Cash is king, long live the king
7 November 2018
Start up business live and die by cash flow. This is especially true for start-up small businesses. As your business grows and more and more income start to flow through your business it can be tempting to relax a bit and think that the pressure is off and you can now pay yourself a bit more, lease a better car or office etc. This can be a symptom of a common fatal mistake for business owners – mistaking income growth for profit.
Once you move past the early knife edge stage of starting up your SME, it is critical that SME owners and top managers understand that future growth will depend on paying close, I would go so far as to say extreme attention, to cash management. In particular the first three years are critical. According to The Australian Bureau of Statistics 42% of all small business fail in the first three years. Even more alarmingly 92% of small business do not see their 11th anniversary. Why?
One reason is that owners can be deceived by what appears to be success. Even though there is an increase in income many small businesses are often only continually in danger from falling over the cash flow edge, depending on the next pay cycle or their overdraft for their survival, and unable to create a cash buffer/reserve for the inevitable crises that come up in business. Often it will only take one creditor to default or one bout of key person illness to send the business to the wall.
However, for the purposes of this blog entry, I want to be positive and talk about SMEs that have been successful in navigating through the early stage of business start-up and that are starting to see real growth. An example would be a SME that has grown from 1-2 employees to now 6-8 employees, income has quadrupled from the first year and the business now has regular customers and a reputation for good products and/or service depending on the nature of the business. Let’s call this type of business an early growth stage SME. This type of SME business has moved past the start up related growth spurt related to customer interest in a new business.
Early Growth Stage SMEs and Cash
As an early growth stage SME, how focused should you be on cash management. The answer is you should be intensely focused on cash management. There is an old adage in business – turnover is vanity, profit is sanity, but cash is reality. All businesses should be closely monitoring their generation of cash, but this is extra true in the heady days when you realise that you have established a successful small business and not only survived the dangerous early years but have achieved growth. Let’s examine what you should be doing as a successful SME.
What do we mean by cash?
The first need is to have a proper understanding of what cash is to your business. Most people think of cash as cash flow – how much money is coming in to the business and at what time and in what amounts. While this is an important cash indicator it is only one indicator that must be managed in an effective cash management strategy. There are other cash indicators such as cash reserves, assets that can be easily converted in to cash (liquid assets) and credit facilities which are potential sources of cash. Your cash management strategy should be thought as having two equal elements – your cash flow and your cash holdings which is cash on hand (operating cash) and cash reserves.
Your accounting system is NOT a good guide to cash management. Accounting systems are designed to show the state of your business against accounting standards which are in turn focused on compliance requirements. They appear to be a good guide as they include comforting titles such as your Profit and Loss statement and your Balance Sheet. A smart SME owner will realise the limitations of the formal set of accounts e.g. the Profit and Loss Statement.
They are snapshot of the profit and loss of business as at a single day usually 30 June.
They are retrospective not prospective
The P & L ignores several things that you pay for such as asset purchases, debt payments, drawings, inventory, and tax
A smart SME owner should implement both the traditional profit and loss reporting systems in conjunction with a cash flow forecast model, so that all cash flows of the business are taken into consideration.
Why do businesses need cash?
Now you are a growth SME you will need a comprehensive cash strategy that provides
operating cash for day to day needs,
enough cash reserves on hand to sustain the short-term volatility of the business cycle
cash reserves to meet short term and long-term growth objectives.
All the above cash needs are possible to meet by credit e.g. an overdraft. However, this is a very dangerous strategy. A smart SME will have a cash management strategy that is based on a judicious use of a mixture of revenue and credit to generate cash. The exact mix will differ for each business and consider factors such as whether your business is seasonal, known regular expenditures e.g. tax payments, insurance premiums, equipment replacement schedules etc. In a later blog article, I will cover in more detail the factors to consider when deciding to use revenue or credit for cash needs. Before making that decision, you should have a clear idea of what creates cash in your business not counting credit.
Cash flow drivers
The following are the main cash flow drivers:
Revenue – Sales and other income into your business is your revenue. This is the most obvious source of income and revenue growth will drive the business into the future.
Gross profit – i.e. revenue minus cost of goods sold is what sustains a business. Gross profit retained in your business becomes cash and can be used to pay for direct expenses or it can contribute to cash reserves. If gross profit is taken out of the business, it provides a return on investor equity.
Overheads and Expenses – are the costs for operating the business. Reductions in overheads and expenses result in more available cash.
Accounts Receivable and Accounts Payable – accounts receivable refers to the amount that customers owe businesses from sales made on credit. Accounts payable is money business owes to suppliers. To create a good working capital strategy, businesses need to be able to collect their outstanding debts faster than they pay their outstanding creditors. This then also creates cash. If businesses get a tightening in their working capital, it will affect their ability to grow, and could even send a growing business bankrupt, as they are paying quicker than receiving, so eventually they will run out of cash.
Inventory – Inventory should be thought of in the same manner as credit. If you hold too much inventory you will increase expenditure through businesses holding costs, and if you hold too little inventory the business may lose both current and future sales. Like the overall cash strategy, the inventory strategy will be different for each business e.g. a retail business with a physical outlet (shop) will have a different inventory need to an on-line retail business.
Capital expenditure – Capital are expenses you incur to operate the business and to make the business more efficient e.g. through new IT systems. Capital expenditure gets treated differently in formal accounts from operating expenditure. Do not let this deceive you though when planning your cash strategy. Capital expenditure is still an expense like any other and because they are often large (lumpy) expenditures they will often need careful consideration in a cash flow strategy especially if paying for the expenditure from revenue is being considered.
I’ve discussed with you why cash flow forecasting and management is so important for the survival of family’s and small businesses, and how the lack of cash flow management is one of the major causes of family and business failures.
I’ve discussed why businesses need cash and why it is necessary for families and small businesses to create cash reserves for that eventual rainy day. By families and small businesses creating and increasing a cash buffer/reserve they are moving away from the cash flow edge.
I also discussed the various cash flow drivers and their effects on a business’s cash flow.
For families and business to create enough cash reserves they should start allocating surplus funds, however small in the beginning to a separate bank account that is never accessed, unless called upon for that rainy-day situation. By families and small businesses creating an ever-increasing cash buffer/ reserve they are then moving away from the cash flow edge.
I have also explained that normal accounting is designed for a different purpose that cash flow management. As an SME owner you should obtain professional assistance with the traditional tax and regulatory compliance accounting, but you should also make sure you receive professional advice in the non-compliance areas of business such as cash flow forecasting and management. You may get both forms of advice from your current accountant. However, if you believe that you need specialist cash flow forecasting and management advice, feel free to ring Walker Strategies to discuss your needs.