Business and Operations
Business Advisor: March 2012
By Simon Francis
By Simon Francis
Business owners traditionally evaluate financial performance based on net income.
Business owners traditionally evaluate financial performance based on net income. Continuous efforts are made to improve the bottom line by generating new sales in addition to applying cost cutting measures. The common assumption is that to gain approval from bankers and other key stakeholders, strong profitability is the only measure that counts. Unfortunately, while profitability is important, cash is the real king of business. The primary reason that most businesses fail is due to the lack of proper cash management. Business owners tend to spend their time building the business instead of placing controls on managing daily cash flow. Frustration occurs as profitability increases and yet there is no cash in bank.
Let’s look at some important reasons why net income and cash are not the same.
The cash lag is the time between making payment for the initial receipt of goods and receiving payment from customers for goods sold. The time can be significant, especially for manufacturers, as materials purchased need to be put through the manufacturing process, packaged and then sold to customers. Shipment is only half of the battle. The business needs to collect its accounts receivable. This can take time as customers want to stretch out their cash flow as long as possible because they face the same demands. It is not uncommon for a manufacturer to experience a cash lag cycle of several months.
Companies that are in a growth mode tend to be cash strapped as a result of additional expenditures and working capital needs, specifically to finance accounts receivable and inventory.
Most growing companies invest in new talent, marketing and infrastructure at the beginning of a growth cycle. The cash outflow for these expenditures is made well in advance of receiving the end cash benefits. Business owners look for a return on their investment but need to be patient and understand that realization is not immediate. In addition, growing companies need to build inventory and receivables. Inventories are built to meet new customer demands and receivables are greater due to sales volumes. Although these assets are good working capital items they are not the same as cash and require financing similar to expenses, either from bank operating lines or personal funds.
Here are three easy tips to help your business improve cash flow management:
Understand your customers
As the business grows, the number, sophistication and demands of customers will also increase. Generally the larger the customer, the longer they will take to pay because they can. Large retailers such as Loblaw’s and Sobeys know they have influence and are important to suppliers since they represent a large volume in sales. As a result they will stretch out their payments as long as possible with the attitude that if the supplier doesn’t like it, they can go somewhere else. On the other side of the scale are the smaller customers, where the biggest fear is not collecting receivables at all.
Manage Accounts receivable
There is only one thing worse than not making a sale: making a sale and not getting paid. If a customer is late on payment, it’s not enough to assume that they will eventually pay. There needs to be follow-up and active communication about the timing to receive payment. Managing accounts receivable is a daily function that should be assigned to a no nonsense person in the organization who can be politely persistent. Although there are costs associated with providing customer discounts, it is a business tactic to help improve collections. This shouldn’t be a bonus for paying when amounts are due; however, a two per cent discount if paid in 10 days or one per cent discount if paid in 30 days will assist with predictability of cash inflows.
As mentioned earlier, payment for goods and materials occurs at the beginning of the cycle. The last thing that businesses want is to disappoint their customers with short shipments due to insufficient inventory levels or not having the product at all. The common thought is that carrying more inventory items and quantities than necessary is better for business. However, carrying too many inventory items (SKUs) can be a detriment to the company. First it’s detrimental to cash flow, difficult to manage and the risk of obsolescence is high. Second, and usually forgotten, is the power of brand equity. The business wants to be known for something and have the product sell itself. Think about the most popular brand of ketchup or of facial tissues – both are commonly known under a specific brand name. These companies are not worried about expanding the amount of product they carry. They are concerned with continuously promoting their core products and only creating and offering new complimentary products after the appropriate market need assessment has been performed. For successful inventory management, moving all products rapidly is of the upmost importance. Don’t be afraid to tell a customer that certain products are not carried by the company. The “all things to all people” business model has proven to be unsuccessful.
It’s important to note that the traditional thinking that business profitability matters the most is short sighted. Cash is truly king as it provides operational flexibility as well as opportunities to enhance product lines, invest in research and development and provide business owners with the reassurance that they don’t have to manage cash flow on an hourly basis. It is common for investors and lenders to request cash flow reporting and forecasting in addition to or even instead of the standard profit and loss forecasts. In these uncertain times it is recommended that cash forecasts be included in the monthly or weekly financial reporting package. Remember that every business decision should be evaluated from both a profitability and cash flow perspective.
Simon Francis, a partner in the audit and assurance practice at the Toronto office of Fuller Landau LLP. Simon can be reached at (416) 645-6583 or firstname.lastname@example.org.