Cash Flow Management: The Magic Number That Will Keep You in Business

Our small business clients hear how important cash flow management is to their business. However, sometimes they don’t understand what that really means. They’re just in survival mode.  “I’ll pay this bill after XYZ pays me”; they tell themselves. Day after day, they seem to be caught between success and failure. They can see profit on the income statement, but their bank account doesn’t prove it. It gives them a weird sense of mixed feelings.

“We’re making money. Why don’t I have any?”

The Problem with Cash Flow Management

Every year, approximately 50,000 businesses file bankruptcy, but it’s estimated that 35% of them show net profit on the income statement. They’re making money, yet still filing for bankruptcy. What’s going on here? This scenario plays itself out time and time again. Even the corporate giants fall victim to cash flow management problems. When you don’t understand the components that drive cash through your business, a profitable business can have problems paying its bills.

It happened to Home Depot in 1985. At the beginning of 1986, Home Depot had $9 million dollars in the bank and was experiencing a cash burn rate of $12 million per month. Yep, they had only 3 weeks of cash left. In 1985, the signs of a problem were there, but the fast pace of expansion overshadowed them. If it wasn’t for some masterful maneuvering by the management team, Home Depot may have been a blip in history, instead of the machine it is today.

The signs are there no matter the size of the business. In fact, the SBA lists the top 10 reasons why small businesses fail on their website. Seven out of the ten reasons are due to poor cash flow management. Your business is begging to be the most efficient machine it can be. It only feels right behind the wheel, when it is purring down the highway. However, a struggling business feels like a machine that’s out of sync. It’s the decisions the management makes that keeps it from reaching its full potential.

A well-run business acts like a machine, where cash flow is both the fuel and the output. The goal is to create a self-sufficient machine where the business can produce its own fuel. Let’s look at a few of the initial indicators that tell managers their business needs a tune-up.

The Financial Gap 

The driving force of a business is its ability to generate cash from operations. That is, sell a product or service for more than it costs. Seems simple enough.  But that is the scenario that begins the creation of a cash flow management problem. Especially in companies that must wait to get paid from their customers. We need to look at the difference between earning money and possessing money. Not only that, how fast does the process of having earned money in a bank account happen.

How many days does it take for a business to buy inventory, sell it, and collect on the invoice? This is a measurement of the speed of cash flowing through the business, measured in days. The number of days inventory sits on the shelf, plus the number of days it takes the business to receive payment, minus the number of days it takes to make a payment, is called the “financial gap”.

The financial gap is the first place a business should look to see if there is a potential cash flow problem. Since we are generating cash flow through sales, we want the number of days in the financial gap to be as small as possible. Nobody wants a huge gap in days between money out and money in. Therefore, as in the London Underground, a business should “Mind the Gap”.

The math looks like this: Inventory days + Accounts Receivable days – Accounts Payable days = The Financial Gap. A small gap means that the business needs less cash on hand to sustain its sales operations.

How Long Can a Small Business Last

The other side of the coin is how a business spends the money it earns from sales, or its gross profit. This money is used to pay for the business’ day-to-day operating expense.  We measure the speed of how fast we spend that cash in days as well. It’s called “Days Cash on Hand”.  Since this is just a use of cash, we want it to last as long as we can. We want these days to be as many as possible without being inefficient. Meaning, sitting on too much cash can be bad as well.

I also call this number “the days until bankruptcy”. It tells the manager how many days his business could survive if there was a downturn in sales. Again, here we are looking for a larger number. We don’t want to be like Home Depot in 1985, with only 21 days to live.

The math for this calculation looks like this: Cash on hand / ((operating expenses – non-cash expenses)/365) = Days Cash on Hand. The more days’ worth of cash you have, the better.

Fulfilling your dream as a small business owner starts with avoiding the main causes businesses fail. It begins with understanding the speed at which cash moves through a business. Two of the metrics that will help a manager understand that speed is to have a small financial gap and a lot of days of cash on hand.

For an easy tool that helps business owners stay on top of these metrics, try Flight by Finagraph. It is designed to help keep businesses in business.

The SmallBizRising Blog is designed to be an educational content hub pulling information, best practices and practical advice for the small business owner and features topics including accountingmarketingtechnology and more.  Be sure to subscribe to stay up to date with new content as it is posted.  The blog was created by The Neat Company and receives contributed content from a group of contributing companies that provide technology, services and solutions to small businesses.

The 5 Silent Killers of Cash Flow

In an economy where the stakes are increasingly high and cash progressively scarce, business owners must proactively manage the balance sheet and income statement or risk falling victim to the five silent killers of cash flow.

Did you know that a majority of businesses that file bankruptcy reported a net profit, yet had negative cash flow? Often the warning signs that a company is in trouble go unnoticed until it is too late. A business can improve their liquidity and create long-term viability by looking closely at the following potential trouble spots.

1. Mis-Financing. Mis-financing is defined as borrowing short-term debt to pay for long-term assets. These assets could include purchasing equipment, leasehold improvements and other fixed items with a short-term line of credit. This process drains the cash out of a business and condenses the timeframe the asset has to pay for itself.

The best way to start checking for mis-financing is by looking at the balance sheet. Check the business’ gross fixed assets (GFA), long-term debt (LTD) and retained earnings (RE). The change in GFA between periods must equal a corresponding change in LTD and/or RE. The effects of improper debt structure can be debilitating to a business. Working in the early stages of mis-financing can help to mitigate the effects it has on a business.

Solution: Matching the term to the useful life of an asset increases the company’s cash flow and frees up the line of credit for seasonal working capital needs.

2. Inventory Management. Driven by revenue growth, business owners can easily lose sight of the gradual increases made in their inventory levels. Whether rapid or steady, inventory creep can begin to impair a company’s cash position. Due to seasonality and sales, many business owners can fall into the trap of purchasing too much inventory because of a great deal. Some believe the myth that “sales cure everything” but the truth is there are many factors to consider. For example, the discount has to overcome the fact that you may have to carry the inventory for a longer amount of time.

Solution: Realign financials with industry standards, or move to a real-time method of inventory management to greatly improve the working capital of a business. Finding the right balance between inventory and sales can drastically increase a business’ available cash.

3. Expense Control. Everyone is aware of the importance of cost cutting during a down economy. However, the key lies in effectively determining the right level of controls to ensure the company’s critical functions are not impaired. One of the best methods for approaching expense control is the mirror technique. This approach examines the growth or decline of sales over a specific period of time and adjusts operating expenses accordingly. For example, if a company’s sales were to decrease by 25 percent during the projected period, operating expenses should also decrease by 25 percent. In order to remain viable and thrive into the future, a business owner must not lose sight of managing the nickels and dimes.

Solution: Slow down, and examine the fluctuation of sales over time. Adjust operating expenses to the same trajectory of revenue.

4. & 5. Accounts Payable and Receivable Management. This is the purest form of working capital, and all depends on how you spin the wheel. It’s a delicate dance because if you spin the wheel to fast, you could end up breaking it and working on a COD (cash on delivery) system. Controlling the speed that receivables are collected and payables are paid are tried and true methods for increasing cash within a company. While effective, these practices must be done with balance to avoid impairing sales through damaged client relationships, or exposing the company to increased late fees.

Solution: Offer early payment incentives for receivables, and delay payment to vendors to shorten the working capital cycle – ultimately improving the financial viability of a company.

With so many concerns to focus on in a day, business owners can never forget that cash is king when it comes to their company’s survival. Taking the time to understand key financial concepts in your business is an effective way to avoid the five silent killers of cash flow.

Cash Flow: It’s good for your health

I couldn’t wait to get back to my desk after visiting the dentist last night.  I find inspiration in the oddest places.  For me, it was the dentist chair this time.  I’m not aware of anyone who thinks the dentist chair is a great place to sit, away from the commotion of the office, and ponder huge subjects.  If you can, there is probably a medal you qualify for.  For me, there is no way I could concentrate on life decisions while the whirls, whizzes, and scraping sounds of the hygienist echoed through my skull.

Nonetheless, inspiration struck while I sat in the chair.  The cleaning hadn’t started yet, but my dentist has implemented a new procedure at the start of a visit.  Believe it or not, I learned I had high blood pressure at the dentist.  This was way outside the norm of a cleaning, but it did cause me to think about my overall health in the moment.

Truth is, elevated blood pressure in not a new condition for me.  In fact, it has lingered around since my late teens.  I believe every doctor since I was 18 has made a comment about it.  I have all the poor lifestyle habits you would think about a person with high blood pressure but have always kept it under control with diet and exercise.  After seeing the results, I knew I had let some important things slip.

This wasn’t the first time I had seen the results rise to this level.  The last time was in the mid 2000’s as I was building my company.  One of the prime contributing factors of high blood pressure is stress.  I have had several stress inducing jobs in my life, but being a small business owner has to rank near the top.  In this capacity, everybody around you depends on you to succeed.  Your employees, their families, your vendors, customers, and their families all rely on you to make good decisions.

The last thing you want to do is to let them down.  I took this responsibility very seriously, even at my own expense.  Cash is the tether that keeps everything together.  A company with a strong cash flow has a strong heavy (read healthy) bond.  Whereas weak cash flow shows signs of underlying health problems in a company, much like my high blood pressure shows in my body.

In the mid 2000’s, I had over 100 employees that I paid every other week.  If you ever want to know what stress feels like; try to think about looking your staff in the eye and telling them you can’t make payroll.  That never happened to me, but there were several times I withheld my own and my wife’s paycheck to make sure everyone else got paid.  There was the stress.  The company survived, but life at home was shaky a few times.  This was also the first time my blood pressure worried me.

After the second time of missing a personal paycheck, I made a lifestyle change in my business.  I was determined to understand how cash moved through my company.  I didn’t want to look on the calendar and wonder what the next pay cycle would bring.  I devoured articles and books about managing cash, and committed to increasing the speed of cash coming in.  The working capital cycle became my new passion.

Once I understood the relationship between my accounts receivable base and my payroll cycles, the world opened.  I could see problems before they even existed and act faster.  The “knowing sooner” part of the equation, helped relieve my stress about cash flow.  Which in turn lowered my blood pressure.  Ok, so did the change in diet and exercise.  Maybe losing a few pounds helped too.

In my opinion, it was the stress that put me over the edge.  The constant worrying about making payroll or being able to buy more inventory was a constant fear.  The fear was all founded in not understanding my business.  The simple act of knowing made all the difference.  Since then it has been a passion of mine to share this simple concept with business owners.  I even joined a firm with the mission of eliminating cash flow as a reason that businesses fail.

Yesterday, I had that same realization that stress had crept up on my again.  The reasons are different this time, but the feeling and the results are the same.  Managing your cash flow and managing your health go hand in hand.  The stronger your cash flow, the healthier you and your company will be.  It just took my dentist to remind me of this.