Cash Flow is the Lifeblood of Business

Cash is King! All business comes down to two things: 1) Cash In and 2) Cash Out. The difference between the two over any period of time is your cash flow.  Understanding the difference between your accounting income and your cash income is crucial (although most businesses keep cash or modified cash based records).  Sales are great…more sales are better…but if you are not collecting those sales in a timely manner you are loosing cash. Lets dive into this deeper. Looking at financial statements based on Generally Accepted Accounting Principles we will find several accounts that differ from actual cash flows:  The first, as mentioned, is sales. GAAP recognizes a sale typically when the product has been delivered even if it has not been paid.  The difference between sales and collections can be significant, especially in startup companies and those with large write offs for bad debt.  The second is Cost of Goods Sold which is the cost of the merchandise or finished goods matched unit for unit to a sale.  Again, GAAP costs all units on hand even is not paid for…that is units paid for on trade credit (Accounts Payable).   The third is depreciation, which is the expensing of large company assets over their useful life.  Depreciation is a non-cash expense, which mean that it is deducted for tax purposes but not paid for.   The fourth is the inclusion of only interest payments for loans.  Because principle is not deductible it is not included on GAAP statements only on the statement of cash flows.   Finally tax payments are shown monthly but are actually paid quarterly.   Breakeven and the Cash to Cash Cycle Understanding cash flow is imperative to determining your breakeven point. Generally, break even is calculated by dividing your over all fixed costs by your gross profit per unit sold (revenue per unit – cost of good sold per unit). This calculation will only tell you what breakeven is based on accounting profits.  A separate method has to be used to determine your cash breakeven point.   A second issue is the cash to cash cycle or cash conversion cycle.  This cycle is the amount of time between your cash payment for merchandise and inventory and the collection of sales on credit.  A company with a negative cash conversion cycle, like a restaurant, can grow uninhibited by the need for cash.  A company with a short cash conversion cycle, like a retail shop, will need some additional cash when experiencing growth.  And, finally, a company with a long cash conversion cycle, like a manufacturer, will need large amounts of permanent working capital (term debt) and access to short term working capital (lines of credit) when it experiences high rates of growth.  In fact, supernormal growth in a company with a long cash cycle can make it bankrupt…making cash management and controlled growth the key to successful manufacturing companies.     Determining Cash Flows Ideally, as an entrepreneur, you will forecast your sales, collections, and budget your costs and other expenses using a business plan program. Once completed you should be able to look at the cash balance from month to month and anticipate any shortfalls in cash that need to be financed.  If you are not confident in your business plan or it seems too complex here is a step by step approach to determine your cash needs.   Step One – Determine Cash Inflows Cash inflows generally occur from cash sales (currency, check, credit card) and collection of sales on credit.  Forecast a reasonable collection period knowing that if your terms are net/30 that some will pay in 30 and others in 45.   Step Two – Determine Cash Outflows  Detail all of your expenses on a cash basis.  List and date all of your expenses month by month or week by week if you have that data available.  Examine which expenses have a fixed date for payment and analyze which could possibly be changed to smooth out your cash expenses.   Step Three – Analyze the Timing of All Cash Flows Keep in mind the seasonal patters and business cycles within your industry while you estimate the timing of cash flows. Businesses generally have two growth patters: 1) revenues and expenses grow at roughly the same rate and 2) large investments must be made in inventory and other expenses, processes must take place and sales must be collected before the revenues come in to cover those expenses.   Step Four – Change and Monitor your Cash Flow Determine which payments are set and cannot be changed and work around those payments.  Determine if you can stretch out your payables to suppliers without losing your good standing or trade credit privileges.  Cash on Demand from a supplier is a sure sign your business is in trouble.  Again change the timing of other payments to smooth out your cash flows.  Finally, determine any permanent working capital needs due to rapid growth and put financing capacity in place before you need it.     Cash planning is critical to successful growth of a small business and growth often causes shortages of cash.  Once you are short on cash very few lenders will issue financing because they will perceive your lack of cash as a red flag.  Anticipating that growth and the cash shortages it might bring will keep you ahead of the game.