Cashflow is the engine of a business

There is an old adage that says that turnover is vanity, profit is sanity and cash is king. In the current climate this is so true. Cash and cashflow is the engine of a business . In this article, we’ll be looking at the following……

Let’s start at the beginning. Almost all businesses need cash to survive – I have seen too many businesses focussing on the future and the strategic plan, and completely missing the ‘day to day’ needs of the business. Some business sectors (such as recruitment agencies) are particularly cash hungry – and this makes the day to day management of cash all the more important. In a recruitment agency, if there is not cash available to pay the wages, there will be no business the following day.

Why is cash so important?

Cash keeps the wheels of business turning. The ability to trade and meet payments as they fall due is one test of solvency, and it is enshrined in law that directors of a company have the responsibility to ensure that this remains the case at all times.

As ever, there are interpretations of this. But, a business with cash is always in a better than one with out. With cash, there are choices to be made, purchases can be undertaken, bargains can be driven, discounts negotiated. A business that is short of cash is always on the back foot – needing to have time to pay, negotiating their way through payment plans, sometimes having to pay a higher price for stock as they have to take credit, not being able to deal with the unforeseen payment.

How does a business generate cash?

This is a short question that has a long answer. Let’s try and break it down into some simple steps.

If a business buys an item for £10 and sells if for £20, after incurring £5 of overhead, then it makes a £5 profit. If this is done with cash, then there will be £5 left in the till at the end of the transaction. Profit generated has turned into cash in its simplest format.

It gets more complicated than this for most businesses though. Take a manufacturing business. It sells a product for £100 that costs £80 including overheads to make. £20 profit. However, it has to buy the material to make the product for cash, which it needs to have to start the transaction. It then takes 10 days to convert the raw material into the product which then sits on the shelf for 20 days before the customer buys it. So that’s 30 days before the sale is made. Then, the customer buys it with credit terms of 30 days, so it doesn’t have to pay until 30 days after they took delivery of the product. Adding this in means that the profit doesn’t actually appear in the business until 60 days after the raw material was bought at the start of the process.

It can get more complicated than that, but you get the idea. When I analyse a business, particularly if it is short of cash, I look at a number of key performance indicators.

  1. If it carries stock, what is the value of this compared to the annual turnover – some businesses carry far too much stock that is never likely to sell.
  2. Debtors (what the company is owed) – how much is this, and what percentage of annual turnover is this – if the debtor figure is more than 2 months gross sales, this indicates that there is a payment issue.
  3. Creditors – (what the company owes) – what is the value, and again, what percentage of annual turnover is this. If this figure is more than 2 months gross purchases, it highlights that there may be some cash pressure in the business.

These 3 categories define the working capital cycle of the business. If we are going to get particularly nerdy, then the ‘net working asset’ ratio compared to turnover provides a measure of the liquidity of the business – and some trend analysis will indicate whether a business is cash positive or not. Positive cashflow is king.

Back to the question though – a business that has a low stockholding, debtors who pay quickly and reasonable creditor times will always have a better cash position than a business that holds a lot of stock, has a slow paying debtor book and creditors who want paying quickly. Align the first scenario with a good profit margin and cash should be appearing in a business reasonably quickly.

I am making a profit but always seem to be short of cash

This is a comment that I often get from businesses that make a profit on paper but are always struggling to meet payments as they fall due. Often, a deeper dive on the financials and the working capital assets reveals the cause of this.

Let’s take a business that is growing by 10% per annum and is making a 10% net profit margin. Assuming that the external sources of finance such as an overdraft remain the same, and creditors do not increase significantly, the profit is likely to disappear into the growth of the sales ledger assuming payment terms remain the same.  

The conversion of profit to cash isn’t happening as the working capital cycle is absorbing the cash that the business is generating. Often, the shareholders think the business is doing well and vote themselves a dividend as the accounts show that the business has generated profit, but in fact cash isn’t being generated and the payment of dividends serves to make the position worse.

Sometimes, debt servicing payments have not been factored in and this is also a cause of the ‘cash disappearance’. I often encourage businesses to work out their ‘trading breakeven’ and their ‘cash breakeven’ – when dividends, loan payments and corporation tax are included, this can be a very different number.

In conclusion

To maximise cashflow, keeping on top of these key working capital performance indicators is essential and having a clear cashflow plan that is reviewed by senior management/directors on a very regular basis. Setting a minimum level of cash/headroom is also very important – this acts as a trigger to the

Monitoring key performance indicators such as stock turn, debtor and creditor payment times will also give early warning signs around cash depletion. Too often, not chasing debtors can give the business a real headache, particularly where there is one key debtor who always pays late.

Extending creditors without agreement is also a dangerous game – it only takes one County Court Judgement to destroy a credit rating at which point all creditors could well shorten their payment terms, leading to even more of a cash squeeze.

Seeking help is not a sign of weakness. Too many businesses leave it far too late and then fail because the right help has not been sought at the right time. There are many well qualified and experienced advisers willing and able to help an SME owner, if only they were prepared to ask for it……!

Author

Richard Mason of Ludgate Finance wrote this article. Richard explains, “following a move to an advisory role in 2007, it became clear that SME’s were struggling to be serviced by the banks. Alternative finance sources were required. With the advent of peer to peer lending, I sourced and completed over 200 deals. I raised in excess of £30 million to support SME’s in their growth and acquisition ambitions.”


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