“Cash is king” is an adage that is often used to underline the importance of solid cash flow management. It also is the culprit, used to explain why so many small businesses fail. In uncertain economic times, companies are experiencing tremendous financial pressure and cash flow management becomes more relevant than ever before. Let’s face it — without the right amount of cash, your business could inadvertently run into major distress, and in extreme cases, even bankruptcy.
Managing cash flow requires that entrepreneurs understand the eight core drivers. For the best financial performance, all of these drivers should be simultaneously managed and optimized. The key influencers of cash flow are:
- Revenue Growth
- Gross Profit
- Overhead & Expenses
- Accounts Receivable (A/R)
- Accounts Payable (A/P)
- Capital Expenditures
- Taxes and Business Risk Management
A Deeper Look at Cash Flow Drivers
Every company has a sustainable rate of growth. Growing too fast will quickly deplete cash resources; while growing too slow can leave a lot of value on the table. To use a racing analogy: If you are racing a long distance race without an infinite fuel supply (i.e., cash), then fuel management becomes crucial. Drive too fast and the car runs out of fuel before the finish line; drive too slow and you lose the race.
Gross profit (i.e., revenue minus its cost of goods sold) is comparable with the fuel economy of an engine. A highly efficient engine leaves a lot of fuel in the tank. Gross profit requires special attention, especially for small businesses, because it literally drives cash flow. For companies that have gross profit built into the price, markup contributes well to cash flow. However, when higher prices are charged to increase gross profit you run the risk of slowing down your sales.
Lower profit margins, on the other hand, can boost sales, but contributes little to cash flow per sale. To optimize your gross profit strategy, as it relates to cash flow, it is a matter of planning your race and installing the right engine (with the right balance of revenue generating horsepower and cash flow generating fuel efficiency).
Overhead and Expenses
Overhead and expenses are additional cash flow factors that impact business performance. Keeping with the racing analogy, these things are much like a car’s weight, aerodynamic design, tires, etc. The rule of thumb is easy and intuitive: it’s always a great idea to find a means to make your car lighter and more streamlined (i.e. reduce overhead, administrative and management expenses, etc.) at every turn.
Accounts Receivables (A/R) and Accounts Payables (A/P)
Accounts Receivable is an accounting term that refers to the amount that customers owe you from sales made on credit. In contrast, Accounts Payable is money you owe to other vendors or suppliers. To create a good working capital strategy, (i.e., cash a business requires for its day-to-day operations) always collect faster than you pay.
Finding ways to collect cash faster and pay later requires some degree of ingenuity and imagination. If you collect cash slower than you receive cash, you are creating a net cash outflow (i.e, a deficit) you have to cover out of your pocket. This will have a huge impact on your ability to fund growth and pursue opportunities. The faster you grow, the wider this gap becomes and you can bankrupt yourself as a result of your own selling success. On the other hand, if you collect faster than you pay, you create a net cash flow surplus. In this case, your growth increases cash.
Generally, it makes business sense to keep as little inventory on hand as possible. If you hold too much inventory, you run the risk of product obsolescence and holding goods you can’t sell. If you hold too little merchandise, you run the risk of excessive back-orders and loss of customer good will. Managing inventory requires quantitative analysis, which may seem overwhelming to many small businesses. But a committed and objective analysis will help sales increase, decrease inventory, and contribute well to cash flow.
Capital Expenses (Capex) are the expenses you incur to make your business run smoother. When applied to my earlier racing analogy, essentially it makes your car faster and more fuel efficient. However, buy wisely with cash flow improvements in mind. For example, if you need a computer to create presentations and write email, you don’t require the latest and greatest hardware. In fact, you could delay buying a new computer equipment by 6 months (when prices fall). Thoughtful business spending helps you save a few dollars at every transaction, which quickly adds up.
Taxes and Risk Management
Having a good tax and asset protection plan in place (developed by consultants) is like having safety equipment and a good pit crew to support you in your race. Without safety equipment, racing is foolhardy, and having a good crew not only makes the race less stressful, it makes you more competitive.
A Baseline for Sustainable Growth
Especially for businesses seeking organic growth, good business judgment dictates being more cash flow centric than profit centric in A/R, A/P and inventory strategies. This, in many cases, translates to sacrificing profits to a) offer fast pay incentives on receivables; b) reject fast pay incentives on payables; and c) not buy excess bulk on inventory.
If you’re a startup or small business, effective cash flow management is absolutely crucial. This is especially important at a time when fundraising is harder than ever before, with startups vying for limited funding resources. Even venture capitalists evaluate a company’s cash flow management strategy to derive insights into how well the company is financially poised to fund growth and deliver to shareholder value.
Some CEO’s seek business loans and raising equity as the only means to boost cash and when they are faced with a cash crunch, they pursue rampant cost cutting measures that may aggravate problems later. Focusing on the core drivers of cash flow helps startups experience avoid this roller coaster ride and establish a baseline for sustainable growth.
Mithun Sridharan is the Managing Director of Blue Ocean Solutions PLC, a Germany-based Strategic & Collateral Marketing services company focusing on Technology product and service organizations. He has over ten years of International experience in Business development, Marketing, Global Delivery and Consulting. Sridharan holds a Master of Business Administration (MBA) from ESMT European School of Management and Technology, Berlin and Master of Science (M.Sc) from Christian Albrechts Universität zu Kiel, Germany. He is a Harvard Manage Mentor Leadership Plus graduate, a Project Management Professional (PMP) and a Certified Information Systems Auditor (CISA). Mithun is based in Eschborn, Germany.