Your small business clients hear how important cash is to their business. However, sometimes they don’t understand what that really means. They’re just in survival mode. “I’ll pay this bill after XYZ pays me,” they tell themselves. Day after day, they seem to be caught between success and failure. They can see profit on the income statement, but their bank account doesn’t prove it. It gives them a weird sense of mixed feelings. “We’re making money. Why don’t I have any?”
Every year, approximately 50,000 businesses file bankruptcy, but it’s estimated that 35 percent of them show net profit on the income statement. They’re making money and still filing for bankruptcy. What’s going on here? This scenario plays itself out time and time again. Even the corporate giants fall victim to cash flow problems. When you don’t understand the components that drive cash through your business, a profitable business can have problems paying its bills.
Cash flow problems can hit any business
It happened to Home Depot in 1985. At the beginning of 1986, Home Depot had $9 million dollars in the bank and was experiencing a cash burn rate of $12 million per month. Yep, they had only three weeks of cash left. In 1985, the signs of a problem were there, but the fast pace of expansion overshadowed them. If it wasn’t for some masterful maneuvering by the management team, Home Depot may have been a blip in history, instead of the machine it is today.
The signs are there no matter the size of the small business. In fact, the SBA lists the top 10 reasons why small businesses fail on their website. Seven out of ten of the reasons are due to poor cash flow management. Your business is begging to be the most efficient machine it can be. It only feels right behind the wheel, when it is purring down the highway. However, a struggling business feels like a machine that’s out of sync. It’s the decisions the management makes that keeps it from reaching its full potential.
Cash is a driving force
A well-run business acts like a machine, where cash is both the fuel and the output. The goal is to create a self-sufficient machine where the business can produce its own fuel. Let’s look at a few of the initial indicators that tell managers their business needs a tune-up.
The driving force of a business is its ability to generate cash from operations. That is selling a product or service for more than it costs. Seems simple enough – most people just look at gross profit and can tell. But, that is the scenario that begins the creation of a cash flow problem, especially in companies that must wait to get paid from their customers. We need to look at the difference between earning money and possessing money. Not only that, but how fast does the process of having earned money in a bank account happen?
How many days does it take for a business to buy inventory, sell it and collect on the invoice? This is a measurement of the speed of cash flowing through the business, and we measure it in days. The number of days inventory sits on the shelf, plus the number of days it takes the business to receive payment, minus the number of days it takes to receive payment, is called the “financial gap.” The financial gap is the first place a business should look to see if there is a potential cash flow problem. Since we are generating cash through sales, we want the number of days in the financial gap to be as small as possible. Nobody wants a huge gap in days between money out and money in. Therefore, as in the London Underground, a business should “Mind the Gap.”
The math looks like this: Inventory days + Accounts Receivable days – Accounts Payable days = The Financial Gap. A small gap means that the business needs less cash on hand to sustain its sales operations.
How much runway have you got?
The other side of the coin is how a business spends the money it earns from sales, or its gross profit. This money is used to pay for the business’ day-to-day operating expense. We measure the speed of how fast we spend that cash in days as well. It’s called Days Cash on Hand. Since this is just a use of cash, we want it to last as long as we can. So, we want these days to be as many as possible without being inefficient. Meaning, you shouldn’t sit on too much cash – that could be considered bad as well.
I also call this number the days until bankruptcy. It tells the manager how many days his business could survive if there was a downturn in sales. Again, here we are looking for a larger number. We don’t want to be like Home Depot in 1985, with only 21 days to live.
The math for this calculation looks like this: Cash on hand / (operating expenses – non-cash expenses)/365) = Days Cash on Hand. The more days’ worth of cash you have, the better.
The more you know, the better your decisions
Fulfilling your dream as a small business owner starts with avoiding the main causes for businesses to fail. It begins with understanding the speed at which cash moves through a business. Two of the metrics that will help a manager understand that speed is to have a small financial gap and a lot of days of cash on hand.