Managing Cash Flow

For most growing businesses, the single most important financial issue is not profitability, it is cash flow. Many companies are continuously strapped for cash even though they are profitable and sales are growing. (Case in point: Amazon, which grew sales like a rocket during its early years but was widely criticized for negative cash flow.)

What exactly is cash flow, and how do you manage it? This article explains the basic concept and highlights the six things that most companies need to pay attention to in order to effectively manage this part of their business.

What is Cash Flow?

The term cash flow simply refers to the fact that cash moves in and out of the business on a regular basis. Generally speaking, cash moves into the business when payments are received from customers or when new funds are invested in the company by its owners. Alternately, cash moves out when the business purchases inventories and supplies, or pays for operating expenses (rent, salaries, etc.), or buys new assets (i.e. a new piece of machinery).

Cash Operating Cycle

As most business owners know, managing the two sides of this equation on a day-to-day basis is a delicate balancing act. In most cases there is a gap between the time that companies pay their bills and the time they get paid by their customers. This is called the cash operating cycle. During this period the business has money tied up in working capital that it needs to finance operations. Businesses that carry little or no inventory and which are paid at the time they sell their products or services will have a very short operating cycle. EBay is a classic example of this: they carry no inventory and get paid sales commissions automatically within a few days from sellers. That's why EBay is a cash cow extraordinaire.

Other businesses such as manufacturers, wholesalers, retailers, etc. can have very long cash operating cycles. These companies are not as lucky as EBay and they have to work harder at managing their cash flow. They do this by paying close attention to the variables that affect cash flow, which are called cash flow drivers.

Key Cash Flow Drivers

For most companies, the key cash flow drivers are as follows: 1) pricing, 2) sales volume, 3) credit terms, 4) inventory management, 5) supplier terms, and 6) expenses. In other words, the specific things that your company does in these six areas- from your pricing strategy to your payment terms to the amount of inventory you carry- will directly impact cash flow. That may not sound very glamorous, but the results can be exciting. A quick example will illustrate the point.

Dell Computer has an inventory turn of about seven days, pays its suppliers on average at about forty days, and gets paid by its customers at the time it delivers its product, which it can build on average within fifteen days of an order being received. What this means is that cash is moving into the company faster than it is moving out. As a result, Dell will always be cash flow positive as long as it continues to get sales (even if it incurs a loss). Consequently, Dell has the potential to grow at a virtually infinite rate. This gives Dell a very strong competitive advantage and that is one of the main reasons that it has been able to become one of the top two computer manufacturers in the world without needing to raise large amounts of equity capital.

As you can imagine, pulling this off is no easy task. If it were, everybody would be doing it. There are some complex calculations involving relationships between the variables that drive profit and cash flow. Most business managers do not think in these multi-dimensional terms, and that's why most businesses under perform in this area.

Nevertheless, the good news is that if your company has been chugging along without a cash flow strategy in place, then there are some basic things you can start doing that will produce big improvements. For most companies (i.e. assuming that you are not seeking additional funds from shareholders or external sources), the first step is to focus on generating more cash from your existing operations. Here are a few tips to get you started. (Note: these ideas may sound relatively simple- the key to success lies in implementation.)

Four Ways to Generate More Cash from Existing Operations

·        Increase gross profit by increasing your prices and / or reducing your cost of sales.

·        Improve accounts receivable collections by shortening the payment terms you offer your customers or making a stronger effort to collect overdue balances.

·        Increase the accounts payable turn rate by renegotiating terms with your suppliers (this might not be possible, but it is worth pursuing if your purchases are growing and you have a good relationship with one or more key suppliers).

·        Reduce operating expenses – this however is sometimes easier said than done.

Fundable Growth Rate

In addition, there is one critical measure that offers companies a tremendously valuable tool for managing their cash flow and defining their overall financial strategy. It is called the Fundable Growth Rate (or FGR for short). This is a single number that tells you how much you can grow your business right now (i.e. without seeking additional cash). The number is different for each company, of course, and depends upon several variables. For example, a company with $1 million revenue that has a 20% profit margin (after tax) and $150K in working capital might have an FGR of 35%. That means that the company can safely grow sales to $1.35 million without requiring additional funds from shareholders or outside sources. If it grows at a slower rate, then it will generate positive cash flow. If it grows faster, then the business will use more cash than it is generating (i.e. negative cash flow) and will require additional funding.

Once you know this number, which basically represents the optimum rate of growth for any business, then you can start to answer some very interesting questions. For example, how much additional sales would be needed to increase your profit goal from $200K to, say, $350K? Are there other things that could be done to achieve that goal- for example, ways to increase gross margin and/or reduce operating expenses? What would happen if you tried to increase sales by offering price discounts or extended payment terms? (Hint: both profitability and cash flow will be impacted, and both need to be considered during planning.)

The beauty of the FGR is that it summarizes the relationships between all the elements that drive cash flow and profit (pricing, sales volume, credit terms, etc.) and makes it possible to focus on one number. This is the essence of great accounting: translating complex financial information into a relatively simple measure that can be used to help you make better decisions.

Conclusion

Cash flow is an inherently tricky subject, even for accountants. Although it seems ironic, businesses that grow too fast can actually fail because they run out of cash (despite the fact that they are profitable). The key is to develop a combination financial strategy that balances revenue growth with cash flow needs. Hopefully this posting has left you with some ideas (i.e. Ways to Generate More Cash from Existing Operations) and key concepts (i.e. Cash Flow Drivers and Fundable Growth Rate) that will help you start to successfully manage your cash flow.

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This article is presented for educational and informational purposes only, and is not intended to constitute legal, accounting, tax, or other professional advice unique to your circumstances.