Cash flow counts

Good financial management can mean the difference between success and survival in the current uncertain climate, as Guy Whitcroft, principal consultant at CapitalSteps and a 30-year veteran of the IT industry, explains.

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Cash flow counts Guy Whitcroft says that focusing on margin at the expense of cash flow can cause companies to run into financial trouble.
By  Guy Whitcroft Published  October 30, 2009 Channel Middle East Logo

In these difficult times it seems appropriate to revisit one of the biggest causes of problems in a business. Something like 80% of business failures are not due to losses, but due to a lack of cash flow. Quite simply, the business doesn’t have the cash to pay its creditors, even though it is profitable on paper.

However, most businesses seem to focus primarily on margin, ignoring cash flow until they hit a serious problem with their creditors, by which time it is often too late. So, what are some of the main problem areas with cash flow and what can be done about them?

Keep on top of your debtors

Debtors — or accounts receivable — is probably the most the obvious area, and one with a quick return. The fact is that reducing your DSO (days sales outstanding) or debtors’ book by just four days overall can have a dramatic effect on your business. For a business doing US$20m a year, this can be worth an extra US$220,000 in free cash flow — it’s like having an extra 1% margin in your business.

The key here is to find ways to ensure prompt, or even early, settlement of invoices. By sending statements to customers in the middle of the month and having credit control call them to go through any queries, many common excuses for late payment can be removed — and your credit control department can spread its workload more effectively. Furthermore, putting the credit control team on commission and having sales people’s commissions partly dependent on prompt payment by their customers, with both being tied to proper provisions policies, will also help.

Don’t delay payments

Now let’s consider creditors and accounts payable. The first thing that many companies do when they run into cash flow problems is to start delaying payments — and they generally do so without consulting their suppliers. While it might seem a logical approach, this is one of the worst things to do. Delayed payments make suppliers nervous and can often result in decreased credit limits for the company, which tightens cash flow even more. What’s more, if the suppliers report the delays to credit insurers (as they are obliged to do if insuring your debt), banks and other suppliers will start turning on the screws too by tightening credit and recalling loans, for example.

In an ideal world, the credit limit with each supplier should be a company’s average monthly trading volume plus 50%, multiplied by the number of months of credit that it gets (e.g days/30).

So, for example, a company doing US$1m a month with a supplier that gets 45 days credit should have a credit limit of US$2.25m (US$1m + US$500,000 x 1.5) to safely cover the peaks and troughs of business. Reducing this throttles the business and often means having to pay cash for an extra big order — and those orders are often at reduced margin anyway.

If the company does run into temporary cash flow problems, working with the bank and the suppliers through the difficulty that it faces in a proactive way will ensure maximum credibility and minimum difficulty for the company.

What’s more, many suppliers offer extremely attractive discounts — far better than the costs of borrowing money from the banks — for early settlement and the companies that take advantage of these can add appreciably to their bottom line. Working with the bank and shareholders to ensure adequate working capital to take advantage of such discounts can add another percent, or more, to the bottom line, even after taking the costs of this money into account.

Avoid the inventory mistake

Inventory levels are the key to a successful technology business. In fact, more money is lost on inventory than any other single area of a typical technology business. Too little means lost sales. Too much means lost profit through both the financial costs of keeping excess inventory and the likely reduced margins the business will have to take to clear it. What’s more, extra inventory means more storage space, higher insurance premiums, and so on. Bearing in mind that PCs have little more shelf-life than many foodstuffs — such is the pace of change — that great additional 5% price break which is offered for taking three months’ inventory at once will end up costing the business money.

It’s essential to ensure tight controls are in place to manage ordering. Look closely at sell-out per week over the past few months to see the trends. Ensure inventory in excess of normal levels cannot be ordered without proper justification, especially when it comes to great offers for large volume orders. And look especially critically at new product lines and models, as this is often where some of the biggest mistakes are made.

Just as importantly, an aggressive provisions policy must be put in place to keep the inventory moving quickly and tied, with overall inventory levels, to commissions for the product and general business management to keep the focus on inventory control.

Think twice about cost cuts

There are, of course, many other areas where cash can be conserved, but the ones outlined above are the more important ones for all businesses.

Overall, pay systems should be in place that reward (and penalise) all staff — including top management — for the areas they have control over, as this maintains focus.

One last point to consider — be careful when deciding, as many businesses do, to cut marketing and training expenditure. Although it can result in a quick improvement to cash flow, history shows that companies that maintain their marketing presence and keep upgrading the skills of their staff in downturns emerge more quickly and more strongly when the market starts to turn up. Downturns are actually the best time to strengthen market presence and skills — and what’s more this can generally be done more cost-effectively.

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