(Thirteenth instalment of the
upcoming book Natural Enterprise.
List of previous instalments here.)
 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:
- Understanding cash flow: The components, critical business
decisions and calculations that comprise and impact cash, the true
'bottom line' for most entrepreneurs.
- Analyzing cash flow: Looking at both historical and
forecast cash flow, detecting possible problems and opportunities for
improvement.
- Budgeting cash flow: Creating a flexible, current cash flow budget that will prevent and detect cash flow problems.
- Improving cash flow: Techniques to deal with cash balances that are dangerously low or reduce your buying flexibility.
- Filling gaps in cash flow: What to do when you don't have enough.
- 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:
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Period 1
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Period 2
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...etc.
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Total
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A. Opening cash balance (row E from previous column)
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B. Cash receipts:
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B1. Sales (cash + credit)
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B2. Receivables, beginning of period (row B3 from previous column)
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B3. Receivables, end of period
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B4. Loan proceeds and capital injections
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B5. Interest and other investment income
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B6. Total receipts (B1+B2-B3+B4+B5)
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C. Cash disbursements:
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C1. Expenses and inventory purchases (cash + credit, exclude depreciation expense)
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C2. New capital expenditures (equipment, premises etc.)
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C3. Payables, beginning of period (row C4 from previous column)
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C4. Payables, end of period
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C5. Loan and capital repayments
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C6. New investments
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C7. Total disbursements (C1+C2+C3-C4+C5+C6)
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D. Cash flow for the period (B6-C7)
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E. Ending cash balance (A+D)
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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.
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MADE IN CANADA
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