KEY ARTICLE TAKEAWAYS
Identify key drivers of cash flow on both your income statement and balance sheet
Understand how each driver can help or hurt cash flow
Learn strategies for improving cash flow
What is a cash flow cycle and how does it work?
A company’s cash flow is determined by the efficiency of its cash cycle. We will look at three examples to help explain a company’s cash flow cycle – a manufacturer which makes products and sells them, a distributor who resells others’ products, and a professional services firm.
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Cash flow cycles for manufacturers
For a manufacturer, assuming it has already invested the capital for its facilities and equipment, the cash cycle starts when it orders raw materials. For some materials, the company might have to pay up front, and in other cases, the material supplier might give it “terms” or a number of days before the company has to pay in full for the material.
Once the raw materials arrive, the company then needs to pay for the labor to build its products, which is usually paid weekly or bi-weekly. The completed manufactured product will sit in inventory until it is sold to a customer. The customer then can either pay up front for the goods, or the company might offer terms to its customers so that the customer pays in 30-60 days. The time between the initial payment for raw materials and the salaries for manufacturing labor and the time the company receives cash from its customers is called its “cash cycle.”
When a cash cycle is long, the company must find capital (debt or equity) to finance this period of time between when it expends cash and when it receives cash. In addition, if the business is growing (it is selling more goods), it will require even more capital to finance this growth because there are more raw materials to buy and more salaries to pay.
Cash flow cycles for distributors
For a distributor, assuming it has already built its facilities for holding inventory, the cash cycle begins when the distributor orders product from its vendors. Again, the vendor might demand cash payment up front, or it might offer 30-60 day terms to the distributor for payment.
Once the product is purchased, it will sit in the distributor’s inventory until it is delivered to a customer. On a sale of the inventory, the customer might be required to pay up front, or the distributor might offer terms to the customer so that the customer can take 30-60 days to pay. Because the distributor doesn’t have to buy materials or invest labor in manufacturing, its cash cycle will usually be shorter than a manufacturer’s cash cycle.
Cash flow cycles for services companies
For a service company whose product is the services or labor of its employees, the cash flow cycle starts when the company hires a new employee. Most companies pay their employees every 1-2 weeks, so 1-2 weeks after hiring the employee the company must start paying the employee.
If the employee requires training or development before they can be productive enough to provide services to actual customers, the company must pay the employee for this period of time. After an employee is able to be billed out to customers, the employee will typically provide services for some period of time (say a month), at which point the company will bill its customers for those services. Again, the customer might be required to pay the company’s invoice immediately, but in most cases, the customer will have 30-60 days to pay the invoice.
The cash cycle for a services company is largely determined by the speed with which new employees can become productive (i.e., billable), the frequency of billing, and the terms of payment offered to customers.
As you can see, the cash cycle for companies can be very different depending on the nature of the business. In addition, as a company grows and sells more goods or services, its cash requirements grow. This is why rapidly growing companies, even if profitable, can require significant investment to maintain their growth while not running out of cash.
Income statement drivers for cash flow
One important driver of a company’s cash flow is its level of profitability. Let’s compare two companies to illustrate the point.
Company A is a manufacturer whose operating margin (operating income divided by revenues) is 5%. Company B is also a manufacturer whose operating margin is 25%.
If both companies sell $1 million of goods in a particular month, Company A’s costs would be 95% of that amount, or $950,000. Conversely, Company B’s costs would be 75% of that amount, or $750,000. Assuming both companies must expend costs before they receive revenue, Company A would need to find $950,000 in capital to finance its operations, whereas Company B would only need $750,000.
Moreover, once each company’s cash cycle is complete, Company A will have just $50,000 to reinvest in the business but Company B will have $250,000 to reinvest, reducing Company B’s requirement for investment capital to finance more growth. As you can see, overall profitability can be a significant driver of cash flow.
Collection timing
Payment timing
Inventory Management
Capital Expenditure
Balance sheet drivers for cash flow
In addition to overall profitability, a company’s balance sheet will also offer critical information for diagnosing cash flow management problems.
Let’s look at four different line items on a typical manufacturing company’s balance sheet: Accounts Receivable (A/R), Inventory, Accounts Payable (A/P), and Fixed Assets (a services company would have the same accounts other than Inventory).
Accounts receivable
These are generated when a company issues an invoice to a customer for a sale. For example, when the manufacturer sells its product to a customer for $50,000 and the customer has 30 days in which to pay the invoice, the A/R balance will increase by $50,000 when the invoice is issued and will decrease $50,000 when the customer pays the invoice (and the company has $50,000 more in cash). When A/R grows over time, its cash flow decreases as an increasing A/R balance simply means there is less cash that has been paid for its goods or services. When A/R shrinks over time, the company has collected more cash, increasing cash flow.
One key metric every company should measure at least monthly is called Days Sales Outstanding. Days Sales Outstanding (or DSO) is calculated by taking the company’s total A/R balance and dividing it by average daily sales (which is total sales over a specified period of time (say 90 days), divided by 90 to get the average daily sales for that time period). For example, if A/R is $150,000 and the average daily sales for the prior quarter (90 days) is $5,000, then DSO will be 30 ($150,000 divided by $5,000).
If DSO grows over time, the company is losing cash flow because customers are taking longer to pay on average. If DSO shrinks over time, the company is increasing cash flow because customers are paying faster. Trending DSO over time can be a good indicator of whether the company’s collection efforts are effective.
Inventory
A manufacturer is comprised of both raw materials as well as finished goods it holds before they are sold to a customer. If the company must purchase raw materials well ahead of when it can use them, this will increase inventory levels and correspondingly decrease cash flow. Likewise, if the company takes a long time to sell its finished goods to customers, this will also increase inventory levels and decrease cash flow.
Similar to DSO we can calculate Days of Inventory. Days of Inventory is calculated by taking total inventory divided by the company’s average direct costs (cost of goods) over a specified period of time (in our example, you would take total cost of goods for 90 days and divide by 90 to get an average daily direct cost number). The higher the number of Days of Inventory, the greater the company’s cash needs to finance inventory. If Days of Inventory grows over time, this could indicate that the company might have stale inventory (or inventory that is not saleable) or that the company is being less efficient in its purchasing processes.
Accounts payable
This represents the amount a company has been billed by vendors but has not paid yet. For example, when purchasing raw materials, the vendor will issue an invoice to the manufacturer that is due in 30 days. When the invoice is received by the manufacturer, A/P will increase, and when the manufacturer pays the invoice, A/P will decrease and cash will also decrease (the cash having been used to pay the invoice).
Similar to A/R and Inventory, A/P can be measured by something called Days Payable Outstanding (DPO). Days Payable Outstanding is calculated by taking total A/P divided by the company’s average non-payroll expenses over a specified period of time (in our example, you would take total expenses (not including payroll) for a 90-day period and divide by 90 to get an average daily expense number).
An increasing DPO indicates that the company is generating cash by “borrowing” more from its vendors (by paying vendors more slowly, the company is using its vendors to help finance operations and generate cash). A decreasing DPO means that the company is using cash to pay its vendors faster, reducing cash flow.
Fixed assets
This represents property, plant, equipment (PP&E), and other long-lived assets. Accounts Receivable, Inventory and Accounts Payable are what is called “current accounts” – these are accounts that are expected to be either collected (in the case of A/R), sold (in the case of inventory) or paid (in the case of A/P) in less than a year. Fixed Assets represent longer-lived assets (assets that the company would not expect to convert to cash in less than a year).
When a company’s Fixed Assets increase over time, this means the company has had to make new investments in PP&E, decreasing cash flow. Cash is being used to purchase long-lived assets to be used in the business. When a company is growing, it might require additional facilities or equipment to accommodate its growth, which will require cash.
What causes cash flow management challenges?
The primary drivers of cash flow management challenges are:
- Operating losses – the company is losing money on each sale, which is reflected in negative cash flow
- A lack of sufficient profitability to finance future growth – the company has operating margins that are too small to provide the operating cash flow to finance growth in the business
- Rapid growth cash requirements that outstrip operating cash flow – the company’s rapid revenue growth cannot be financed internally and requires additional investment
- A/R collection challenges – the company cannot collect fast enough from its customers
- Excess inventory build-up – the company’s inventory balances are not sold fast enough to generate cash
- Tightening of vendor terms – the company is required by its vendors to pay in fewer days, reducing cash flow
- Lumpy capital expenditure requirements for fixed assets – in order to accommodate growth, the company must periodically purchase PP&E which requires more cash than is generated by operations
How to fix cash flow management challenges
The first step in fixing a cash flow management challenge is to identify its root cause from the causes outlined above. Is the cause rapid revenue growth or lack of profitability? Poor collections or aggressive vendors? Determining root cause is critical to developing a plan to remediate your cash flow management challenges.
Once you have identified the root cause of your cash flow management challenges, you can then get to work to increase cash flow. There are several options to increase cash flow:
- Increase operating profitability – by raising operating margins, the company creates additional cash flow from every completed sale.
- Reduce revenue growth – if the company is not able to find appropriate debt or equity financing (see below), it can put the brakes on revenue growth so that operating cash flow can adequately finance growth
- Decrease DSO – by accelerating the average period of time between invoicing and collecting cash from customers, a company will increase cash flow – this can be accomplished by changing payment terms for customers, taking up-front deposits, or simply monitoring collections more closely for customers who are not paying on time
- Decrease Days of Inventory – by decreasing the amount of inventory on the balance sheet, the company will convert more inventory to cash, generating cash flow
- Increase DPO – by lengthening the average time it takes for you to pay your vendors, you can increase cash flow by essentially “borrowing” from your vendors
- Defer capital expenditures – a company with tight cash flow can decide to defer capital expenditures for some period of time until its cash flow recovers sufficiently to be able to pay for the capital expenditures
Outside debt or equity financing
If the cumulative impact of these remedial measures for cash flow management challenges are not sufficient, then the company must look for outside financing. This financing could take the form of debt (a bank loan, for example) or equity (from an investor who will invest cash in exchange for a share of equity in your business). Generally speaking, the cost of debt to a company will almost always be less than the cost of equity, but debt will be less flexible than equity in terms of how the company uses the capital. As a result, if a company can borrow money on reasonable terms, this will be preferable to issuing equity and diluting the existing owners’ equity ownership percentage.
Every growing business suffers from cash flow challenges. Smart business owners will pay close attention to each driver of its cash flow, forecast future cash needs, and plan for raising additional capital well before it is required (to minimize disruption to the business). If you need help analyzing or forecasting your cash flow needs, or require help finding debt or equity capital, please reach out to us as chris@classvipartners.com. We are happy to discuss different options with you to help you continue to grow your business.
AUTHORED BY:
Chris Younger | Managing Director | Class VI Securities, LLC | Class VI Family Office, LLC
Chris co-founded Class VI in 2005 with a mission to Enable the Entrepreneurial Spirit. Sharing a passion for what entrepreneurs mean to our community, Chris and his business partner David Tolson felt they could do a better job for business owners and have had a great time helping clients ever since.
Prior to Class VI, Chris spent more than 20 years gaining experience in executive management, marketing, sales, law, and mergers and acquisitions.