Cash is Queen: Why Cash flow Matters
In many of his works, the late great Peter Drucker posits that cash flow does matter more than profits. I tend to agree – to a certain extent. In this post, I want to show how cash flow can be more significant than profits, in some circumstances.
“It doesn’t matter how great your business model is, how profitable you are, or how many investors you have lined up,” wrote a contributor to The Platinum Wealth Newswire recently, “you won’t survive if you can’t manage your company’s cash.”
One can hardly argue with the above statement. In fact, a Google search of “What causes small businesses to fail” returns over a million results, the first ten of which are agreed on:
• Insufficient capital (money)
• Lack of experience.
• Poor location.
• Poor inventory management.
• Over-investment in fixed assets.
• Poor credit arrangements.
• Personal use of business funds.
• Unexpected growth.
In most instances, lack of capital is almost always at the top. This is what Investopedia has to say about the phenomenon:
“Of the vast number of small businesses that fail each year, nearly half of the entrepreneurs state a lack of funding or working capital is to blame. In most instances, a business owner is intimately aware of how much money is needed to keep operations running on a day-to-day basis, including funding payroll; paying fixed and varied overhead expenses such as rent and utilities; and ensuring outside vendors are paid on time. However, owners of failing companies are less in tune with how much revenue is generated by sales of products or services. This disconnect leads to funding shortfalls that quickly put a small business out of operation.”
Indeed, once you compound the lack of cash with its poor management the pitfall grows considerably. Some studies found that up to 80% of businesses fail due to poor cash flow management skills.
We do, however, have to bear in mind that both cash flow and profits are crucial aspects of a business. For a business to be successful in the long term, it needs to generate profits while also operating with positive cash flow. I emphasise “long-term” because time frames are of the essence here. Let us, in broad language, define the terms:
Cash flow is the inflow and outflow of money from a business. It is necessary for daily operations, taxes, purchasing inventory, and paying employees and operating costs. Cash includes cash equivalents.
Profit is the surplus after all expenses are deducted from revenue. Profit is the overall picture of a business and the basis on which tax is calculated.
Cash flow is not the same as profitability. A profitable business can still be unable to pay its bills. Similarly, just because a business is meeting all of its financial obligations, doesn’t mean it’s profitable. Profit is an accounting term, which really only exists on paper. Measuring profit is a very specific way of looking at a business. It doesn’t tell you a whole lot about how the business is getting by day-to-day.
Which One is More Important
It follows, therefore, that when determining which one is more important, it depends on the business and the circumstances. For example, a business may see a profit every month, but its money is tied up in hard assets or accounts receivable (debtors), and there is no cash to pay employees. Once a debt is paid or the business sees an influx of revenue, it starts to see positive cash flow again. In this example, cash flow is more important because it keeps the business running while still maintaining a profit. Alternately, a business may see increased revenue and cash flow, but there is a substantial amount of debt (with the attendant debt servicing burden) so the business does not make a profit.
The absence of a profit eventually has a declining effect on the cash flow. In this instance, a profit is more important. Another thing to remember when determining whether to focus on cash flow or profit is cash flow can be bought. A business owner can put up his or her personal assets as capital into the business or get a small business loan from a bank to keep the business running until it starts seeing cash flow again. The same cannot be said about profit.
For us to answer the question of which one is more important we have to, at this point, bring in the concept of the business life cycle. Let us turn over to the diagram below.
The business life cycle usually includes its birth or incorporation stage, its initial growth stage, its expansion stage as it becomes more widely known and moves into new markets, its mature operation stage, and its eventual decline as consumer interest in its products wane and key employees depart. At this stage, it will either re-invent itself or die.
According to the JP Morgan Institute, roughly a third of new businesses exit (or die) within their first two years; and half exit within their first five years. We have already looked at the leading causes of small businesses death.
Established businesses often have a buffer of extra cash to get them through shortfalls. Growing businesses often don’t because they are always reinvesting. Years with the biggest growth—including the first few years—are also the most challenging when it comes to cash flow. This is one of the reasons it’s so hard to get a new business off the ground. This is the stage when cash is king and getting good at managing cash flow is one of the best things you can do for your business.
Since the majority of businesses do not exist beyond six years, it is, therefore, safe to surmise that the majority of businesses in any economy are small businesses. Most of these will be in the startup or incorporation, initial growth, and expansion stages. As we have seen, these are the stages when cash flow management is paramount. In a nutshell, your business may be healthy, have a great profit margin, and your staff may be motivated and great at their jobs. But if you don’t have cash at the right time to pay for your operations and your debts, you may be in trouble.
The Zimbabwe Situation
In a 2016 interview with Standard Business, Confederation of Zimbabwe Industries (CZI) president, Mr Busisa Moyo said the manufacturing and commercial sectors were low on inventories because foreign suppliers were cutting back on raw material delivery to Zimbabwe and in some cases taking legal action as local companies failed to pay for supplies due to the prevailing cash crisis in the country.
In 2017, a KPMG poll found that cash challenges have had a significant impact on Zimbabwean businesses. That was when, according to the Reserve Bank of Zimbabwe, cash circulation in the formal sector had reduced to 1.4% of total deposits in the banking sector. During KPMG’s Audit Committee Forum held in July 2017, a quick poll of more than 100 business executives was conducted. Seventy-six percent of the participants said their businesses had experienced a significant negative impact as a result of cash shortages.
Zimbabwe relies on imports as the country’s manufacturing sector is not producing much due to lack of working capital, high production costs, low capacity utilisation levels as well as obsolete equipment. Between 2009 and 2016 Zimbabwe imported products worth over $20 billion.
What this all amount to is that if cash was king in general, in Zimbabwe it is an all-powerful emperor.
General Causes of Cash flow problems
I want to categorize the sources of cash flow problems into four categories as shown in the diagram below; namely, economic conditions within the country, lack of cash flow management know-how, errors and fraud within the cash flow channel.
Of these four categories, one is exogenous (caused by factors outside the organism, organisation or system) while the other three are endogenous (caused by factors inside the organism, organisation or system). While there is little that an entrepreneur can do to end cash shortages within the economy, there is a lot that one can do to mitigate their effects. The endogenous factors, on the other hand, are squarely within the purview of every businessperson – these are the essence of entrepreneurship.
Let us look at each of these categories in turn.
1. Economic Conditions
All the measures that a business person can take to address internal cash flow problems will go a long way in mitigating the effects of the liquidity challenges within the economy. This would include the use of non-traditional transacting systems such as barter exchange.
2. Lack of Knowledge
“My people are destroyed for lack of knowledge. Because you have rejected knowledge, I also reject you as my priests; because you have ignored the law of your God, I also will ignore your children.” Hosea 4:6
Need I say more? Save to add that a flagrant lack of knowledge in some instances is akin to actively rejecting it! There are many ways one can avail himself or herself of knowledge. Here are just but a few – online courses, business coaching clinics and business classes. Learning does not end when one leaves school.
Here are some of the major causes of cash flow problems arising out of poor cash flow management skills.
i. Declining Sales and/or Declining Gross Profit Margins
a) Declining Sales
- Declining sales have a devastating effect on your cash flow as a relatively small decline can cause a massive reduction in your profitability (remember profit feeds cash and vice versa).
- This typically occurs when economic conditions deteriorate, there is an increase in competition from global competitors, new competitors enter your market or your industry declines.
- As sales decline, your overheads will probably remain unchanged so net profit decreases rapidly.
- The table below vividly demonstrates the devastating effect of declining sales.
The table shows the disconcerting feature of a 20% decline in sales inviting a whopping 140% fall in net profit, i.e. a net loss of $2.
b) Declining Gross Profit Margins
- Declining gross profit margins have a devastating effect on your cash flow as a relatively small decline can cause a massive reduction in your profitability.
- Typically occurs when there is pressure on sales.
ii. Your Business Is Unprofitable
- Simply put, you are spending more than you are charging to provide your customers with goods or services. For example, for every $1,000 you charge your customer you are spending $1,050! That is for every $1,000,000 you earn you are spending $1,050,000!
- Inevitably your losses will accumulate to the point of having to borrow more money just to stay in business. But eventually you will come to the point where it is neither wise nor possible to borrow more money and you will have to sell your business, close it down, liquidate it, or someone else will liquidate it for you, for example, creditors.
- A much better solution is to take immediate action to restructure your business to generate strong and sustainable profits; this will probably require a very experienced business turnaround specialist to guide you through this process.
Main causes of lack of profitability include:
- A flawed business model.
- An underperforming business; your sales & marketing and/or operations are not working like clockwork.
- Lack of understanding of financial statements.
- Lack of accurate and timely financial statements.
- Lack of familiarity with KPI’s (Key Performance Indicators) and strict monitoring of them
- Low gross profit margins due to high direct costs and/or not charging enough for your products/services and/or extreme competitive industry pressures.
- Poor performance and lack of productivity of staff.
- Poor processes, many errors/defects.
- Poor stock purchasing and management.
- Excessive overheads.
- Excessive interest and/or vehicle and equipment (fixed assets) finance commitments.
- Poor credit approval of customers and poor debtor collection management practices resulting in high bad debts experience.
- Undisciplined spending.
iii. You Have a Natural Negative Cash Flow Business Model: Examples include:
- You sell on credit terms, 30, 60, or even 90-day terms, but you have to pay your payroll, rent, overheads, etc. weeks, if not months before you are paid by your customers. And your payment terms with your suppliers are shorter than the payment terms you have given your customers.
- You carry imported stock which you have paid for weeks or months before it lands in your warehouse.
- You are paid by way of progress claims for which you also provide credit so you receive payment long after you have paid your direct factory expenses or subcontractors and materials expenses. Furthermore, retention payments are withheld by your head contractors or by your customers.
There are ways to address every one of these circumstances which involve redesigning your business model and also using appropriate means of financing, many of which are still available, even if you are already in financial distress.
iv. Excessive Debt and Capital Expenditure and/or Excessive Personal Drawings/Benefits
- High repayments due to excessive debt and/or repayment of loans over too short a period. This especially applies to vehicle and equipment loans and lease repayments which are typically structured over relatively short terms with low or nil balloon or residual values.
- Capital expenditure funded out of cash flow instead of being financed over the useful life of the asset, which puts pressure on cash flow.
- Funding purchase of personal property, assets or the repayments on these properties far beyond the capacity of your business to sustain these payments as well as meeting the ongoing payment of all business expenses within normal trading terms, including taxes and superannuation (pension fund).
- Excessive living and lifestyle expenses.
v. Poor Stock or Poor Credit and Debtor Management
- Poor stock management, such as carrying stock that doesn’t sell through, carrying excessive levels of stock, not clearing discontinued or obsolete stock, poor demand planning, undisciplined purchasing habits, or a poor stock management system to name a few.
- Poor credit management, that is no or poor credit approval processes before providing customers with credit which will sooner or later result in bad debt write-offs and in the worst cases will result in failure of the business.
- Poor debtor management which includes lack of disciplined collection of debts due by customers, allowing continued credit when customers have not paid their bills within company credit terms, and lack of regular reconciling of debtors accounts.
3. Fraud and Error within the Cash flow Channel
“To err is human”. The ancillary of this quote from Alexander Pope goes “to forgive, divine.” Unfortunately, fraudsters and cash flow errors are not in the business of forgiving! Whereas error is an unintentional blunder, fraud, on the other hand, is a well thought out plan to steal and deceive. We use the term “fraud” as a generic term which includes all surprise, trick, thievery, cunning and unfair ways by which another is cheated. The question then is, if all people tend to make mistakes (when they are under stress, pressure, unwell, inattentive, etc.), while some tend to be dishonest, what do we do about it? The answer is, of cause, internal controls. In any organisation, the cost of internal control and compliance with financial, accounting as well as regulatory requirements is a necessary cost of operation. An appropriate system of internal control should neither be costly nor onerous.
The main internal control principles include:
- Establish responsibilities. Every staff member should know what they are supposed to do; tasks do not have to slip between two people.
- Maintain adequate records. This includes a complete set of accounting records as well as those required by law and regulations.
- A comprehensive company policies and procedures manual covering all departments within your organization will become your “bible” for the company. A relevant facet of the manual is the Code of Ethics, incorporating a ‘Fraud Ethics Policy which will incorporate:
o The process and methodology for performing ‘Fraud Vulnerability Reviews’;
o The development and roll-out of a ‘Fraud Response Plan’, including the implementation of a ‘Whistle Blower’ fraud reporting facility;
o The roll-out of a Fraud Awareness program for all staff;
o The process of performing regular fraud detection reviews, thereby limiting your exposure to fraud losses.
- Segregation of duties. This is indispensable in a system of internal control. The rationale for segregation of duties is that the work of one employee should, without a duplication of effort, provide a reliable basis for evaluating the work of another employee. There are two common applications of this principle:
a. The responsibility for related activities should be assigned to different individuals.
b. The responsibility for record keeping for an asset should be separate from the physical custody of an asset.
- Screening and employee rotation. Procedures for the hiring of new employees should not be left to chance. Proper background checks should be done. Wherever possible and appropriate, employees should change jobs within the organisation as a matter of policy. Many fraud schemes are detected this way.
- Use technological controls. By eliminating the use of paper-based processes and limiting human interface in transactions, computers can aid internal control. However, there should be general and application controls around the technology itself. One of the first steps that we would take to design or improve internal control in small business is to ensure that each team member has access only to the applications and data needed to carry out their job responsibilities. Starting with the computer and network, ensure that each person has a unique username and password that is used to log on each day.
- Perform regular independent reviews. This is a primary management responsibility: Watching over the shoulders of subordinates is not necessarily eavesdropping.
- Insure assets by bonding key employees. Consider agreements (such as a fidelity bond) under which a bonding or insurance company guarantees payment of a specified sum as damages, in the event one or more of the employees covered in the bond cause financial loss to the insured employer. Se my previous post on fidelity bond here.
Profit is of course what most people are in business for. It’s an easy measure of ‘success’, and without profits, it would be impossible to secure finance, attract investors, or grow operations. However, in order to achieve this profit in the first place, businesses must first align the timing of their cash used, with the timing of their cash received. That is, they need to shore up a steady cash flow.
However, the profit trap can be an easy one for anyone to fall into. Below are three reasons it can pay to spend less time focusing on your bottom line and more on observing and shoring up steady cash flow.
1. Focusing on cash flow can highlight operational issues
Movements in cash flow can sometimes indicate operational, as opposed to sales-related, issues. As an example, what may appear to be a quiet month revenue-wise might actually be a large number of clients neglecting to pay on time. Those same clients may all decide to pay at once in the following month, making it appear that revenue is back on track when in actual fact it’s just that your cash flow is out of balance. In this case, these cash flow movements highlight a need to implement systems that ensure more steady payments from clients.
2. Growth becomes more manageable
Growth should be the Holy Grail for most business owners. Expanding your offering’s reach through investment in new locations, R&D, or new staff can all help to boost future profits. And if you are able to understand what your net cash position is, you will be better positioned to make more informed decisions to grow your business. Decisions on factors such as staffing, office space, leases, and even business structure all become far clearer with a clear understanding of your business’s cash flow.
3. Debt becomes cheaper and easier to manage
Your business may be healthy, have a great profit margin, and your staff may be motivated and great at their jobs. But if you don’t have cash at the right time to pay your debts, you may be in trouble.
Debt obviously becomes more expensive if you’re unable to pay on time, with late fees and overdrafts adding up. This can also cause unnecessary stress for the business owner. But with steady cash flow, a business manager can plan for debt repayments, and make better decisions regarding how much debt to take on.
Finally, remember to safeguard your hard earned cash: The cost of internal control and compliance with financial, accounting as well as regulatory requirements is a necessary cost of doing business.
© Caleb Mutsumba