Cash Traps

So What’s Accrual Accounting and Why Does it Matter?

So you make a sale. When you deliver the goods, you record it as a sale. If the customer didn't pay you immediately, you record the accrued amount as Accounts Receivable.

You order some goods. When you receive them, you don't pay for them. Instead, you record the accrued amount as Accounts Payable.

At the end of the tax year you have some expenses outstanding, like professional services you know you'll be billed for but you haven't been billed yet. You accrue those expenses into the current tax year. They are deductible against income.

In so-called cash basis accounting, the opposite of accrual accounting, you don't put the sale or the purchase onto your books until the money changes hands. With business-to-business sales, the norm is the money changes hands later. So accrual accounting is better. It gives your books a more accurate picture of your financial flow and financial position.

Why does this matter here? Because timing of sales, costs, and expenses makes a difference. Start your forecasts correctly so the can be part of a more formal financial forecast when you finally need one.

So What If You Wait a Bit Longer to Get Paid?

Does it matter if you wait longer to get paid by your customers? Only about a million dollars' worth.

In this example, the company on the left gets paid by its customers in 45 days on average, and the one on the right in 90 days. Nothing else changes. Assumptions for sales, costs, expenses, and everything else are exactly the same. In the first case, the minimum cash balance is just less than half a million dollars, and in the second case, the one on the right, the cash balance is actually a deficit of more than half a million dollars.

This of the implications. Both scenarios have the same sales of about $6 million per year, with the same profits of about 7% on sales. But the company on the left is doing just fine, and the company on the right is in real trouble, possibly going under.

Source: Business Plan Pro, AMT Sample Plan, Cash Pilot View. The cash pilot allows instant adjustment of critical cash variables including sales on credit as a percent of sales, collection days, inventory on hand, and payment days. This view shows the scenario on the left with 45 days collection says on average, and the one on the right with 90 days on average.

Note: Interested in Business Plan Pro? Since this article was published, we’ve created LivePlan—our cloud-based business planning and business management tool. 

Beware the Cash Traps

Profits aren't cash. Profits are an accounting concept; cash is what we spend. We pay the bills and payroll with cash. While the plan-as-you-go business plan doesn't necessarily include a full-blown financial forecast (at least not until needed) it should still be aware of cash balances and cash flow.

This should be a pretty simple concept, but it gets hard because we're trained to think about profits more than cash. It's the general way of the world. When they do the mythical business plan on a napkin, they think about what it costs to build something, and how much more they can sell it for, which means profits.

However, you can be profitable without having any money in the bank. And what's worse is that it tends to happen a lot when you're growing, which turns good news into bad news and catches people unprepared.

Here are some traps you can watch for, to catch cash flow problems before they happen.

Every Dollar of Receivables is A Dollar Less Cash

Although it's not intuitive, it's true that more receivables mean less cash. You can do the analysis pretty quickly. Assets have to be equal to capital minus liabilities, so if you have a dollar of receivables as an asset, that pretty much means you have one dollar less in cash. If your customers had paid you, it would be money, not accounts receivable.

This comes up all the time is business-to-business sales. In most of the world, when a business delivers goods or services to another business, instead of getting the money for the sale right away, there is an invoice and the business customer pays later. That's not always true, but it is the rule, not the exception. We call that sales on credit, by the way, and it has nothing to do with sales paid for by credit card (which, ironically, is usually the same as cash less a couple of days and a couple of percentage points as fees).

We can use this in making financial projections: the more assets you have in receivables, the less in cash.

Example: A company running smoothly with an average of 45 days wait for its receivables has a steady cash flow with a minimum balance of just a little less than $500,000. The same company is more than half a million dollars in deficit when its collection days goes to 90 instead of 45. That's a swing of more than a million dollars between the two assumptions. And that's in a company with less than $10 million annual sales, and fewer than 50 employees.

And the trick is that the profit and loss doesn't care about receivables. You have as much profit when you sell $1,000 that your customers haven't paid yet as when you sell $1,000 that your customers paid instantly in cash. Obviously, the cash flow implications are different in either case.

Every Dollar of Inventory is a Dollar Less Cash

When your business has to buy stuff before it can sell it, that's called inventory. It's one of your assets. And keeping a lot of inventory can do bad things to your cash flow, unless you don't pay for it.

This can be pretty simple math. If having nothing in inventory leaves you with $20,000 in cash, then having $19,000 in inventory leaves you with only $1,000 in cash. That is, if you've paid for the inventory. That's because your other assets, your liabilities, and your capital are all the same.

Sometimes, of course, you cannot pay for that inventory, which means you have more payables, and your cash balance is supported by those payables.

The difference in cash with different assumptions can be startling. You can look ahead to see that in a graphic called What a Difference Two Months Makes.

Every Dollar of Payables is a Dollar More of Cash

While receivables and inventory suck up money by dedicating assets to things that might have been cash but aren't, paying your own bills late is a standard way to protect your cash flow. The same basic math applies, so it you leave your money in cash instead of using it to pay your bills, you have more cash.

It's called accounts payable, meaning money that you owe. Every dollar in accounts payable is a dollar you have in cash that won't be there if you pay that bill. The same problem you have when you sell to businesses is an advantage you have when you are a business. The seller's accounts receivable is the buyer's accounts payable.

Now I don't want to imply that you don't pay your bills, or that it doesn't matter. Your business will have credit problems and a bad reputation if it doesn't pay bills on time, or if it is chronically late with the bills. Still, a lot of businesses use accounts payable to help finance themselves.

Run Silent, Run Deep, Run Out of Money

The most important problem is getting people who haven't been running companies to believe that cash flow and profits are different. That's so vitally important because, on the surface, it doesn't add up. It isn't believable.

I developed business planning software originally as templates for business-planning clients to deal with the following amazingly typical exchange:

Me: So if you grow faster, then you'll need to get more financing.

They: No, that can't be true, because we're profitable. We make money with each sale, so the more we sell, the more we can fund ourselves.

Me: Bingo! Please sit down here for a few minutes and deal with these numbers.

And so it would go. As soon as you're managing inventory or selling on credit -- which means just about any sale you make to a business -- then your cash flow is waiting in the wings, a silent killer, to foul you up.

I learned this first in business school and then forgot about it. I learned it later again, the hard way, when Palo Alto Software sales tripled in 1995 and that nearly killed the company. Why? How? Well, we experienced a huge sales increase ;by selling a software product through traditional channels of distribution, meaning stores, and that means selling to distributors who then resell to stores, and that means that it can take five months between selling the product and being paid for the product. In the meantime, you've got to make payroll and pay your vendors.

Yes, it's a good problem to have -- we all want to increase our sales and profits -- but it's a whole lot easier to deal with if you plan the cash implications well.

Often in presentations I use one of my favorite metaphors, the Willamette River as it runs through Eugene, Oregon, where I live. The river slows down coming out of the Cascade Mountains and into Eugene, and it looks deep, slow, and peaceful, but it's much more dangerous there than when it's throwing up white water through the rapids. Why? Because it seems so calm and welcoming. People disrespect its currents, get caught in weeds, branches, or rocks, and ... well that's a good metaphor for the way cash flow hits small businesses when things are good, when sales are growing.

What's particularly painful about the cash-flow problems that come with growth is that, precisely because there is growth, these problems can be prevented by planning.

You can see how the sales are growing, then determine what your cost of sales will be, and look at what you have to pay, to whom, and when. See how your checking account will balance go down and down. Next, chart out when your customers will pay you. It will be obvious if you will run out of money before those profits actually reach your hands. You can then plan how to find the financing to float your boat before you actually hit the snag and sink.

We've had growth spurts since then that were far less painful because we understood the dangers of cash flow, planned for the cash implications of growth, and worked with our bank ahead of time to make sure the working capital was there.

Adapted from an article originally published on blog.timberry.com. All rights reserved.
Image: courtesy of University of Oregon Department of Journalism

Inventory: What a Difference Two Months Make

In this example, the company on the left keeps one month's worth of inventory, and the one on the right keeps three months. That's the only difference between both of these cash scenarios. The result of the three-month inventory assumption in this case is almost a million dollars of deficit by the end of the year.

Source: Business Plan Pro, AMT Sample Plan, Cash Pilot View. The cash pilot allows instant adjustment of critical cash variables including sales on credit as a percent of sales, collection days, inventory on hand, and payment days. This view shows the scenario on the left with a month of inventory on average, and the one on the right with three months of inventory on average.

Ten Rules for Managing Cash

Cash flow problems can kill businesses that might otherwise survive. According to a U.S. Bank study, 82 percent of business failures are due to poor cash management. To prevent this from happening to your business, here are my ten cash flow rules to remember.

1. Profits aren't cash; they're accounting. And accounting is a lot more creative than you think. You can't pay bills with profits. Actually, profits can lull you to sleep. If you pay your bills and your customers don't, it's suddenly business hell. You can make profits without making any money.
2. Cash flow isn't intuitive. Don't try to do it in your head. Making the sales doesn't necessarily mean you have the money. Incurring the expense doesn't necessarily mean you paid for it already. Inventory is usually bought and paid for and then stored until it becomes cost of sales.
3. Growth sucks up cash. It's paradoxical. The best of times can be hiding the worst of times. One of the toughest years my company had was when we doubled sales and almost went broke. We were building things two months in advance and getting the money from sales six months late. Add growth to that and it can be like a Trojan horse, hiding a problem inside a solution. 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.
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 best survival skill. Technically, working capital is an accounting term for what's left over 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.
7. "Receivables" is a four-letter word. (See rule 4.) 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.
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: 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. Project them 12 months ahead and compare your plan with what actually happens.
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.

Adapted with permission from an Entrepreneur.com column. All rights reserved.