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How and Why to Manage Cash Flow

No matter how profitable your company looks, it can still be in danger of going under without sufficient cash flow. Cash is your business’s lifeblood, its survival. Yet the world is full of “profitable” companies bleeding themselves dry and slowly—or sometimes not so slowly—going under because they haven’t paid due attention to cash flow.

How does this happen?

Well, consider this. If you’re starting a new business, what do you think about? How to make a profit. You think about what it’ll cost to manufacture your widgets, how many widgets you can sell, and how much you can sell them for. All of this tells you how much profit you’ll make on each one. All our training results in the equation business = sales – costs and expenses = profit. It’s ingrained into every one of us from the time we first think about writing a business plan .

But you don’t really spend profits in a business; you can only spend money. That’s cash, checks, liquidity, money. And when I say cash, I don’t mean bills and coins; I mean checks, wire transfers, whatever else is immediate money. You need liquidity to make it day-to-day. You see examples of this all around you every day. How many times have you read in the scandal sheets about some celebrity who “has” all the money in the world, and yet is flat broke? What’s their mistake? They buy mansions, boats, cars, and land for themselves, their families and friends, but they don’t have enough cash in their checking account to pay the electric bill. If that happens, it doesn’t matter how many estates you’ve got, the lights are still going out. And when you don’t manage cash flow in your business, the lights go out for you and your enterprise too.

Want to keep the lights on?

Let’s assume you do, and that you need to understand the mechanics of cash flow a little better to keep that switch from being thrown. Here’s a quick, simple scenario that can easily explain the relationship between income statement, balance sheet, and actual cash. Say we have a business which starts with $100, which we’ll call capital. Under the formula assets = capital + liabilities, then, your balance sheet shows assets of $100—the money—and capital of $100. Take a look at this laid out in the first chart, Starting Numbers.

Out of the starting gate

If you buy a widget for $100 and sell it for $150, you should end up with $50 profit, and you have $150 in the bank. Coincidentally, your bank balance sheet shows the same $100 in original capital plus $50 in earnings, equal to cash assets of $150.

Sell a widget 

The illustration shows your income statement and balance sheet at this point.

And so on; sell three widgets 

But that’s not exactly how real business operates!

Step back a moment and consider this. Products are sold to businesses on terms, with the money due in 30 days. This means if you sold that widget on credit, and you’re not seeing that money for 30 days, you don’t really have $150 in the bank. Instead, a customer owes you $150, which is what we call “Accounts Receivable.” This is what really happens to the huge number of businesses that sell to other businesses.

Sell a widget on terms 

Knowing you can buy a widget for $100 and sell it for $150, you get your Widget supplier to sell to you on the same terms you sell—net 30 instead of cash. Now, you owe $100 to suppliers, which is called “Accounts Payable.” You also have $100 worth of widget in inventory. This leads to what is shown in the next chart:

Buy a widget on terms 

You have an extra $100 in assets (the widget in inventory) and an extra $100 as liabilities (Accounts Payable), so you are still in balance. But you still have no money. 

Our next illustration shows the financial picture when your business sells to other businesses on credit, as is the norm, and purchases inventory on credit; this is shown as a short-term debt.

This is much closer to the way business is done in the real world—you have significant amounts sitting in inventory and accounts receivable, so you have to monitor your cash very carefully.

Your cushion: working capital

Although the example above is closer to real business workings, you’ll see what’s missing right away: running expenses such as salaries, telephones, rent, or advertising your widgets. These all affect your cash situation—and they’re unavoidable. You can’t get far without paying the rent, and you can’t wait to pay your telephone bill until your customers pay you!

Another hard fact: suppliers aren’t likely to give you widgets on credit when you have no assets and no history. Even a bank would look askance at this plan. Yes, banks do loan against inventory and receivables, but only to a certain percentage of total value.  So what’s the missing element?

Working capital

While in strict accounting terms working capital = short-term assets – short-term liabilities, in reality, working capital is crucial “glue” for your cash flow. The time to get it in the bank is before you need it!  Here’s what that scenario looks like in a company doing things right:

Your widget company, well-financed

See the difference? Instead of $100, this business begins with capital of $400. This makes everything easier, from buying on credit to borrowing against assets. This widget company has effective working capital

at the beginning—whereas with even a cursory look, you could see that $100 wouldn’t be enough. Following these illustrations lets you see the difference quite plainly. REMEMBER: Every one dollar in accounts receivable or in inventory represents one dollar LESS in cash; every one dollar in accounts payable is one dollar MORE.

Now, let’s see how this works in a real business:

This first chart shows a sample business plan cash flow for 12 months, given standard assumptions for sales, costs, expenses, profits, and cash management. This is an actual company that’s profitable and self-supporting: it sells about half a million dollars annually and produces about two percent net profit on sales.

Starting case

The Crucial Color Code

You’ll notice two sets of bars on this graph. Green shows the checkbook balance at the end of each month, while blue represents the cash flow, which is the change in the cash balance from the last day of one month to the last day of the next. Now, for practical purposes, you can’t have the green bars drop below zero; if your checkbook balance is negative, you’re bouncing checks. (Math is neutral about this; banks are not.) On the other hand, you can allow the blue cash flow bars to drop below zero without major difficulties, as long as the “green” is, so to speak, “in the black.” For example, if the company’s balance is $10,000 at the end of January, but its February cash flow is a negative $5,000, it’s still okay: although the cash flow is -$5,000, the green bar stays positive.

To the right here you see the cash flow assumptions associated with that cash flow.

In the Cash Inflow assumptions, the bicycle store makes only 10% of its sales on credit, meaning sales to other businesses, for which it delivers an invoice and then waits weeks or months for that other business to pay it. Sales on credit have nothing to do with credit cards; they are business-to-business sales. Instead of the sale generating money in the bank, it generates what we call Accounts Receivable, an asset, that isn’t money until the customer pays that invoice. Most businesses wait about a month or 45 days before they pay invoices. That waiting period is called collection period, usually measured in days, and in this example you can see the assumption is 60 days. We can assume that it has one corporate client (perhaps a local university, or a bike rental business) that accounts for 10% of its sales.

In the Cash Outflow assumptions, you see the other side of that coin. This business pays all of its bills later, none of them immediately (so the purchases on credit are 100%). And it pays them an average of 45 days after receiving them, so the payment delay is 45 days.

In the Inventory assumptions, the business keeps an average of a month’s worth of inventory on hand. And the minimum inventory purchase is $1,000.

In the next illustration, however, you’ll see what happens when we change one factor: that same company now has 50% of its sales on credit. Maybe that same client that was 10% in the previous example is now a collection of several clients that account for 50% of sales, which makes 50% of sales on credit. Nothing else changes—no new employees, no change in costs, no additional expenses.

Change #1: More sales on credit

Notice how that green bar suddenly dips? This one change makes a significant difference in cash flow, all by itself. Merely changing the percent of sales on credit tips the scales precariously.

This illustrates in clear detail the difference between cash and profits. The company’s still as “profitable” as it was before. But its projected bank balance for the middle of the year is negative.  This means the company needs that amount in new money or new borrowing; this shortfall can’t be remedied by increased sales or reduced expenses. Failing to plan for this kind of shortfall is enough to put a company out of business.

What else can be a recipe for disaster? Let’s talk inventory turnover.

In this final example, sales on credit go back to the original 10% assumption, but inventory shifts from one month worth to three. Accountants call this Inventory Turnover; this change creates an inventory turnover rate of four instead of the previous five, which means the company keeps more inventory on hand. What does this do to the cash flow?

Change #2: Inventory turnover—what a difference two months can make!

Keep in mind—this is still a “profitable” company, but now it’s in real problem territory. With a cash balance that sinks to more than $20,000 below zero in the summer, this company needs some big-time new money, loans, or capital investment if it expects to stay afloat. You may find this hard to believe until you see it happen, but if you’re watching it happen in your business, you may already be sinking fast.

That’s why it’s all about the CASH. Beginning, middle, and ending. If things like these “sneak up” on a company by surprise, it’s only a matter of time before that business is headed for the rocks. And this may be the singular best argument for thorough business planning.

Remember, it’s not enough to have a business be “profitable.” You can’t spend profits. You don’t pay employees or creditors with them. When you need cash, nothing else can substitute for it—and even “little” changes can substantially alter it.

Plan accordingly!

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