MANAGING YOUR BUSINESS’ CASH FLOW AND WORKING CAPITAL

Enterprises fail for two main reasons: They make poor business decisions, or they run out of cash. Much of Natural Enterprise has been about how to make business decisions knowledgeably and intelligently, taking the risk out of selling and marketing by doing thorough advance research on what people need and by letting your customers ‘virally’ market for you, and taking the risk out of financing by doing it yourself, organically. This chapter is about managing cash.

While it’s obvious that if your cash outflows consistently exceed your cash inflows, eventually your business will be bankrupt, many businesses still run out of cash because either (a) they are overly optimistic in forecasting cash flow and budgeting expenses, or (b) they don’t track cash carefully enough and find themselves with a brief, but catastrophic, shortfall. And as we all know, if you need cash quickly and urgently, that’s precisely when lenders are most reluctant, and cost is highest.

A company I advised a few years ago in the computer systems business found itself in a cash crisis because it was too successful. The entrepreneur was well connected, knew his product line well, and priced his products fairly yet competitively. As a result, his business grew explosively. After starting with small and medium sized customers, he moved up to large enterprises and public institutions like schools and hospitals. His revenues were growing at 15% per month, quintupling each year. The problem was, his large customers, especially those in the public sector, often took two or three months to pay for their systems once they’d been installed, the larger systems took longer to install (he couldn’t hire competent people fast enough to keep up with the demand), yet the manufacturers insisted that this new ‘upstart’ company pay them within 30 days. The entrepreneur was going back to the bank every month to negotiate larger and larger loans to finance his receivables and inventory. Eventually they balked, and he had to negotiate more expensive financing with a technology financing company, with some major concessions if his company defaulted or exceeded their credit limit. Despite my counsel, he refused to turn away business to slow down his rate of growth to a manageable level. He was getting backed up with expensive inventory sitting waiting for other system components to come from other vendors, some of which were now demanding cash on delivery, and was accumulating a lot of products returned under warrantee for repair and replacement, which vendors, instead of buying back, instead credited to his (overdue) account. Some customers got impatient with delayed deliveries or faulty components and cancelled orders, leaving large amounts of unsellable stock in inventory. Additional, expensive warehouse space was rented. To try to speed up repairs, a massive quantity of unbudgeted repair parts was stocked. The lender was now reviewing the company’s receivables and inventories weekly, writing down the 90-day-old receivables from school boards that took months to approve and disburse capital expenditures, and from customers refusing to pay for incomplete or unsuccessful installations, and writing down also the inventories of returned parts and repair parts. Lending was frozen, and the company was warned that unless debt was reduced they would exercise their option to seize the assets, convert their debt to voting control of the company, and/or place the company in the hands of a receiver. Desperate, the entrepreneur, who was now spending all his time looking for secondary financing instead of running his business, made the worst possible decision: He called in the employees and announced that he would have to delay payroll for two weeks. Stressed-out employees quit in droves, and the business collapsed.

It takes enormous self-discipline to say ‘no’ to customers you’re just not scaled up to handle. Good cash flow management processes can help you exercise that discipline. The CCH Business Owners’ Toolkit breaks cash flow management into six components:

1. Understanding cash flow: The components, critical business decisions and calculations that comprise and impact cash, the true ‘bottom line’ for most entrepreneurs.
2. Analyzing cash flow: Looking at both historical and forecast cash flow, detecting possible problems and opportunities for improvement.
3. Budgeting cash flow: Creating a flexible, current cash flow budget that will prevent and detect cash flow problems.
4. Improving cash flow: Techniques to deal with cash balances that are dangerously low or reduce your buying flexibility.
5. Filling gaps in cash flow: What to do when you don’t have enough.
6. Handling surplus cash flow: What to do when you have too much.

Let’s start with a bit of Accounting 101.

The term working capital refers to cash and securities, plus receivables (amounts due from customers) and inventory (raw materials, work in process and finished goods), less payables (amounts due in the next month or other operating cycle to creditors). The term liquidity describes your ability to sell inventory at its retail value, and collect receivables on a timely basis, to pay current payables (also called current liabilities). The net amount of your working capital (after adjusting for receivables you don’t think you can collect and inventory you don’t think you can sell) is a measure of your business’ solvency: If this net amount is a negative number, you are technically insolvent, and depending on the terms of your arrangements with creditors, you may be forced into receivership or bankruptcy.

A cash flow budget starts with your opening cash balance, adds expected receipts for each period, and subtracts expected payments for each period, to forecast a closing cash balance. Cash receipts consist of cash sales proceeds, amounts you expect to collect on outstanding receivables, and proceeds from any loans or capital injections. Cash disbursements consist of cash purchases, amounts you expect to pay on outstanding payables, loan or capital repayments, and new investments. So your cash flow budget, forecast, and actual statement looks something like this:

So for example if you buy a new machine that costs $50,000 but finance $40,000 of it through the bank, the $50,000 is included on line C2, and the $40,000 on line B4, so the net cash impact for the period is $10,000 (your down payment); as you make payments on the new loan, those payments go on line C5. The numbers that go in row B1, C1 and C2 will come from your sales forecast, your expense budget and your capital budget respectively. (My book Natural Enterprise will include downloadable cash flow spreadsheets with additional detail). A brand new business will often include a ‘Period 0’ column to show start-up capital and start-up expenses before operations begin.

This model is adaptable to businesses in almost any industry, and depending on the volume of receipts and disbursement the periods can be as short as a day or as long as a year. The calculations are the same. As the business operates, you can overwrite the budget data with the actual data (or show them side-by-side) to see how accurate your forecasts were, and to update them. Accountants prepare a similar cash flow statement as part of the annual financial statements, except that they segment ‘operating’ items (B1, B2, B3, C1, C3, C4) from ‘financing and investing’ items (B4, B5, C2, C5, C6) to compute separately ‘cash flow from operations’ and ‘cash flow from non-operating activities’.

Once you have your cash flow budget done, the most important thing to do is shop it to your business colleagues and others you trust for their assessment of its reasonableness. You should have both accountants (who can check the math and the assumptions) and people who understand your business (who can check the plausibility of your forecasts) look at your cash flow budget regularly — this will help make your forecast more accurate, without which it’s not of much value.

It won’t take long for you to learn to analyze the budget and actual data and find danger signs and opportunities. If cash flow varies significantly from your forecast: Were your sales and expense forecasts reasonable? Is cash being collected faster or slower than expected? Are bad debts (receivables you cannot collect) different from expected? Is inventory moving faster or slower than expected? Are inventory writedowns (products you cannot sell for full retail) different from expected? Regardless of the reason for the variance, does this suggest you need to revise your budget for future periods?

If collections are slow or bad debts high, you may need to change your credit terms for some or all customers. This is a balancing act: If your credit is too tight, you’ll lose customers and business, but if it’s too loose you’ll end up writing off receivables, which is even worse. Some businesses offer discounts to customers who pay promptly, and again the rate needs to be chosen carefully: Too high and the discounts cut into your margin, too low and customers won’t be incented to pay their bills promptly. And collecting interest on overdue accounts is a difficult and often futile process. In some cases you can even accelerate your cash receipts from customers further by getting deposits (cash before delivery), issuing progress billings (getting part payment for work you haven’t finished yet), asking for cash on delivery (usually only practical with small, retail customers and customers with poor credit ratings), or asking for an annual retainer (common in professional services businesses). Depending on the nature of your customers, you may want to have them sign credit agreements (that improve your position if they are slow or if they default) and/or do credit checks on them (either yourself or through an agency). In some businesses, the sale of receivables to a third party (called factoring) is common. This can significantly accelerate your cash flow, but depending on the quality of your customers can carry a heavy, even prohibitive, price tag (the factor’s fee can cut significantly into your profit margin). Some factors merely collect receivables for you, leaving you with the bad debts, while others pay a percentage of the receivable up front and accept some or all responsibility for accounts they can’t collect. Talk to a financial advisor before factoring, and check the factor’s credentials with other customers.

If the sales cycle (the period from first customer interest to actual purchase) is longer than expected, look at ways to make it easier for the customer to buy. While this depends on the product and customers, consider helping them with financing, offering delivery, taking credit cards or debit cards or PayPal type online credit and cash clearance options, offering layaway, or using other attractive and creative sales initiatives. But be cautious about lowering your prices: If you’ve done your homework following the advice in this book, you should have set your price correctly in the first place, and lowering it is unlikely to help you sell more, and will lower all customers’ perceived value of that product or service. And if your customers catch you raising prices later, reasonably or not, they will probably resent it. Look at your own processes as well: If you offer credit, get your bills out promptly and make it easy to pay (e.g. offer prepaid return envelopes). It can sometimes even be worthwhile to visit a customer in person just to pick up a large cheque. If you sell business-to-business across the country or beyond, consider arranging ‘lockbox’ accounts in each major city so that the local financial institution credits your account the day payment is received, and money isn’t tied up in the mail.

If your cash flow shortfall is due to higher-than expected inventory levels or write-downs, you may need to revisit your contractual arrangements with your suppliers. Will they sell to you on consignment (i.e. will they take back, at full price less a restocking fee, what you are unable to sell to your customers)? Are the vendors’ return provisions and warrantees reasonable? Remember, you’re the middleman between your vendors and customers, and no matter what your sale terms, customers expect you to look after their problems, and will be unhappy (and stop buying from you) if they’re foisted off on an uncaring or unreasonable manufacturer further up the supply chain. Careful inventory management is critical to businesses that sell someone else’s product. There are two additional keys to good inventory management: (a) Calculate and buy ‘economic order quantities’ — the amount that qualifies for volume purchase discounts but doesn’t give you more than you can sell in a reasonable time period, and (b) Maintain for each product just enough so that the costs of carrying inventory (costs of financing and stocking it) equal the costs of not carrying it (missed sales) — yet another balancing act. Many entrepreneurs err on the side of having too much inventory and holding it too long before selling it off at a discount. All of these practices and decisions have a major, and often unexpected, impact on cash flow.

Likewise, ensure you taking advantage of volume and early-payment discounts from your suppliers. Both these discounts sacrifice short-term cash flow for larger, longer-term cash flow, but if the discounts are significant you will want to take advantage of them — if your cash flow will allow it. Negotiate the longest payment terms you can with your suppliers, but never abuse their trust — if you’re slow paying it will soon start showing up in the price you pay. And consider leasing rather than buying to defer the cash flow impact of capital purchases — but check the implicit interest rate in the lease first — some of them are usurious.

Is your ending cash balance for each period high enough to avoid the need for unbudgeted loans or cash infusions? If not, or if your cash balances jump around a lot from period to period consider setting up a ‘sweep’ account — an account that will provide reasonable-cost overdraft protection for short periods, and will automatically transfer longer-term shortages to lines of credit and longer-term surpluses to higher-interest accounts. This can free you up from making day-to-day decisions about cash shortages and surpluses, and lets you take a longer view of cash and business management. If cash balances remain very high, which is common among entrepreneurs with the wisdom to set aside a ‘cash reserve’ early on, consider whether the excess can be invested in something that will allow you to liquidate it if and when you do need the cash.

If cash balances remain unexpectedly low, diagnose the reasons and use the cash and working capital management techniques listed above to try to solve them. Don’t let unsatisfactory cash flow drag on and just hope for the best — if your business isn’t generating the cash flow you expected despite all your advance research, you need to go back and look at the business plan and reassess the viability of the enterprise. I’ve seen entrepreneurs pour some of their own money back into a business which no longer fills an unmet need, and end up needlessly personally bankrupt. Talk to people you know — accountants, other entrepreneurs, even competitors, and objectively assess why your enterprise isn’t performing as expected. And fix the problem before you throw more cash away.

If your business is international, there’s an additional cash headache to consider: foreign exchange costs and fluctuations. If you do a lot of business in a foreign currency, set up an account denominated in that currency and only transfer occasional large sums between it and your domestic account, to avoid much of the arbitrage costs of constant conversion. If you have significant assets, inventories, receivables or loans denominated in a foreign currency, you might want to consider hedging against foreign exchange fluctuation. This won’t give you a windfall if the foreign currency moves in a propitious direction, but will protect you if it goes in the opposite direction. If you do this, get expert advice — hedging is a complicated and sometimes expensive process.

Managing cash is one of the most tedious aspects of entrepreneurial business, but it’s an essential one, and one that should not be left up to your accountant or outsourced. It’s the pulse of your business’ financial health, of customer satisfaction, and of the value that your enterprise is providing. Just like every other aspect of your business, with proper planning and management it can be a ‘no surprises’ experience — which is exactly what you want it to be.