This article is part of our “Business Planning Guide”—a curated list of our articles that will help you with the planning process!

Although cash is critical, people think in terms of profits instead of cash. We all do. When you and your friends imagine a new business, you think of what it would cost to make the product, what you could sell it for, and what the profits per unit might be. We are trained to think of business as sales minus costs and expenses, which is profits.

Unfortunately, we don’t spend the profits in a business. We spend cash. Profitable companies go broke because they had all their money tied up in assets and couldn’t pay their expenses. Working capital is critical to business health. Unfortunately, we don’t see the cash implications as clearly as we should, which is one of the best reasons for proper business planning. We have to manage cash, as well as profits.

In Part 1 of this article I talked about Cash Flow and how it is effected in business operations, and gave a simple example. Now let’s look at the implications in a real case. The real case is a computer reseller (that is, computer store) in a medium-sized local market, with sales of about $6 million per year.

The first chart, in this first illustration, shows a representative sample business plan cash flow for 12 months, given standard assumptions for sales, costs, expenses, profits, and cash management. The sample company is profitable and growing. It sells about $6 million annually, produces about 8 percent net profit on sales, and is self supporting.

As the cash case starts

The chart shows a 12-month projection of cash resources. Of the two sets of bars the green one represents the checkbook balance at the end of each month, and the red represents the cash flow, which is how much the balance changes in a month. The green bars should never drop below zero, because if your checkbook balance is less than zero, then you are bouncing checks. The mathematics don’t care, but the banks do. The red cash flow bars, on the other hand, can drop below zero without major problems, as long as the balance stays above zero. For example, if a company’s balance was $10,000 at the end of January, and its February cash flow is a negative $5,000, then the balance at the end of February is $5,000 and the cash flow is -$5,000. The green bar stays positive, but the red one is negative.

In the illustration below, only one assumption has changed: that same company now waits an extra 15 days, on average, to receive money from customers on invoices presented. The average wait, which is called “collection days” goes from 45 days to 60 days.

Nothing else changes — no new employees, no change in costs, no additional expenses.

Changing collection days only

A single change, from 45 to 60 days, makes a huge difference in the cash flow. No other changes except waiting on average an extra 15 days before receiving money owed, “Accounts Receivable”, from their customers.

Notice here the critical importance of cash, and the critical difference between cash and profits. With this single change in assumptions, the company is still as profitable as it was, down to the last dollar. Now, however, its projected bank balance in January is more than $50,000 below zero. Therefore, the company needs more than $50,000 in additional financing.

This is new money needed, new investment or new borrowing. The problem can’t be solved by reducing expenses or increasing sales.

Companies go out of business for problems like these. Even otherwise-healthy companies can go under for lack of cash. This kind of projection can kill a company if it sneaks up by surprise, but can be easily managed when there is a plan for it. This is an eloquent argument for good business planning.

In the third case, shown in the following illustration, we set the collection days back to the original assumption of 45 days, but change the assumption for inventory. Where previously it kept an average of two month’s worth of inventory on hand, in this changed assumption it now keeps three months of inventory on hand. Accountants call this Inventory Turnover. The changed assumption creates an inventory turnover rate of 4, instead of the previous rate of 5. The collection days are back to 45 in this next scene, but inventory turnover went from 5 to 4, which means keeping more inventory on hand.

Changing Inventory Only

The change in inventory turnover shows the cash balance is now well below zero. The implications of the above illustration are massive. This is still a profitable company, but it has a critical financial problem. You see how the cash balance bar falls to more than $600,000 below zero in November. That means that this company needs new money, new loans or new capital investment, to make up its cash deficit, even though it is still profitable. This is hard to swallow until you see it happen in real business, but it is the truth and it will happen.

Profits are not cash.

Read Part I: All About Cash Flow

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