. The business still 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, particularly if they are not on top of their receivables. Company Growth Companies in growth mode tend to be cash-strapped — despite more sales — because of additional expenditures and working capital needs. Commonly, that money is used to finance accounts receivable and inventory instead of sitting in the bank. Inventories are built to meet new customer demands and receivables grow due to higher sales volumes. Most growing companies invest in new talent, marketing and infrastructure at the beginning of a growth cycle. The cash outflow for these expenditures is made well in advance of receiving the end cash benefits. Business owners look for a return on their investment, but need to be patient and understand that realization can take time.
Although these assets are good working capital items, they are not the same as cash and require financing similar to expenses, either from bank operating lines of credit or personal funds.
KEEPING THE COFFERS FILLED WITH CASH
How do you keep your company’s coffers filled? Here are three easy tips to help your business improve cash flow management: Get to Know Your Customers As the business grows, the number, sophistication and customer demands will also increase. Generally the larger the customer, the longer they will take to pay… because they can. Large, established retailers know they have influence and are important to suppliers since they represent a large volume in sales. As a result, they tend to stretch out their payments as long as possible, 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 biggest fear for a supplier is not collecting receivables at all. 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 to receive payment. Managing accounts receivable is a daily function that should be assigned to a no-nonsense person in the organization who can be politely persistent.
Customer discounts for early payment are often used to help improve receivables. Common discounts include a two per cent discount if paid in 10 days or one per cent discount if paid in 30 days. Since some customers like to save money, you will have takers on those offers. Early payments increase the predictability of cash inflows. Although there are costs associated with providing customer discounts, being paid most of what you are owed quickly is better than being paid late… or not at all. Manage Inventory As mentioned earlier, payment for goods and materials occurs at the beginning of the cycle. The last thing that businesses want is to disappoint their customers with short shipments due to insufficient inventory or not having the product at all. The common remedy is to carry more inventory items (SKUs). However, carrying too many SKUs can be detrimental. First, too many SKUs impact and limit cash flow since inventory ties up money; second, too much inventory becomes difficult to manage, and third, the risk of merchandise obsolescence increases. For successful inventory management, be sure to move products quickly and get them out to the customers. While business profitability matters, cash is truly king as it provides operational flexibility, as well as opportunities to enhance product lines, invest in research and development, and provide business owners with the reassurance 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 these uncertain times, cash flow forecasts should be included in weekly and monthly financial reporting packages. Every business decision should be evaluated from both a profitability and cash flow perspective. A good accountant would be well-versed in creating cash forecasts, identify drains on your cash flow and work for you.
FORECASTING FUTURE CASH FLOW – HOW IT HELPED ONE BUSINESS OWNER
As mentioned business changes on the horizon, such as adding a new line of products and plans for growth can affect cash flow. In these circumstances, what you think will be and what will be, can be two different situations entirely. It is advisable that your accountant produce cash flow projections to determine the impact of any business changes to your cash flow, so you can make informed decisions, and be more prepared for the outcome.
This was the situation faced by one client, a jewellery retailer. This retailer planned to carry a new line of products which he expected would double his sales. Given that his margin was roughly 50%, he presumed with an additional $500,000 in sales, he would net $250,000. We created cash flow projections to predict the outcome and the impact on cash caused by this new line of products. The projections were both eye-opening and invaluable to our client.
Since the client would have to invest $100,000 up front in inventory, and extend credit to his customers to encourage the purchase of this new line, our projections determined that in year one the jeweller’s cash flow would be flat, and that he would need to access a line of credit to have enough cash on hand to overcome any deficiencies in cash. It was only in year two that the retailer would have had more cash flow, and no longer need the line of credit to manage cash.