Feature, V3I1

Managing Cash Flows

Having cash is like having gas in the car. Whether you drive a 2017 BMW or a 2007 Beetle, you can’t go anywhere without gas in the tank.

A business can be unprofitable and have plenty of cash (for a while). On the other hand, a business can be very profitable and have little or no cash on hand. The amount of cash on hand by itself does not tell us whether a business is growing or fading, profitable or unprofitable, or how well it’s operating.

And yet, as the cliché goes, “cash is king.” This is true because without cash your business could be insolvent overnight.

In late 2008, Tesla was burning through $4 million per month and needed to raise a $40 million round of financing. Elon Musk scraped together half the cash needed and asked his investors to match the other half. They agreed, but one investor fund’s representative hadn’t signed one page of a critical document.

He wanted Musk to make a presentation in person the following week, but Musk knew they needed cash in order to make payroll so couldn’t afford to wait that long to close the deal. So, he told the banking investor that he would just take out another loan himself and fund the entire $40 million unless the investor was ready to move forward immediately.

The investor came through and the deal closed on Christmas Eve, just hours before Tesla would have gone bankrupt. Tesla didn’t have enough cash in the bank to make payroll the next day. Tesla now has a market cap of approximately $34.5 billion and is an ambitious player in the electric vehicle market. But I’m sure Musk would have liked to avoid some of the drama along the way.

How can we avoid a cash flow crunch in our businesses? Cash might get tight after relocating to a new facility or while expanding the selection of stock inventory. Managing cash flows is the key to avoiding the bumps.

Measuring Cash Flows


Someone once said that “what gets measured gets managed,” so first let’s take a look at measuring cash.

The amount of cash you have on hand is relatively easy to measure. A quick look at the balance in our bank account may seem to be the answer but it’s not. Until the cash balance with the bank is reconciled back to your general ledger (or checkbook), you don’t know how much cash you have available to spend. Your accounts should be reconciled at least once a month, and more often than that if cash is tight.

A common measure of effective cash management is the cash conversion cycle (the number of days it takes to convert cash input costs into cash receipts from customers). This is also known as the “cash cycle.” In a nutshell, it simply measures how long it takes to convert cash into inventory and then through sales convert back into cash (cash cycle = days inventory outstanding – days payables outstanding).

To calculate the cash cycle, we need to first figure out how many days our cash is tied up in inventory. To do this take your cost of goods sold (COGS) and divide it by your
average inventory (don’t use just your ending inventory).

Let’s say your COGS for the year was $750,000 and your average inventory was $200,000 (beginning inventory of $150,000 + ending inventory of $250,000, divided by 2 = $200,000). Your inventory turnover (or “turns”) is 3.75 ($750,000 divided by $200,000 = 3.75). To convert this ratio into days, divide 365 by the inventory turns, which gives us 97.3 days. This is how many days you own your inventory.

But since you don’t have to pay your suppliers on delivery, you may not actually have to pay out any cash for a portion of the 97 days you’re holding the inventory. So, we need to calculate the days payable outstanding.

Accounts payable are unpaid bills from suppliers. This ratio tells you how many days you wait (on average) to pay a supplier.

Take your cost of goods sold (COGS) of $750,000 and divide it by your average accounts payable balance (say the average is $75,000). This would give us an accounts payables turnover ratio of 10. Divide 365 days in the period by the payables turnover ratio for a result of 36.5 days. This is how many days your suppliers are funding your cost of goods sold. Is this cheaper than bank financing? Maybe!

Next we need to determine how many days’ sales you’re financing in the form of customer accounts receivable. Take your sales for the period (say $1,000,000) and divide
this by your average accounts receivable (say this is $90,000). $1,000,000 divided by $90,000 = 11.11. Divide 365 by this ratio for a result of 32.85 days sales outstanding. If you’re offering 30 day terms, this ratio is telling you that, on average, your customers are waiting until the invoices are past due to pay you. Not a great scenario.

Finally, putting it all together for the cash cycle. If we take our days inventory outstanding of 97 days, minus days payables outstanding of 36, plus days sales outstanding of 32, we get a cash cycle of 93 days. This means that it takes 93 days to convert your cash into inventory and back to cash.

Another metric for short-term liquidity is the current ratio.

It’s an easy calculation: current assets minus current liabilities.

For most small businesses, current assets consist of cash, accounts receivable, inventory, and prepaid expenses. Typical current liabilities include accounts payable, credit cards payable, and accrued expenses. The current ratio should be at least 1, ideally higher. The limitation of the current ratio is that current assets include some assets like stale inventory or even old accounts receivable that may not be immediately converted into cash.

To address this limitation, we can look to the acid-test, or quick ratio. It’s the same as the current ratio, except inventory and prepaid expenses are excluded from the numerator. We’re left with cash and accounts receivable to compare to our current liabilities—a better picture of our short-term liquidity.

No single ratio gives us a complete diagnosis of our cash position, and there are many more not mentioned here. These are just several of the popular and basic ones.

Preparing a statement of cash flows is the best way to look at how cash was generated and used over a period of time, such as a quarter or a year. What a lot of entrepreneurs don’t intuitively grasp is that profit does not equal cash flows.

If a business generates a healthy profit for the year but ends up with no money in the bank at the end of the year, the statement of cash flows will tell us where that cash went.

Let’s suppose the profit & loss statement of Lean Sheds LLC showed a bottom line of $200,000 for the year 2016 but had no money left at the end of the year. We review the statement of cash flows and notice that accounts receivable increased by $50,000 during the year. These sales were included in our revenue even though the customer hasn’t paid yet.

Next, we notice that Lean Sheds, LLC had purchased $50,000 of equipment. Finally, we see that the owner of the business had taken out $100,000 in the spring to pay prior year taxes and make some renovations to his home.

Now we understand where the profits went. This example is a bit oversimplified, but hopefully helps makes the point: profits are not equal to cash flows.


Planning Cash Flows

As the popular adage has it, “Failing to plan is planning to fail.” Think back to a time when you were really tight on cash. What was the event that caused the cash flow crunch? Perhaps a key dealer went bankrupt and you had to write off a large amount of accounts receivable. Or maybe sales slumped due to a recession.

Was the pain avoidable or unavoidable? If a recession made things tough, this is a largely unavoidable occurrence (although steps can be taken to mitigate your own risk). Was it caused by a recurring event or a one-off occurrence? If the event was both avoidable and recurring, there’s a high probability that it can be prevented from happening again.

For instance, setting credit levels and implementing a clear and effective collections process can help speed up cash receipts and avoid customer write-offs. For an RTO provider, creating a cash flow forecast in advance of busy season is critical to ensure sufficient cash on hand. If you’re experiencing rapid growth, up dating the cash flow forecast quarterly or even monthly is a good way to go.

Managing Cash Flows

Are there more ways we proactively manage our cash? Verne Harnish and the team at Gazelles summarize seven financial “levers” available to managers to improve cash flows. I add a bit of application to our industry.

Price: You can increase the price of your goods and services. Depending on the local competition and market conditions, raising prices across the board may not be advisable. But perhaps pricing can be adjusted for shed options, furniture or other ancillary items in order to increase gross sales. Applying a bit of pricing strategy can help move the needle in the right direction.

Volume: You can sell more units at the same price. Creative marketing and ambitious selling are the key to pushing up volume. Retailers may choose to offer discounts for early shoppers (say late February in the Northeast) to win a few sales that may have gone to a competitor later in the season. Earlier sales also boost cash flows during the seasonal winter slump.

Cost of goods sold (COGS)/direct costs: You can reduce the price you pay for your raw materials and direct labor. Negotiating for better prices never goes out of style. I am often surprised at the deals that are available when I just ask. Buying lumber in large volume at the dips in the market is a viable option (if you have the cash).

Operating expenses: You can reduce your operating costs. Look for waste in general spending. The next step is to identify costs that could be replaced with a more effective solution. For instance, what is your ROI on current marketing expenses? Could you get the same impact for less money? Make sure your dollars are spent intentionally.

Accounts Receivable: You can collect from your debtors faster. Having clear credit policies and good procedures for collecting AR is key. Having the right accountability structure for your staff is necessary to ensure execution is happening as expected.

Inventory/work in progress: You can reduce the amount of stock you have on hand. Reducing the inventory on hand means more cash is freed up for other uses. The trade-off with Just-In-Time inventory practices is the bulk purchasing discount (mentioned earlier). Your cash position will set your parameters. All things being equal, less inventory is more (cash).

Accounts Payable: You can slow down the payment of creditors. Brushing up on negotiating skills can help you win better terms with vendors. Perhaps 15 day terms can be moved back to net 30, or even longer. If a vendor prefers quick payments, ask for terms discounts.

Controlling Cash Flows

Controlling cash flows isn’t an easy task. Planning ahead, thinking creatively and investing prudently go a long way toward achieving healthy cash flows and long term sustainability.

Finally, tap into the expertise and experience of your accountant and banker to better understand the financial position of your business and get more ideas for improving cash flows.


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