3 ways business planning improves cash flow
Updated: Feb 12, 2020
"My sales are growing, and I am profitable; why am I struggling to pay my bills? Sound familiar? According to various studies one of the many challenges private businesses face is cash management. Many businesses owners will understand their markets, products, and even their profit numbers however this does not translate into cash. larger private corporations get this wrong sometimes even with more resources than a smaller enterprise. Cash management is difficult because there can be many variables that can cause shortfalls. It may be compared to squeezing a balloon. The causes for struggling cash or liquidity include working capital, capital structure, and sales profitability. In this article I’m going to highlight how a business can recognize the possible cause of their cash problem.
1. Why sales and profit do not equate to cash
Creating projections of sales and profitability to determine viability is a first step in understanding the numbers of your business. Unfortunately, a lot of the financial metrics used are based on larger more mature organizations that have reached steady state. As a newer and growing business owner your business has fewer product lines and customers. Small or large changes in customer behavior or the market competition, product availability can severely impact your business. The impacts could include change in volume, change in price, or change in product costs. I will walk through how pricing and volume changes impact your cash position.
If competition increases, lowering price may be the strategy used to increase or maintain sales to meet competitor pricing. Price reductions will increase volumes however they are hard to overcome as for every change in price an equal amount of profit and cash is lost to cover fixed expenses. A quick example is a product selling at $10 per unit and costs $5 per unit to make will result in $5 per unit profit. Let’s say your company was selling 100 units at $10 for $50 of profit. If you lower the price $1 at the same cost level it will require you sell 25% more volume to get the same original profit. Now if you lower price and keep volume the same your profit will be lower by 20%. Competing for customers on price will always reduce both profitability and cash flow. One should analyze if there is a need for more volume at a lower price. An excellent way to determine this is to always use a break-even analysis at every major pricing or volume change. A 20% percent reduction in cash flow can be quite challenging due to the ongoing fixed costs required of businesses such as employees, lease agreements for space, and financing used to start the business. In a scenario like this the business owner must inject more capital or take home less cash out of the business.
In non-cash businesses another common issue is changes in customer payment behavior after delivery of goods and services. Customers will take advantage of payment terms provided as that give them free financing. For the seller this introduces a timing issue where costs are incurred upfront while payments maybe delayed or never received. In a growing business this should be expected and planned for however some business planning models do not account for the timing of cash as this introduces an advanced finance concept of balance sheet structure and how it’s financed. Cash flow timing is hard to project in a newer business with less data points. Therefore, one of the key causes of financial misunderstanding is that of profit and loss projection vs cash flow. Timing is often not discussed in larger steady state businesses as they have consistent prior sales and payments to average out changes in expected incoming cash. A proper cash flow forecast will always prepare an owner from big swings in their cash flow and minimize personal outlays into the business. If properly planned for it will require an upfront cash investment to pay the run rate expense costs of the business
2. Growing your sales will eat your cash
Every successful business wants to grow sales year of year, month over month. Sales growth can be looked upon as success of sales and marketing strategy. This will always be excellent for a company with abundant resources to cover the investment growing sales require. This investment will grow incrementally as the size of the business grows. The first investment is working capital, or the cash required to purchase inventories, fund expanded payroll, and fund the time between sales and collections. As one’s business grows working capital will always grow and is often misunderstood. The funding for a growing will always start from the cash on prior profitable sales. If the profit is retained in the business this should not be an issue. If the business owner requires distributions of profits this will create a need for a constant search of new capital within the business. An example from the company that creates a $10 product with 50% product margin and requires one month to produce. In this quick example if a company’s sales average $50k a month and customers pay within 30 days the working capital will be approximately $100K. $50K to ensure the business has appropriate inventory on hand and another $50K for the sales sold on credit. If the company is growing fast at a rate of 25% per year that would equate to sales growing to $62.5K per month. If all else stays the same the working capital at any given month would grow to $125K. This 25% growth rate has translated to $25K of cash that the business must retain on a monthly basis. In real life situations its possible a 25% growth rate may require more capital as more volume may increase the cost of supply and holding costs as well as more risky customers that require more generous payment terms. Growth may also require your fixed costs to go up. New equipment, more space, and more employees. At this point we are changing the break even point of the business. Again, the business owner is required to sacrifice cash distributions or salary to keep the business afloat.
3. The solution is better understanding and preparation
To ensure the business owner is getting the appropriate cash out of your business requires a holistic review of the business. “know your numbers” as they say but be sure which are the right numbers for your business. It was pointed out earlier larger more established businesses don’t usually have these issues as they have access to resources such as planning, financing, and historical information to draw from. First things first if you have a product that is selling and you’re not getting cash out of the business it will either be a growth issue or a capital issue. Growth requires continuous cash investment in the business. A great example of this is Amazon, which had negative profits for over a decade and continuously invested large sums of cash into its business. Amazon knew they had a great business and projected which year they would turn from a cash negative to cash positive. Planning at this level will help a business owner understand the amount of cash investment needed to successfully manage the business without worrying about cash. This leads to the next solution which is appropriate financing. In finance there is a CFO saying that states your financing needs must be matched with your financing sources. While this may be a struggle for a new business trying to build credibility with financing providers, knowing when to use the right financing will help alleviate problems down the line.
4. Seeking the right cash flow solutions
This short article was meant to help business owners identify where the cash is in their business. If you’re already running a business and need help, I would first recommend a review of your company financials to see where you cash is within the business. This could be as simple as historical review of your cash flow statements built from your balance sheet and P&L. The next review should be that of your Accounts receivable aging and inventory aging. Is there a big customer that’s not paying on time? Is there a pricey product that’s not selling? Once this is investigated a strategy and direction can be set to ease cash flow problems.
5. Call to Action
If this article helped or you have a question on any of the topics above feel free to reach out to me at firstname.lastname@example.org