Further to my recent post about cash flow, my client asked me what their company could do if they thought there was a risk of over trading and have a cash flow problem?

Just to recap, the problem of fast growth is that you need to produce more goods or deliver more services and the timing between paying your suppliers and creditors and your receipt of funds from your clients creates a funding gap and a cash shortage.

Using the Six Minute Strategist methodology, let’s look at this under six headings

Assets

As assets build up they suck in cash. So to mitigate the problem you need to reduce the build up of assets.  How can you do this?  One solution is simply to sell less but this could do long term damage to your business. It is better to try to negotiate better terms with your customers. This might include asking for some payments in advance or agree shorter payment terms, 14 days rather than 30 perhaps.  Faster payments leads to better cash flow.

Liabilities

If you are paying any of your suppliers in advance or quickly, arrange to extend your credit terms perhaps to 60 days from thirty or stage your payments to them.  In any event, where you can you should avoid paying in advance for any services.

Prepayments is a slight anomaly as a prepayment is a source of cash, a customer has paid you in advance for goods and services to be provided in the future.  However under UK accounting rules as you don’t actually own the money until you fulfil your side of the contract and so it is accounted for as a liability.

Clearly while you need to pay your taxes on time, including Corporation Tax, VAT and PAYE, if you are in difficulties you can discuss this with the taxman (at least in the UK) and try to negotiate for some more time.   For other liabilities, you can negotiate with your landlord or electricity company for example to extend the timetable of the payments you owe them.

The clear message here is that TIME above all is your enemy.

Funding

If the first two steps do not solve your problem, you should consider how you might get additional funding into your business.  This might involve a discussion with your bank manager to get an overdraft or a short term loan.  If your problem is caused by a large order you might be able to turn to factoring or invoice discounting.  In essence, the bank or a finance house pays you the value (with a small discount) of your outstanding invoice and collects the cash themselves a little later.

If the Bank cannot solve the problem, your business may need some additional capital in the form of debt, a convertible or equity from either existing shareholders or third party investors.  The former can be faster but raising capital from new investors can take between three and six months.

One of your last resort solutions is to try to use your credit cards to provide some liquidity.  This is expensive and a very short term solution and not one I would recommend.

Ratios – Watching the Trend

In my first blog post, How do you Account for Cash?  I explained the three ratios which help to keep a close eye on the health of your working capital. The Current Ratio, The Quick Ratio and the Cash Flow Ratio.  You can go back to the original post and see the definitions there.

The important point about these ratios is not the snap shot you get on the day you calculate them but in their trends over time.  Set up your accounting system to capture this information daily and enable you to graph it or capture the ratios in your own spreadsheet and watch them over time.  You can go back to the underlying data to see why the trend is positive or negative and what parts of your working capital are having the most impact once you understand what you are looking for.

Remember the story of the frog in the boiling water, if the water is brought to the boil slowly, the frog doesn’t notice the heat going up!

Debtor and Creditor Days

This is a measure of how quickly you collect your debts and how quickly you pay your creditors and is another easy ratio calculation you can do to help you monitor your working capital.

Debtor Days – divide your trade debtors by Sales and multiply by 365.  You can also take your debtor days at two different dates, take the average of them and divide by sales and then multiply by 365.

To calculate Creditor Days – take your annual purchases or cost of goods sold (a proxy only) and use this denominator.  Divide Creditors by this and multiply by 365.

Clearly you want to be collecting your debtors faster and paying your creditors more slowly.

Be proactive – Watch the cash

The key point to remember is to manage your working capital proactively and anticipate the possibility of problems arising.  The best way to do this is to prepare and manage your own Cash Flow Forecast.  Remember that this will require a financial mode, which includes the profit and loss account, the balance sheet and cash flow.  This model must be integrated between the three and must not be circular.  Once set up you can model different scenarios and ask “What if?” questions.

If you think you are about to win a huge contract and this will put your working capital under pressure, take the initiative and take control of the situation.  Early conversations with your bank manager or shareholders to discuss how this can be funded can help prevent the problem turning into a crisis.

With customers you can try to improve the payment and delivery terms in the negotiations while you are closing the deal, but be careful not to put your customer off.

My last point here is to involve all your Staff.  Keep them appraised of the performance of the company and encourage and reward them for coming up with ways to improve business performance, profitability and cash flow.  They are in an excellent place to save money and to identify areas where further savings and efficiencies can be made.

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I have been doing some advisory work for a client and the subject got on to the importance of cash flow.  This is such a critical topic for small businesses that I thought it was worth publishing a Six Minute Strategist post about it

What is Cash flow?  Profits measure the performance of a business over a period of time but in order to show a true picture, accounting rules and conventions use accrual accounting to smooth out timing differences.  The result is normally that profits measured at any point in time rarely equal cash.  Cash flow is therefore the actual cash generated by a business on a day to day basis.

How do you calculate Cash Flow?

Lets concentrate for the moment on Cash Flow from Operations. (We can get on to Financing and Investment Cash Flows in due course).  Operational Cash Flow is the cash generated by the business.

The first part is the positive side of the equation – the cash generated from customers.  Essentially this is sales.  However, the recording of a sale and the receipt of the cash for that sale can be weeks or months apart.  The debtors or receivables account records the sale until it is paid off by the client settling his invoice.  In cash flow terms, this is a USE of cash – i.e. your cash is tied up until the customer sends you the money.  When measuring cash flow, it is important to look at the increase in the asset side of the working capital account and make sure that this is fundable.

On the other side of the account, the creditors or payables side, you record the accounts to whom you owe money.  This can include payments to your suppliers, tax and social security, heating, rents and rates.  If this account increases – i.e. you do not pay your suppliers, they are funding your business and it is a SOURCE of cash.

These movements in working capital are the key measures against which you can calculate the actual cash generated by your business, week to week and month to month.

Another area to watch carefully is the Non-Cash Adjustments to your profit figure – predominantly depreciation and amortisation.  These are long term adjustments to balance sheet assets reflecting the gradual use of these assets over time.  They do not involve any cash going out of the business.  That happened when you acquired the asset.  Operating cash flow is therefore adjusted for any not cash elements before calculating the changes in working capital.

Investment Cash Flows are the capital and operational expenditures into your business.  These items are reflected in the balance sheet and not the profit and loss account unless your accounting policies specifically enable you to write these off as incurred.  Be mindful of the tax implications too (beyond the scope of this post and my expertise too!)

Financing Cash Flows are monies received by the business to further enable it to fund itself.  These can be in the form of  wide variety of financial instruments; debt, equity, convertibles etc.  The negative side of these entries are the repayments made by the company to these investors and funders and include dividends.

How can you measure Liquidity?

If cash flow is the life blood of a business, liquidity is a measure of its fitness – its ability to respond to adverse events.  There are three ratios which we can look at – the Current Ratio, the Quick Ratio and the Operating Cash Flow Ratio.  These are simple to use and you can use them in your business by simply opening your report and accounts.

The Current Ratio is a measure of the relationship between current assets and liabilities.  In short, do you have enough assets (people owing you money) to repay your liabilities (people to whom you owe money).  The slight catch here is that if you had to try to liquidate your receivables quickly would you be able to get full value for them.

The Quick Ratio deducts inventories and prepayments from current assets and then divides the remainder by current liabilities.  This recognises that some of these assets are not readily fungible (not easy to turn into cash at short notice).

The Operating Cash Flow ratio divides the operating cash flow from the business by the current liabilities and recognises the ability of the business to settle its creditors and other monies owing from operational cash flow and does not involve the sale of any current assets.

Why is this important?

One of the greatest risks faced by growing companies is something called “Over Trading”.  This happens when the company grows too fast.  The debtors/current assets of the business expand too fast and the company is unable to fund the timing gap between selling a product or service and recovering the cash for this from its clients.  At times like this, companies may need financial investment or loans from their banks and if this has not been anticipated in advance it can lead to substantial dilution for equity holders or in the worst case, the failure of the business in its entirety.

If you like this please RT.  If you would like to receive more from me, The Six Minute Strategist, please subscribe and join my mailing list.  You can comment below or email me at john[at]jbdcolley[dot]com.