Category Archives: Cash Plan

Beware of Cash Flow Traps

Yes, for sure, as a business owner you have to beware of cash flow traps.

Profits do not guarantee cash in the bank.

Let me show you the difference between profits and cash with a simple example. Take the estimates we have in the previous sections for the sales, direct costs, and operating expenses of Garrett’s bicycle shop. Put them together and you have the illustration here below as projected operating income (remember that income and profit are the same thing):

Sample Case Operating Income
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Now we compare that to a simple cash flow projection based on the assumption that the store makes 90% of its sales on account (to be paid later) and its customers wait two months to pay those invoices. (That would be unusual for a bicycle store, yes, but it’s the common case for most existing business-to-business companies.) Also, let’s assume Garrett keeps about a month’s worth of sales as products in the store, called inventory, that customers can buy; and he has to buy those products in advance of selling them. The result is cash flow vastly different from profits, as you can see in the following illustration:

Cash Flow Example

Conclusion: Profits are not cash

The difference between profits and cash, in this case, is more than $90,000 for a business selling about $30,000 monthly. That business would be profitable but bankrupt for lack of cash. And the change in the two scenarios is just cash flow, not a penny of sales, cost of sales, or expenses. No prices are changed, no new employees added, and no changes made in salary.

Here’s how that difference looks graphically:

Operating Profits vs. Cash

So you see it in this example: beware the cash flow traps. Profits are not cash in the bank.

Assess Your Cash Flow Risk

Cash flow risk assessment

Assess your cash flow risk with this simple method here. Your business might not have the factors that make cash flow so different from profits. Maybe managing sales and expenses is enough for your business. It depends on the specific factors here.

1. Product InventoryGive yourself 1 point if you deal with product inventory you have to buy and pay for before you can sell it. Add another point for each month of average inventory
2.Sales on Credit1 point if you have to wait for customers to pay invoices (instead of collecting all in cash, check, or credit card when you make the sale of deliver the service.) Add an additional point for every month beyond one that you wait, on average, for customers to pay.
3. Deposits in advanceIf you added a point for #2 above, subtract 1/2 point for having customers pay significant (35% or more) deposits up front.
4. Other SpendingAdd another point if you have to pay significant principle payments on debts, or purchase significant assets (equipment, vehicles, etc.)
5.Accounts payableSubtract 1/2 point if you pay expenses by collecting invoices from vendors and waiting a month or more before paying.

What the cash flow risk assessment means

If you scored less than one with this cash flow risk assessment, heave a sigh of relief and watch your sales, cost of sales, and expenses very carefully. You don’t have to calculate cash flow as a separate exercise. Develop and manage projections of sales, cost of sales, operating expenses, and other spending including repayment of debt and purchase of assets. Put your sales, costs, expenses, and other spending into a worksheet showing your projections for the next 12 months. And maybe, just to be sure, you continue reading with the next section on cash traps, and the one after that, showing a cash example.

If you assess your cash flow risk as 1 or more on this cash flow risk assement, you might still read the next two sections just to be sure, but face it, you can’t afford not to manage cash flow carefully. Aside from just lean business planning, you need to fully understand and manage cash flow; or have somebody on your team who does. You need the three linked projections covered in Section 5: Profit and Loss, Balance Sheet, and, especially, Projected Cash Flow.

Essential Principles of Cash Flow

Cash Traps

True cash-only businesses are extremely rare. Such a business would have to sell entirely in cash, check, or credit card; not ever have to buy inventory or anything else before it makes a sale, and would immediately pay for everything it buys. Maybe that’s a crafts-market artisan? A writer? I’m not sure; but that’s why I put the cash flow risk assessment ahead of this section. For the rest of us, you have to understand these essential principles of cash flow. When in doubt, plan for the worst.

Profits aren’t cash.

Profits aren’t cash; they’re accounting. And accounting is a lot more creative than you think. You can’t pay bills with profits. Actually, profits can lull you to sleep. If you pay your bills and your customers don’t, it’s suddenly business hell. You can make profits without making any money. Profits are an accounting concept; cash is what we spend. We pay the bills and payroll with cash. While a lean business plan doesn’t necessarily include a full-blown financial forecast (at least not until the business plan event, when it will be needed), of course it should include planning for cash.

This should be a pretty simple concept, but it becomes difficult because we’re trained to think about profits more than cash. It’s the general way of the world. When people do the mythical business plan on a napkin, they think about what it costs to build something, and how much more they can sell it for, which means profits.

Essential principle of cash flow: Profits are not cash

However, you can be profitable without having any money in the bank. And what’s worse is that it tends to happen a lot when you’re growing, which turns good news into bad news and catches people unprepared.

Cash Flow Isn’t Intuitive.

Don’t try to do it in your head unless you have that extremely simple business. Making the sale doesn’t necessarily mean you have the money for it. Incurring the expense doesn’t necessarily mean you paid for it already. Inventory is usually bought and paid for and then stored until it becomes cost of sales. Being profitable doesn’t guarantee you have money in the bank. Most of us have to  take the extra step to plan cash, not just profits.

Essential principle of cash flow: it is not intuitive

Growth Sucks Up Cash.

It’s paradoxical. The best of times can be hiding the worst of times. One of the toughest years my company had was when we doubled sales and almost went broke. We were building things two months in advance and getting the money from sales six months later. Add growth to that and it can be like a Trojan horse, hiding a problem inside a solution. Yes, of course you want to grow, but be careful because growth costs cash. It’s a matter of working capital. The faster you grow, the more financing you need.

Every Dollar of Receivables is A Dollar Less Cash.

Although it’s not intuitive, it’s true that more receivables mean less cash. You can do the analysis pretty quickly. Assets have to equal capital minus liabilities, so if you have a dollar of receivables as an asset, that pretty much means you have one dollar less in cash. If your customers had paid you, it would be money, not accounts receivable.

This comes up all the time in business-to-business sales. In most of the world, when a business delivers goods or services to another business, instead of getting the money for the sale right away, there is an invoice and the business customer pays later. That’s not always true, but it is the rule, not the exception. We call that “sales on credit,” by the way, and it has nothing to do with sales paid for by credit card (which, ironically, is usually the same as cash less a couple of days and a couple of percentage points as fees). Some people call it “sales on account.”

We can use this essential principle of cash flow in making financial projections: the more assets you have in receivables, the less in cash.

Example: A company running smoothly with an average of a 45-day wait for its receivables has a steady cash flow with a minimum balance of just a little less than $500,000. The same company is more than half a million dollars in deficit when the number of its average collection days goes to 90 instead of 45. That’s a swing of more than a million dollars between the two assumptions. And that’s in a company with less than $10 million annual sales, and fewer than 50 employees. And the company in the sample case that preceded this section, with sales of about $30,000 a month, has a gap between operating profits and cash flow of more than $90,000. You can click here to jump back to those numbers and a chart to go with it.

And the trick is that profit and loss doesn’t care about receivables. You have as much profit when you sell $1,000 that your customers haven’t paid yet as when you sell $1,000 that your customers paid instantly in cash. Obviously, the cash flow implications are different in either case.

Learn to live with it: every additional dollar in receivables is one dollar less in cash flow.

Every Dollar Spent on Inventory is a Dollar Less Cash.

When your business has to buy stuff before it can sell it, that’s called inventory. It’s one of your assets. And keeping a lot of inventory can do bad things to your cash flow, unless you don’t pay for it.

This can be pretty simple math. If having nothing in inventory leaves you with $20,000 in cash, then having $19,000 in inventory leaves you with only $1,000 in cash. That is, if you’ve paid for the inventory. That’s because your other assets, your liabilities, and your capital are all the same.

Sometimes, of course, you cannot pay for that inventory, which means you have more payables, and your cash balance is supported by those payables. That’s my next point…

Every Dollar of Payables is a Dollar More of Cash.

While receivables and inventory suck up money by dedicating assets to things that might have been cash but aren’t, paying your own bills late is a standard way to protect your cash flow. The same basic math applies, so if you leave your money in cash instead of using it to pay your bills, you have more cash.

It’s called “accounts payable,” meaning money that you owe. Every dollar in accounts payable is a dollar you have in cash that won’t be there if you pay that bill. The same problem you have when you sell to businesses is an advantage you have when you are a business. The seller’s accounts receivable is the buyer’s accounts payable.

Now I don’t want to imply that you don’t pay your bills, or that it doesn’t matter. Your business will have credit problems and a bad reputation if it doesn’t pay bills on time, or if it is chronically late with payments. Still, a lot of businesses use accounts payable to help finance themselves.

Working Capital is a Survival Skill.

Technically, working capital is an accounting term for what’s left over when you subtract current liabilities from current assets. Practically, it’s money in the bank that you use to pay your running costs and expenses and buy inventory while waiting to get paid by your business customers.

Quote me on this one: working capital is a survival skill.

Bankers Hate Surprises.

Plan ahead. You get no extra points for spontaneity when dealing with banks. If you see a growth spurt coming, a new product opportunity or a problem with customers paying, the sooner you get to the bank armed with charts and a realistic plan, the better off you’ll be.

Watch The Vital Metrics.

If you have sales on credit, Collection days measure how long you wait to get paid. If you manage physical products, Inventory turnover is a measure of how long your inventory sits on your working capital and clogs your cash flow. And for any business that takes advantage of the standard commercial credit, Payment days measure how long you wait to pay your vendors. Always monitor these three vital signs of cash flow. Estimate them 12 months ahead and compare your plan with what actually happens.

Managing Cash Flow

At this point you’ve done your sales forecast and spending budget. Unless your business is extremely simple, you should still plan for cash. You already did most of the projections.

To really project cash flow properly you need to understand the relationship between the three main accounting statements, which are beyond the scope of lean business planning. I do recommend that every business owner should plan cash flow using correct financial calculations that link the main financial statements to make a connected system in which every change affects the whole system, and the balance always balances. However, for the purpose of your lean plan, you may choose to manage cash flow by watching the flow of sales and expenses and key balances.

Hint: LivePlan does this almost automatically. You input assumptions for inventory, sales on credit, how long you wait, and LivePlan takes all of that into account as it projects your estimated cash month by month.