Written by Ankit Sarawagi
The first sign that a company is failing is when the founders see the company’s bank balance fall to an unacceptable level. By that stage, there is little that can be done to rectify the situation. What makes correcting a cash crunch problem more difficult is that I can – without a doubt – say that most of the cash crunches that I have dealt with during my advisory career could have been prevented; they became apparent 3 to 6 months before the crunch, but no one noticed. The timing of cash inflows and outflows is what should have been monitored.
Cash and Profit are Not Variables of the Same Equation
Numerous founders that I have worked with have been profitable on paper, but still unable to meet payroll. This has impacted founders more than they had anticipated. This situation is particularly true for businesses of a certain nature, e.g. professional services and D2C brands with inventory, etc. A company can record a positive cash inflow for an accounting period and still be cash negative. This is because accounting profit is not the measure of cash inflow.
This was frequently the case for one of my clients, a services firm in a good position. For this client, cash flow was an issue even though revenue was growing, and the P&L was positive because the payment terms of new clients were 60 days, and cash outflow for payroll and vendors was weekly. It renegotiated payment plans with several significant customers while also enhancing collections for past due accounts. The cash situation was better in two quarters without making any fundamental changes in the operations.
The Forecast That Matters
Small and mid-sized companies usually have budgets; very few have a 13-week cash flow forecast. That most likely is the largest gap in your accounting. A budget tells you your plan for earnings and expenditures for the year while a cash flow forecast tells you, net of any accounts receivable, if you have the cash to meet your payroll in six weeks.
It’s moving a few numbers around. For example, inflows (in your case customer payments) are estimated and grouped by the date you expect to actually receive the payment, for instance, not the date the invoice was issued. Outflows are grouped by date for commitments already made (payroll, rent, payments on loans, and accounts payable) and are committed on varying terms. You must actually do this, however, weekly, to catch potential cash shortfalls for three or more months with no formal finance function in place other than someone to update a spreadsheet every Monday.
Where Founders Get It Wrong
The largest gap in knowledge about cash flow is usually not knowing that cash flow is important. It is the most monthly errand. Knowing the cash shortfalls monthly means it’s too late. Cash shortfalls should be happening “gradually” but with a monthly cash flow it should be “gradually” too late.
The second error is confusing available credit with available cash. A credit line is meant to cover an emergency, not substitute for an active collection and payment management. I’ve seen businesses depend on credit lines to cover the structural gap of when they are received versus when they are to be paid. This will only shift the problem and add an interest cost to it.
The Takeaway
The most critical thing that differentiates the calm founder from the perpetual firefighting founder is the regular assessment of cash flow. They assess on a weekly as opposed to a monthly basis and they look at the future flow, not just the past. It is almost free to assess the flow weekly as opposed to monthly.
In the interim, issues that have a low cost of correction, such as the renegotiation of payment terms, can be used instead of a panic-driven costly, sub-optimal, short-term business credit facility, to manage cash flow.
Growth is meant to be the good problem. It only becomes a bad problem when there is a gap of cash inflow and outflow and no one is watching.
Author Bio:
Ankit Sarawagi is a Chartered Accountant and Curator of Cfomatrix. He works with growing businesses on financial management, strategy, and risk analysis. As a member of the Forbes Finance Council, he brings valuable insight with industrial expertise.