Strategic Growth: The Cash Flow Pitfall

tl;dr: Cash management is a priority function for businesses of all sizes and stages. The bad news is that you’ll probably always have to manage cash. The good news is, there are tools to help you understand your cash ecosystem, head-off potential cash crunches, and work your way out of any cash issues you’re experiencing.

Consider this business fable:

A small manufacturer of computer accessories builds lap top bags that sell like hotcakes. They’re hand-stitched and tanned leather so they look and smell great. They’ve integrated some really useful charging ports and pockets, and overall — people love these bags. Over the course of two years in business and rave customer reviews, they continually get one piece of feedback: when are you going to make purses? They do their due diligence and validate the market. They hunt down new suppliers, adjust their material projections, and run ROI and Payback Period calculations just to be safe. The financials look good and they make the jump. They launch to rave reviews and purse orders start pouring in to supplement their bags. They’ve always built to order in two weeks, it’s part of their brand positioning, so they adapt on the fly and bump their order quantities up to deliver. They hire new staff to help keep up with demand. Three months in, and they’re staring at a daunting backlog, but all the financial indicators look good. The’ve booked twice as many sales, and they’ve only added 50% to the cost of goods sold so far. But in the process, they’ve maxed out the business line of credit and all of their vendor credit limits. The new hires are catching on, but they’re still not getting purses and laptop bags out the door in the two-week window as promised. The small disruption puts the receivables and payables out of cadence, and the fluctuations in cash force them to start prioritizing which bills get paid. Even worse, the added cost of employees and debt-service only exacerbate their precarious week-to-week cash position, so the lead times start to stretch more while they work through their supply chain issues. Some of the orders start to cancel and all of a sudden that double-booked sales number starts to shrink by percentage points, creeping back down to around a 50% growth, bought and paid for by a 50% increase in cost of goods sold. Worse than that, they lost several customers in the process because they couldn’t hit their promised targets, putting future revenue in doubt.

This small fable illustrates several growth pitfalls, but really highlights one of the worst: The Cash Flow Pitfall. It’s what happens when a validated idea gets crushed under the weight of it’s own greatness. It’s what happens when you’re not liquid enough to manage your business growth, and it’s one of the most common and challenging pitfalls of business growth. The exact nature of this particular growth challenge scales and adapts with the business lifecycle, making it particularly difficult to foresee and navigate. In today’s installment of the Strategic Growth series, let’s get into the nitty-gritty of planning for and navigating The Cash Flow Pitfall.

A Quick note for solopreneur readers: it’s useful to think about your business functions independently and to build a headspace for working within each function. Even though you’re responsible for the success of your entire company, seeing each of these functions independently helps you dial in your tactical focus. It’s also a great way to quickly find out where you’re deficient and where you should hire first when the time comes. When you read this article, and indeed this series, I’ll often speak about different business functions — don’t let that turn you off! Instead, try to think about those functions within the context of your own business headspaces.

Step 1: Diagram Your Cash Ecosystem

90% of the business leaders I work with that are struggling with cash flow have, at best, a nebulous understanding of their business’s cash ecosystem. An important distinction here is that positive cash flow and profits are not the same thing. Just like our bag manufacturing example, there are plenty of businesses posting quarterly profits that still struggle to fulfill their weekly obligations. The first step in diagramming your cash ecosystem is to start with the basics — what’s going out and what’s coming in? Depending on the size and complexity of your business this can be as easy as 30 minutes with a beer and a notepad, or as hard as days of drilling down in account transactions. If you have financial software with robust enough reporting, this might be a default system report. If not, build yourself a bare bones cash flow dashboard in your preferred spreadsheet software. At minimum, it should show you something like this, which you can download here:

The key here is to quickly understand if you’re going to have cash flow issues in a given period — if you see red, you do. I recommend copying this sheet to create a year’s worth of historical cash flow diagrams, just to get a sense of how consistent your cash performance is. Are you usually cash-poor throughout the month, and are there any trends you can identify?

Whatever tool you use, the most important thing is to come away with a clear understanding of your current, historical, and projected future cash ecosystem, because that’s going to set some constraints on your strategic planning. Namely, is your current cash position sustainable, and how will that ecosystem change if you start investing in your businesses growth? This step in the process is exploratory, and it’s all about getting intimate with your business’ relationship with cash. Once your comfortable with this information, it’s time to make it actionable.

Step 2: Manage Your Cash Ecosystem

If you’re currently struggling with cash flow shortages, this section is for you. I can’t stress enough that every business challenge is unique, and this particular example may not reflect your challenges. There are however, some key targets that you want to achieve with any cash management efforts, and this section will talk about those in depth. If you’re more concerned about how to plan for and mitigate future cash shortages, skip to Step 3.

We can simplify a business into a machine that takes resource inputs, adds value, and outputs a solution:

Input Resources → Add Value → Output Solution

The specific value of cash to your machine will vary, but it’s safe to say that having access to some is going to be important, whether that’s to access resources, add value, or to find a lucrative home for whatever solution you output. Since your cash may be important in any or all of these functions, the tactical shape of your cash flow management efforts can take many forms (purchasing controls, payment prioritization, vendor management, inventory controls, risk management, etc.). Recognizing which of these is most impactful and important is what you should learn when you’re diagramming your cash ecosystem, and each is far too hefty to dig into in this article. Instead, let’s focus on the key targets of your cash flow management efforts: visibility, cadence, and balance.

1. Visibility — proactive cash flow management means you’re planning ahead, not reacting. You’ll need an operational process for collecting, prioritizing, and discussing your bills, expenses, and purchasing requests. And you’ll need these numbers to roll up to a full picture of the financials and their timing. Visibility is your prime directive, without it, you can’t measure cadence or balance.
2. Cadence — cash flows in, and cash flows out, that’s the nature of business. At the end of a period, we’re hoping that more cash flows in than out. Depending on how you slice and dice those periods, however, that picture can change wildly. Your cash flow controls have to make sure you have the cash on hand that the cadence of your transactions requires.
3. Balance — at the end of the day, you have to make more than you spend. You can take the long view on balancing cash transactions because growth often takes investment, but how is the net cash flow trending? Watching your balance trend is a great net-present indicator of your business performance. If you’re leaking cash and the other aspects of your finances don’t reflect it (AR/Inventory/Assets) something not great is happening.

For a concrete example of how this might manifest, here’s an example of a fairly involved Cash Management Workbook I developed for one of my clients.

This dashboard gives you a high-level snapshot of your accounts and cash flow. It’s got built in distinctions for fixed expenses, payment agreements with vendors, discretionary spending that pops up, inter-account transfers and, if necessary, external deposit scenario war-gaming.

This particular client was struggling with runaway spending that they needed to bring into balance. With 30 employees and multiple locations, they needed a more transparent way to control and discuss spending priorities. In addition, they’d been stretching many of their vendor bills past due and were running into supplier delivery issues, continuing to move their cash cycle out of balance. They needed more visibility to give them the ability to bring spending into cadence and balance strategically, and they use this as the main jumping-off point for managing cash on a weekly basis. It’s also the key mechanism they have for collecting, prioritizing, and managing vendor bill issues, allowing them to focus on the most important accounts when cash flow is tight.

Pictured here is a discretionary spending tab where users can concurrently add vendor contact notes, spending priorities, and general notes about requests.

When cash gets tight, it’s not uncommon to need to negotiate structured payment plans to bring certain accounts back into terms. Pictured here is a place to track payment agreements made with vendors.

Understanding your fixed expenses vs. your discretionary spending is critical. Some expenses just can’t be missed. This particular workbook considers the company’s operating load (payroll, taxes, 401ks, insurance) and negotiated structured payment agreements as the total weekly fixed load.

Of course, the issues that this particular client faced may not be the issues your business is facing, and maybe diving this deep into a workbook isn’t the best solution for you. If you’re not sure what the best strategy is, get in touch. If I can’t help you I’ll definitely point you toward some great resources.

Step 3a: Develop your Cash Health Indicators

The most useful tool I know of to proactively identify and head-off cash flow shortages is the Cash Conversion Cycle.

In short, the cash conversion cycle (CCC) is a cash flow calculation that attempts to measure the time it takes a company to convert its investment in inventory and other resource inputs back into cash.

The cash conversion cycle calculation is made up of several key financial elements. It’s a great 10,000-foot view of how efficiently and effectively your business machine makes cash from your cash inputs. The CCC and its component ratios aren’t particularly useful out of context, but they’re really great trend indicators, which makes them perfect for monitoring your cash ecosystem to spot problems before you have acute cash flow issues. For the simplest CCC period calculation, you’ll need to aggregate:

1. Income for the period
2. COGS for the period
3. Inventory at period close (you can also use an average inventory over periods if you prefer, but I find that if you have fairly consistent inventory period close is sufficient)
4. Accounts Payable at period close
5. Accounts Receivable at period close

We’ll take this information and develop 3 indicators of the cash conversion cycle, Days Inventory Outstanding (DIO), Days Sales Outstanding (DSO), and Days Payables Outstanding (DPO). Each represents a different pillar of your cash conversion process, respectively, how long it takes to turn inventory you purchase into a sale, how long it takes you to collect on sales, and how long it takes you to pay your bills. To calculate your CCC, you’re going to add together how long you have inventory and how long it takes to collect, and subtract how long it takes you to pay your bills. Brace yourself for some math:

CCC = DIO + DSO - DPO

DIO = (Inventory/COGS) x Days in Period

DSO = (AR/Total Sales) x Days in Period

DPO = (AP/COGS) x Days in Period

Because this calculation is really about watching trends, you can modify this for whatever period you like as long as you calculate it consistently. I’ve personally applied it as a weekly modified calculation, but find that monthly and quarterly make the most sense based on most businesses’ inventory processes. Much like with your cash flow diagram, go back a few years and develop a historical base line of these financial indicators so you know how you’ve been performing. Next, let’s talk about how to interpret these indicators, what kinds of leading indicators highlight potential cash flow issues, and how to proactively strategize around those issues.

Step 3b: Use the Data

You’ve probably figured out by now that I’m a big proponent of data-driven analysis and decision making. I’ll take that model over the proverbial gut-check any day, and the reason is simple: it’s just not that hard to find good data anymore. It’s much more important (and harder) to find the right data and this is an important distinction to keep in mind when you start building your own internal processes. There are plenty of “data nerds” who can pull together really interesting dashboards and charts to get lost in (and I will happily nerd out with you if you share some good ones), but your analyses should be grounded in problem solving. And they need to be displayed and presented in a way that promotes actionability. In short, you need to have a pretty good research question, and you need to make sure that whatever comes out the other end of that effort is going to be useful to you in your decision-making and strategic planning. So with that in mind, what can your CCC tell you?

Well, at the risk of being redundant, it tells you how long it takes your business to turn cash back into (hopefully more) cash. In general, you should be interested in how your current CCC calculation compares to previous periods, because this is going to tell you if this cycle is getting relatively slower or faster. The CCC is a great metric because it not only stands alone, but also provides incredibly useful detail through it’s component indicators. If you notice your CCC start to lengthen, all you have to do is look at your DIO, DSO, and DPO and identify where the changes are happening. In general, you want to have smaller DIO and DSO values because these indicate that you’re turning inventory over quickly, and collecting AR dollars quickly. DPO gets a little bit more tricky. In reality, you want to maximize this number without souring your vendor relationships. If most of your vendor terms are Net 30, a DPO of 30 to 45 is a realistic target. Let’s apply some example numbers to these ideas:

Sample quarterly financials for a fictitious company.

A continuous chart showing the different elements of our fictitious company’s CCC.

Looking at the continuous trend by quarter we can see that our fictitious company’s business has a fairly predictable business cycle. There is some fluctuation in the nominal values, but with an Average Quarterly DIO of 67 days, Average Quarterly DSO of 30 days, and an average DPO of 35 days, this company’s cash cycle is healthy and fairly well-balanced on average. If anything, this company could focus on production throughput to shorten their cash conversion cycle, provided there’s a way to do that without adversely affecting the operational efficiency and driving up the cost of goods sold or expenses. The CCC has a tendency to lengthen in Q2 and Q3, and diving into the component calculations we can see that in these periods our fictitious company was holding onto inventory a little bit longer and not collecting on sales as quickly as normal. As a result, the DPO in Q4 of 2017 stretches to 50 days (15 days above average), which is a good indicator that even though this company is posting net profits, they likely had to manage cash more closely in this quarter than they normally would. All-in-all, this is a stable cash ecosystem.

Now let’s take a look at the opposite:

Sample financials for our second company.

A continuous chart showing the different elements of our second fictitious company’s CCC.

Immediately, we can see that our second company is posting year-over-year revenue losses. It’s clear that, at least in this three year period, the business environment is changing.

This company’s cost-of-goods sold is more-or-less elastically tied to these revenue fluctuations which won’t raise too many alarm bells on a Profit and Loss statement. But the CCC is telling a different story. Firstly, the CCC is stretching dramatically, approximately 110 days over a three-year period. This means that it’s taking 110 days longer to convert cash back into cash for this business. Diving deeper, every component indicator is also stretching. Our DIO is +150 days, our DSO is + 60 days, and our DPO is + 90 days. We can make some powerful inferences from these ratio in context:

1. This company failed to recognize their changing market and landscape, and did not adjust accordingly. We see that both DSO and DIO have been trending upward, which is a good indicator that this company is buying resources faster than it’s converting them into sales.
2. The steady increase in DSO exacerbates the cadence and balance issues created by poor purchasing and inventory contorls. Not only are they taking longer to turn inventory into sales, once these sales finally do go through, they’re taking longer to collect!
3. Not surprisingly, this company isn’t paying it’s bills in a timely manner. With a DPO of 187, keeping the lights on week-to-week is a minor miracle. It’s a testament to a hard-working AP team diligently negotiating with vendors to keep materials flowing.

This company’s leadership, wasn’t paying attention to their cash ecosystem, and they’re paying the price. The takeaway here is that whether you’re trying to survive, expanding into new markets, or targeting growth in your existing sectors, your CCC is a really powerful weather vane to diagnose and predict cash flow problems. In the chart below you’ll find some common causes of changes in component CCC indicators. When you’ve decided to invest in your businesses growth, keep an eye on these changing indicators, at minimum quarterly, so that you can nimbly adjust to your changing cash ecosystem and avoid shortages.

Your CCC cheat sheet. If CCC is stretching, look to your component indicators and these common causes.

Step 4: Strategize, Adapt, Repeat

Everything you’ve done up until now has been useful, but reactive. The reality is that you now need to take this information and incorporate it into your strategic planning. It’s not very useful for me to arm-chair quarterback your business strategy without any context, so now, as ever, it’s up to you! The good news is that now you have some dashboards and tools at your disposal to help inform your decision-making, and also validate any interactive testing/tactical execution that you choose to pursue. A strong cash position is a great foundation for your business growth. And with the right tools in place, coupled with a strong understanding of your cash ecosystem, you have the ability to strategize around, through, or out of your cash flow crunch.