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.

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