Why Growth Doesn’t Always Solve Cash Flow Issues
Most companies start with a great idea that solves a problem for the consumer or for other companies. People are hired, products and services are developed, and customers are acquired. After the blood, sweat, and tears that come with the startup phase of the company, the next logical phase is growth. Where we get fooled is thinking that growing the revenues and gross margin will be enough. Unfortunately, profit alone is not enough to grow companies.
While increasing revenue certainly is the starting point on the path to growth, it’s definitely not the whole enchilada. The next step is to get very good at managing Working Capital. I’m sure you’ve heard that most business don’t fail due to lack of revenues (and profit) but they lack the cash for growth. Cash is the result of managing Working Capital in your business…in all businesses. So let’s take a deeper dive into understanding this financial intelligence fundamental.
There are two Working Capital concepts: the Balance Sheet concept and the Operating concept. The Balance Sheet concept is used to determine your liquidity (i.e. ability to meet short-term obligations). I’ll be discussing this in more depth in my next article on how to increase your Working Capital. The second concept that we’ll focus on here is the Operating concept. It consists of three primary operating activities:
- Purchasing resources
- Using the resources to produce your product
- Marketing and selling your product
The financial term for this is the “cash operating cycle” also known as the “cash conversion cycle”. In simple terms:
How long it takes from the outlay of cash (purchasing resources) to convert back to cash.
With most companies this is the first metric we explore both to understand the business operations and to establish a benchmark so we can measure future improvements. Once it is measured and understood, it can be improved. The formula to determine your cash conversion cycle is:
+ Days of Sales Outstanding
+ Days of Sales in Inventory
– Days Payables Outstanding
We work with a cash conversion cycle calculator to begin to understand the numbers. While the formula is important to calculate the metric, what is more important is understanding each component in the formula so you can shorten the days in your cash conversion cycle. Fewer days in the cash conversion cycle means less cash to fund your current and forecasted operations. Many businesses look to their banks for lines of credit to fill the void of cash for maintaining or growing their businesses. While they certainly are a resource, they will not fund inefficient or poor performing cash conversion cycles. In addition, it is critical that you know the amount of Working Capital necessary to fund your growth. With realistic Profit Plans and related Cash Flow Forecasts, you can identify the levels of Working Capital required for growth.
My next article will take a deeper dive into each component of the Cash Conversion Cycle and how to improve it. In the meantime, if you’d like to get an understanding of your company’s cash conversion cycle, I’m happy to meet with you for a complimentary consultation. Just email me personally at firstname.lastname@example.org or visit our website at www.CFORickArthur.com.