A well-respected business with great sales, growing rapidly and making profits. Yet they had massive cash flow issues. I see this situation a lot and it’s more common than you think, if not identified and managed early on, can be a massive distraction from your core activities and in the end, can destroy many good businesses.
To get control of your cash flow you need to understand what drives cash, what you can change to optimise cash and plan your business processes around your cash flow. Cash flow is the lifeblood of any business and understanding how it flows through your business refer to my earlier post ‘Understanding Business Cash Flow’. In this post, we will look at ways to optimise that flow to help you be more successful.
To do this, first, let’s look into the short term drivers of cash flow and how seasonality can cause cash caps. Then we’re going to look at what is the long-term impact of growth on your cash and thirdly what do we need to monitor to keep on top of our cash flow.
Let’s start with short-term impacts of cash, generally caused by timing differences between when you complete an activity and when you collect the cash or pay the expenses. The first concept to understand is cash and profits are not the same things understanding this is the first step in finding ways at optimising your cash flow.
To give you an illustration of how you use cash to make profits we will use a concept called the working capital cycle. Every business has a working capital cycle but they are not all the same. I’m going to start out with a generic working capital cycle then I’ll talk about retailers and service businesses. You start off with the money or cash sitting in your bank account. Now your money sitting in your bank account is lazy, you want to use that cash to make profits. One way is for you to buy something that you can sell. In this case, you’re going to take the cash out of the bank account and go to buy some stock.The stock comes in and you fill up your store or your warehouse or your garage at home wherever you put your stock.
If you’re in a business that has stock one of the things I’d like you to do is sometime in the next couple of days go to where most of your stock is standing in the middle of it close your eyes and imagine that stock as bags of cash. For they are bags of cash you cannot use, you cannot use that cash until they are sold. For some of us when you sell your stock you get your cash straight away either as cash or credit card. For others, though you sell on credit, you issue invoices and end up with things called debtors or accounts receivable this is where you become the banker to your customers. What you are doing is you are lending your customers the money to buy your goods or services. You hope they pay you back eventually and that dollar comes back into your bank account.
The reason we are interested in this cycle it’s all about how long or fast it takes for your dollar to go all the way around and ends back in your hands. If you can turn your dollar faster around the cycle it may do one of 3 things for you.
The first thing is if you turn your dollar around faster you end up with more cash back in your bank account that’s more cash you can do other things with.
The second thing is if you are using an overdraft from the bank to fund your working capital cycle you may be able to reduce your overdraft by turning your cycle faster and operating your business more efficiently.
The third thing if you are growing your business, you need more stock or more debtors but if you turned this cycle faster you don’t need as much more stock or as much more debtors, allowing you the ability to grow faster without having all your cash tied up. It’s all about how fast can you turn your dollar around this cycle.
You usually measure this speed or turns in days how many days on average does that stock sits on the shelf for before you sell it. How many days on average does it take you to collect debtors? The turn to days of course days are time and time, of course, is money. Turning your working capital cycle faster frees up cash.
Not all businesses are the same. The retailers out there are looking at this and saying we get everything in cash and credit cards I don’t have debtors” and you would be right. Your cycle just goes from cash into the bank to stock and back into cash. That’s simple and all well and good, however the biggest killer for retailers no matter where you go in the world is poor management of stock or inventory.
How often is it a bill comes in you can’t pay it because all your cash is tied up in the stock on the floor?
Hold on a second now, what about for a service business, surely they don’t have stock. Again I agree, however you have something that acts a little bit like stock it’s called work in progress or WIP. Basically, you take on a job from a customer you do all the work for them and then you send out an invoice. When you’re doing all that work before you can send out that invoice what do you have to payout do you have to pay out wages, do you have to pay out rent, do you have to pay out your general overheads? If you do then it’s chewing up your cash.
The cash is further chewed up when you send out an invoice and you have to wait for your dollar to come back into the bank account. Whatever business you’re in you have and will need to understand the concept of the working capital cycle. Understand how the cash flows through your business allows you can find where your cash is hiding. The working capital cycle and cash gaps give you an insight into the drivers of short-term cash. To fully understand how to optimise your cash flow you also need to understand the impact of long-term growth in cash.
To find cash using your financial statements it’s important to understand how your business works financially. The financial operating cycle is a great way to understand this.
When you first go into business what did you do? You get all the money together you can to put into your business to get it up and running. We call this net worth or equity I like to call this the owner’s money. The owner’s money though is not always enough to get the business up and running. So what do you do? You borrow some money. In accounting terms the borrowed money is called liabilities I like to call it other people’s money. Let’s recap, you have your money (the owner’s money), you have other people’s money (the liabilities). You get all this money and put into your business and spend it on things like cash, debtors, stock, plant and equipment, computers, motor vehicles, land and buildings things us accountants like to call assets.
This equation I’ve just shown you is your balance sheet. The balance sheet tells you where you got the money from. The owners and other people, it also tells you what you spend it on, like assets. And why did you buy these assets, well to make sales of course.
Sales are the main activity of the business. Of course, once you have sales you’re going to have the cost associated with the sales and expenses. Hopefully, your sales are greater than your expenses and you make a profit. Of course, the tax man takes a little bit of the profit and you end up hopefully with a healthy net profit after tax. This, of course, is your profit and loss statement or the income statement.
I’m hoping you are starting to see a relationship between your balance sheet and your income statement. You get everything together in your balance sheet so you can do all this activity on your income statement. The relationship doesn’t end there. If you’ve made all this lovely healthy net profit after tax what did you do end up doing with it?
There are 3 things you can do with your profits. Firstly you can reinvest them into the assets of the business buying more assets and you’ll have the capacity to grow your sales. Secondly, you can use them to pay back some of those other people your liabilities. And get your debt levels down to a level of risk you are comfortable with. Thirdly, you can take the profits out of the business or as I like to term it, take them home. You can take profits our by dividends or wages to spend them on whatever you like or into super for retirement. This financial operating cycle is how every business in the world operates. It does not matter how big you are or how small you are, it does not matter what industry you are in, they all operate the same way financially. From a cash flow point of view, it is really important for us to understand this financial operating cycle.
It is common most people see cash flow as having the money to pay bills. These bills come from our suppliers and they are called creditors or liabilities. Liabilities are on the balance sheet, not the income statement. For this reason, the majority of your cash flow lives on your balance sheet, not your income statement. So if you really want to optimise your long term cash flow you need to understand how your balance sheet works, that is the long-term impact of cash.
Let me explain why the balance sheet impacts your cash flow through a model of how long-term growth impacts your business. The 3 main areas you need to look at are sales, profit and assets and how they interact with each other. If you pick a certain level of sales, let’s say at a point you are making a certain level of profit and utilising a certain amount of assets. Next year you grow sales from A to B and if you manage your profit and assets at the same level of efficiency you see your profit increase but also your assets. It is this increase in assets that is using up the cash in the long term. However, depending on how you manage your profits and assets there can be a number of different outcomes, It maybe you can increase your sales without increasing your assets. I term this fast growth and it can usually be achieved if you have excess capacity in your assets or you can outsource some of your assets.
What would be wonderful is if you could get sales to increase and use fewer assets, I call this optimise growth. This can happen particularly if you find a way to use your assets more productively but quite often it’s not sustainable in the long term. There are also instances when sales grow, assets grow but your profit doesn’t. I call this declining growth. Your input cost is growing faster than your sales. Where you really don’t want to end up is in financial distress. Where your sales grow, your assets grow but your profit goes backwards. If your find yourself here it may be time to think of getting out of this business. Now given all the different ways to go, where should you be aiming for? The preferred way is in the wedge between optimised growth and maybe slightly into declining growth. In fact, optimised growth and declining growth are usually short term phenomenon’s, where you should be looking for your long term strategy is in the fast growth wedge. Nearly all option except optimised growth require more assets. More assets mean you will need more cash to fund your business.
Now that we understand the short and long-term impact of cash, how do you keep an eye on your cash to ensure it is being optimised. One of the ways I like to keep on top of my cash position is to use ratios. Ratios give you an early warning system and help you to optimise your cash flow. However, the most important tool in optimising your cash flow is your cash flow budget or forecast so be sure to ask your bookkeeper or accountant to help you with this if you are not sure.
It is important to put your actual against your cash flow forecast each month to not only see if things have changed but also to keep learning about how the cash flows through your business. The cash flow forecast is one of the most important tools to help you optimise the cash flow of your business.
As we have seen to optimise your cash flow it is important to understand both the short term and long term drivers of cash in the short term get to know your working capital cycle and start to reduce your cash gaps. Monitor your cash flow religiously and make sure you have a cash flow forecast.
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