Recently we've talked to owners of a number of small to midsize businesses that are struggling with cash flow issues. For the first time in many years, the owners are finding that they have to put their own money into the business to cover expenses. Given the economy, this isn't surprising.
One of the most common reactions to a cash flow squeeze is for owners to attempt to grow sales. This makes sense. All else equal, sales growth will result in increased net income. But, as a savvy finance expert drilled into my head years ago, "You can't buy beer with net income, you can only buy beer with cash." Unfortunately, while growing sales may result in increased net income, it could also result in a short-term reduction in cash flow - oh no, less beer!
This is the case because sales growth will drive increases in balance sheet accounts. For example, a sales increase may be accompanied by a requirement for more inventory. This in turn, would mean that accounts payable will increase because the company has to pay for the inventory. Similarly, if more product is sold, accounts receivable will grow because customers will owe the company more money. When an asset account such as inventory or accounts receivable increases, it uses cash. In the same way, when a liability account such as accounts payable grows, it throws off cash.
Consider the case of one distribution business. Gross profit is 40% of sales and net income is 10% of sales. The business has to maintain inventory to enable timely shipments to its customers. Its inventory turns four times per year. The business offers net 30 day terms. But, the average customer stretches this a bit and pays in 45 days. The distributor has to pay its suppliers in 30 days.
If the company's balance sheet ratios remain unchanged, the cash flow implications of a dollar of sales growth in the current year are as follows:
ItemCash Flow Effect *
Increase in Net Income+$0.10
Increase in Accounts Payable+$0.05
Increase in Inventory-$0.15
Increase in Accounts Receivable-$0.12
The net of this arithmetic is the counter intuitive result that a dollar of sales growth does not increase cash flow in the first year. On the contrary, it uses $0.12 of cash. The implication is that a successful push to grow revenue that results in a $1 million sales increase this year would actually result in the company having $120,000 less cash than if sales had stayed flat.
To be sure, the changes in balance sheet accounts (i.e., accounts payable, inventory, and accounts receivable) are a one-time event. Therefore, if the dollar of sales growth is sustained it will result in $0.10 of positive cash flow in each subsequent year. However, businesses that are in a crunch right now may not be able to withstand the initial year of negative cash flow resulting from the sales growth. A business can literally grow itself into bankruptcy. This is not hypothetical! Unfortunately, it happens to businesses frequently.
If your company is experiencing cash flow difficulties, as illustrated above, the right course of action may not be intuitively obvious. It depends on the specific economics of your business. During this time in the life of your business, the wrong move will be counterproductive at best and possibly fatal. There are things that can be done to increase cash flow that go beyond sales growth. At this critical juncture, a carefully thought out plan of action is imperative! * For details on these calculations, please contact the author.