Ask any banker what makes a successful business and he will tell you its cash flow. Businesses experiencing periods of high growth in particular, are often drawn in to a false sense of security. Just because you are running a profitable business, does not always mean cash is there to pay the bills, as most SME operators will tell you.
As we come to the end of an economic period of high growth, more and more we are seeing customers who are making a profit and yet cashflow is a daily challenge. How can this occur? To the non financial this statement does not make sense!
When a bank assesses the financials of these types of businesses the first thing that they see is that the business is operating with negative cash after operations. Cash after operations is a cash flow calculation which takes the operational cash inputs (cash collections from sales) and outputs (cash payments to suppliers) of the business. In short, a business in this circumstance is paying out more cash to buy goods and services than it is receiving cash for the sale of goods and services. Whilst each sale transaction is profitable, if the timing of the transactions is long, then the aggregate during a year can be that the company is paying out more than it is drawing in.
Whilst there are a number of key influences on the cash after operations calculation, one stand-out influence is the business working capital cycle measured as a %. A businesses Working Capital % indicates the number of cents required in working capital for the business to produce $1 of revenue. It is calculated as the Accounts receivable + Inventory – Accounts Payable over COGS, and expressed as a percentage.
Now if your Working Capital % is higher than your Gross Margin %, then, simply, you are requiring more money to fund your growth, than you are earning. And this is when you start going backwards.
As businesses who have been in this position would know, this puts strain on the businesses creditor reltionships, as you struggle to pay and Accounts payable days blow out. It puts strain on your debtors, as you become less tolerant of tardy payment and you become less “fun” to deal with. It also affects your COGs as suppliers become more inclined to charge credit risk margins for their goods. Most importantly this extra cash needs to come from somewhere, and so the business either needs to start obtaining more debt funding from lenders, or more equity funding from partners, both of which generally come at an expense that is far more insidious.
So what is the cure? The short answer is that it differs for each business, and yes, sometimes discounting sales in return for shorter payment terms can be appropriate. The must do for a business in this position is to recognise the key causes of the cash shortage. This is done with 3 main questions:
- Is the business turning a profit? If yes then the problem is likely to be timing and capital based
- Why is the working capital % so high? Have your debt collection processes fallen down, are you carrying too much non productive stock?
- Are there non operating related expenses that are causing the cash shortage and are they on going?
If you are having issues with cash flow and would like to speak to an expert before you talk to a bank to cover your shortfall, why not give us a call. Our team of banking consultants can help you to look at you business strategy and the impacts that it is having on cash flow, and help you be better armed for a discussion with a lender or equity partner. For more information, we can have one of our team contact you for an obligation free discussion: