Cash Flow – The Life Blood of Your Company

By: Rich Kramarik

Most CEOs and business owners have heard the term “Cash Flow.”  Many will even say, “I manage the cash flow daily.”  But, the reality is that a very large number of these business executives don’t really understand cash flow or strategies to manage cash.  What we mean by this statement is that executives don’t know the actions they can or should take to forecast cash needs and uses, or actions they can take to improve a poor cash position.

 One example is the CEO of an engineering/design company who manages income or profit on a project-by-project basis.  He says that on every project he is meeting the projected project hours forecasted, but the company is losing money.  Why?  Because on his project expense forecast he does not include all the company overhead costs like the large number of overtime hours paid to hourly employees at time-and-a-half.  These overtime payments along with other “incidental” expenses were adding up to 20% of project revenue. These costs not included in the project-by-project budgets lead to a negative cash flow.

 Another example is the CEO who does not need to watch cash flow because, “…the bank account always has plenty of money in it.”  He pays ahead on bills and pays vendors as soon as he gets the invoice.  He gets paid in advance for work to be completed next month.  Then one day he goes to write a check and there is no money in the account. Why, because his gut feeling on cash position is not in sync with the real cash position.

 Just to be sure we are on the same page; cash flow is essentially the movement of ALL money into and out of your business. It's this cycle of total cash inflows vs. total cash outflows that determine your business' solvency.  Cash flow analysis involves examining the components of your business that affect cash flow, such as accounts receivable, inventory, accounts payable, investments and credit terms. By performing a cash flow analysis on these separate components, you'll be able to more easily identify cash flow problems and find ways to improve your cash flow.

 Equally important to cash flow tracking is cash flow forecasting.  The cash flow forecast shows how cash is expected to flow in and out of your business. For you, it's an important tool for cash flow management, letting you know when your expenditures are too high or when you might want to arrange short term investments to deal with a cash flow surplus. As part of your business plan, a cash flow forecast will give you a much better idea of how much capital investment your business may need.

 Either your cash flow tracking or forecasting can show you a cash gap.  A cash flow gap occurs when your cash inflows and cash outflows don't keep pace with each other, leaving your business short of cash. This is an especially common problem for small businesses, where cash outflows may often precede cash inflows.  Many different expenses, from purchasing materials necessary to do the work through licensing or permit fees, may have to be paid out before the business gets paid for the work completed.

 How do you close this cash flow gap and keep your business solvent?

Keep a close eye on your cash flow, so you can forecast potential cash flow problems and take steps to remedy them.  Take steps to shorten your cash flow conversion period, so your business can bring in money faster. These steps may include:

 1) Preparing customer invoices immediately upon delivery of your goods or services to the customer. If you wait to prepare your invoices at the end of the month, for example, you may be adding as many as 30 extra days to your cash flow conversion period!  If you are already sending invoices out within seven days of the work completing – reduce that time to 3 days and in some cases you will see an almost 30% increase in cash flow.

 2) Monitoring your customers' use of credit and adjusting their credit limits accordingly.  If the amount owed is increasing each month you may have a credit problem.  Don’t wait for three to six months to take action.

 3) Offering customers a discount for paying their invoices early. For instance, if your usual policy is to have payments due in 30 days, offer a small discount such as 2 percent to customers who pay within 14 days.  If you are already doing this, start writing contracts with payment terms of 15 days – this is very common today.

 4) Establishing a deposit policy for works in progress. For example, if you deliver a service, such as software development, training, or architectural services, you can adopt a policy that customers pay a certain percentage of the total invoice up front before the job begins.  Likewise, don’t hesitate to build “milestone” or “progress” payments into the contract. 

 5) Tracking your past-due accounts and actively pursuing collections. Most accounting software programs let you easily track past-due accounts, but you also need to have a clear process for pursuing collections. Such a process might involve sending out a series of letters letting your customer know that his or her account is past due and what steps will follow if he or she does not pay, such as turning the account over to a collection agency.  A middle ground step may include a customer committed payment schedule to “catch-up.”

 6) Use “power invoices.”  Invoices that say due on receipt or due in 30 days are saying “pay when you get around to it” to your customers.  Worse yet are invoices or statements that age what is owed by “current, 30 days, 60 days, 90 days.”  By showing the aging you are saying you are willing to carry what’s owed for that length of time.  Instead write invoices with a specific due date such as, “Due January 28, 2006.” 

 You have to have money coming in regularly to maintain an adequate cash flow for your business, not just endlessly streaming out. Forecasting and monitoring your cash flow and taking steps to shorten your cash flow conversion period will go a long way toward eliminating those dangerous cash flow gaps.

Cash Flow the Life Blood of Your Company
Case Study

By: Rich Kramarik

This situation is a hardware sales and installation services company with five million dollars in revenue with a solid recurring revenue stream from a set of long standing customers.  This CEO was struggling with her cash situation for two reasons.  First, her COO was convinced and had budgets and contracts to back up the view that the sales and installation projects were all profitable.  Second, she didn’t have the money in the bank to pay the bills.  Each month she had to transfer money into the company from other sources. 

 It didn’t take long to see some indicators of the problem when we started looking at the financial statements, budgets and project records.  This was something this CEO was not doing.  We found that the COO was pricing product at a point he thought he needed to in order to win the business.  On average that turned out to be a 10% margin.  Clearly, this number should have been at least 30% and probably closer to 50%.  So, one reason for the cash shortage was hardware sales profit was 200% lower than it should be.  The bigger issue however was that when the COO built expenses into his budget model that he used to price the service projects, he did not include any of the company overhead costs.  He did not include building rent, employee benefits, phone, inventory carrying costs, tools, office supplies, computers, etc.  These costs were equal to 33% of revenue.  So, a couple of simple accounting/forecasting errors set up this CEO and put her in the situation of actually loosing money on every contract.  The overall numbers came in to be that for every $1 she earned in revenue she had to spend $1.33 to earn it.  This company did not know how to track cash flow.

 The management team thought that there was no way for them to increase prices to the correct level without loosing customers.  We agreed and suggested that they just increase prices by 5% on new contracts over the next six months and see if there was any negative impact on sales.  There was not.  We then suggested that they increase prices another 5% and again there was no negative impact on sales.  The CEO continued this slow progression of price increases and steadily improved the cash position.

 We also found that the COO was signing contracts for work that would be completed over a three to six month period with a single customer payment at the end of the project.  This meant that the CEO had to pay for all the hardware and employee overhead out of pocket for three to six months before she got paid.  This is a cash flow nightmare.  So, we got the COO to write all new contracts with up-front payments for materials and milestone payments each month for labor completed each month.  This turns out to have been an industry practice that the COO had not implemented because he thought it would hurt their sales success if he implemented it. 

 After working on these “piece-parts” we worked with the CEO to put a cash flow management system in place.  This included:  

1. Weekly cash flow reports from the accounting company that showed the last week and year-to-date cash flow position.

2. Cash flow forecasting process that “rolled-up” all the individual project forecasts into a company wide forecast.

3. Decreased the time to get invoices out to the customers from two weeks to three days.

4. Increased accounts payable days from 20 to 45

These actions and some management training moved this company to a break even position within six months and small profits in one year’s time. The company did not loose any customers and was even able to add customers with the new (higher) pricing.  This is a real story and we hope that it illustrates that it’s difficult for CEOs to know what they don’t know.   

* * * 

Some times your company’s cash flow is impacted by the unknown.  And, then sometimes the “unknown” is something you could have or even should have known.  In this talk with Paladin the company is in the business of refilling and reselling laser printer and ink jet cartridges. 

 This toner cartridge refurbishing business has traditionally been a very lucrative business of picking up free expended cartridges, buying some toner, cleaning and refilling the cartridges and then selling them for half the price of the new cartridge.  But, after a time the original equipment manufacturers (OEM) started putting electronic chips in the cartridges that burned out when the toner ran out.  This meant that the refilling companies now had to buy new chips and install them on the reconditioned cartridges.  Of course the OEMs charged a premium on these chips.  On top of this the OEMs started printing statements on the cartridges that said that the printer warrantee was violated if a non-OEM cartridge was used in the printer.  So, now the cartridge refilling company had new cash flow requirements to purchase the chips – eating into cash flow.  And, they had to also spend additional money on marketing activities to overcome the OEM statements that using the refilled cartridge would invalidate the printer warrantee – more negative cash flow. 

 The long term impact of this situation was reduced cash flow, reduced margin and reduced profits.  This situation was then exacerbated by the introduction of low cost, high quality ink jet printers.  For two years, it was not economically feasible to commercially refill the ink cartridges for resale.   Then about a year ago a company introduced commercial, high capacity ink cartridge refilling machines.  Our cartridge refilling company had to make major capital investments to purchase this new equipment.  But, on top of that there were training costs, new marketing programs, new inventory costs, and more – which all negatively impacted cash flow. 

 The company could have seen these industry changes coming and planned for them, but they did not.  It took a couple of years for them to dig out of the technology introduction hole they fell into. 

 We use this talk to make the point that cash flow planning needs to include considerations beyond the typical things discussed in the other talk with Paladin discussed above and the issues discussed in the other article in this news letter.  Cash management also includes researching, planning and forecasting technology changes that may impact your products.  Then, you also need to update your sales, marketing and financial plans to ensure you will not run into cash flow problems.

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            Bob De Contreras                                                  
            Rich Kramarik