Cash is king and all business owners know it. Research “causes of business failure” and lack of cash turns up everywhere. A commonly-cited US bank study says 82 percent of business failures are due to poor cash management. Cash flow problems can kill businesses that might otherwise survive.
I learned the hard way, when my own business suddenly took off, that even growth can stifle cash. In my specific case, it was a matter of building physical products for inventory, selling through channels, and waiting to get paid by distributors.
I’d learned cash flow in business school, but I had to learn it again, for real, by going to my bank, signing a lien on my house equity, and getting an emergency loan.
Don’t let this happen to you. Here are my favorite 10 rules for managing cash flow.
1. Don’t confuse profits with cash
Cash and profits aren’t the same things. Profits are an accounting concept, not money in the bank. Profits are what’s leftover after you subtract costs and expenses from sales. But please read on to my points to follow about how you can be profitable but have money tied up in inventory, or in your accounts receivable, waiting for your customers to pay their invoices.
2. Cash flow isn’t intuitive
Don’t try to calculate it in your head. As soon as you have inventory (like most product businesses including manufacturing, assembly, distribution, and retail) or sales on credit (like most B2B businesses) or sales on credit, cash flow takes a hit.
Inventory is usually bought and paid for and then stored until it becomes cost of sales. Making the sale doesn’t necessarily mean you have the money. Incurring the expense doesn’t necessarily mean you paid for it already.
Cash-based accounting sounds good but often isn’t. It takes accrual accounting to reflect unpaid bills and prepaid expenses, spending on inventory, and other factors that can kill cash flow. You or somebody you trust must be able to do and understand a cash flow statement and do regular cash flow analysis.
3. Growth can absorb cash
As in my case above, sudden growth often requires extra cash. We were building things two months in advance and getting the money from sales six months late. We doubled sales in six months and almost went broke in the meantime.
It’s paradoxical. The best of times can be hiding the worst of times. The impact of buying inventory and waiting to get paid can be devastating. Yes, of course you want to grow; we all want to grow our businesses. But be careful because growth costs cash. It’s a matter of working capital. The faster you grow, the more financing you need.
4. Business-to-business sales suck up your cash
The simple view is that sales mean money, but when you’re a business selling to another business, it’s rarely that simple. You deliver the goods or services along with an invoice, and they pay the invoice later. Usually, that’s months later. And businesses are good customers, so you can’t just throw them into collections because then they’ll never buy from you again. So you wait. When you sell something to a distributor that sells it to a retailer, you typically get the money four or five months later if you’re lucky. Yes, there are ways to speed up getting paid, but also, in many businesses, you have to accept standard practices. And that means waiting.
The money your customers owe you is called “accounts receivable.” Here’s a shortcut to cash planning: Every dollar in accounts receivable is a dollar less cash.
5. Inventory sucks up cash
You have to buy your product or build it before you can sell it. Even if you put the product on your shelves and wait to sell it, your suppliers expect to get paid. Here’s a simple rule of thumb: Every dollar you have in inventory is a dollar you don’t have in cash.
6. Working capital is your peace of mind
Technically, working capital is an accounting term for what’s leftover when you subtract current liabilities from current assets. Practically, it’s money in the bank that you use to pay your running costs and expenses and buy inventory while waiting to get paid by your business customers.
Working capital is money in the bank. It’s the result of good cash flow. Sometimes you can adjust business practices to improve the cash impact, and sometimes it’s just a cost of doing business. You have to be aware of it and plan for it ahead of time.
7. So-called “best practices” aren’t always enough
Sure there are sometimes some ways to mitigate underlying cash flow weaknesses. Some businesses manage to get prepayments, discounts for prompt payments, on-time inventory delivery, and so forth. Still, in many business cases, the solution is in planning for cash and having enough working capital, rather than changing the way business is done.
For example, a consultant can’t often simply demand deposits or prepayments from clients. I survived in management consulting for decades but learned quickly that my large-company clients passed my invoices on to finance people and were not concerned about how long I waited for checks.
It was not their problem; and if I’d tried to make it their problem, they’d have hired my competition. So I arranged a bank credit line to finance my receivables.
And, for another example, not all manufacturing businesses can manage their vendors and direct costs well enough to cut inventory turnover. Sometimes the inventory you have to hold in house is just a cost of doing business.
All of which means that best practices don’t often trump common practices. Cash flow is your problem, not your clients’. Inventory turnover is your problem, not your vendors’.
8. Bankers hate surprises
Plan ahead. You get no extra points for spontaneity when dealing with banks. If you see a growth spurt coming, a new product opportunity, or a problem with customers paying, the sooner you get to the bank armed with charts and a realistic plan, the better off you’ll be.
9. Watch these three vital metrics
Pay attention to these three vital metrics.
- “Collection days” is a measure of how long you wait to get paid.
- “Inventory turnover” is a measure of how long your inventory sits on your working capital and clogs your cash flow.
- “Payment days” is how long you wait to pay your vendors.
Always monitor these three vital signs of cash flow. Create a cash flow forecast and project them 12 months ahead and compare your plan to what actually happens. Look for unexpected changes and figure out what happened, and why. Take action where you can.
10. If you’re the exception rather than the rule, hooray for you
If all your customers pay you immediately when they buy from you, and you don’t buy things before you sell them, then relax. But if you sell to businesses, keep in mind that they usually don’t pay immediately.