“How to Analyze Cash Flow to Find Your Ideal Growth Rate”

Businesses are supposed to grow, and the faster the better, right? Growth is certainly desirable, but it can also be dangerous. In fact, growing too rapidly is one of the leading causes of business failure. The cause: cash starvation.

When your sales surge, you have to buy more inventory, hire more production workers, and spend more to package and deliver those orders. This generates expenses that you have to pay quickly. However, most of your sales are to customers who won’t be sending you checks for 30 days or more. If you have not planned for that growth and figured out where you will get the cash you will need to sustain your accelerating level of activity, you could be forced to shut your doors, becoming yet another victim of success. Fortunately, this is an easily avoided fate.

As with many other aspects of running a company, the hardest part of planning and controlling growth is that it requires self-discipline. You have to monitor how much cash you have on hand, and how much will be needed in the coming weeks and months. You may even have to make the difficult decision to turn down some business temporarily to avoid growing faster than your cash flow allows.

In this Quick-Read you will find:

• How cash flows through your company.
• Techniques for calculating how much more cash your company will need as your sales grow.
• Ways to get that cash.
• How to control your growth to match the amount of cash available.

SOLUTION [top]

What’s so hard about driving a race car? You get in, mash the gas pedal to the floor and keep accelerating until you win, right? In fact that strategy will almost certainly result in a headlong crash into a wall. Building your business without paying attention to the risks that accompany growth can have equally dire consequences.

There are many external factors that can limit your ability to grow your company. The labor market may be tight, making it hard to find the employees you need. The supply of workers with specific skills (precision machinists or software programmers, for example) may be especially limited. Environmental or land-use regulations may make it impossible for you to expand your factory.

But the most common — and most perilous — problem for a fast-growing small business is simply running out of cash. If you can’t come up with the cash to pay your employees, suppliers, landlord and creditors, you are likely to come to work one day and find a padlock on the front door. That can happen even if your financial statements show that you are making a profit!

It all comes down to what is called the "operating cycle," which means the way cash flows through your company. At the start of the cycle, you have some cash in your checking account and other cash tied up in inventories of raw ingredients, work in progress and finished goods. When you sell the finished goods on credit, your accounts receivable increases by the amount of money your customer owes you. In effect you are using your cash to finance your customer’s use of your product until that customer pays you. When the customer’s check arrives, cash flows back into your company, completing the operating cycle.

If your sales volume didn’t vary much, you would just need enough cash each month to cover your outlays until your customers paid what they owe. But things get much more complicated when your company is growing quickly. Orders from new and existing customers soar, and your receivables rise accordingly. You have to ramp up production, which means hiring and training more people, adding production and warehouse capacity, and spending more on sales, marketing, distribution, delivery and so on.

You are so busy with hiring, buying and spending that you may think you don’t have time to do cash flow forecasts. That’s a prescription for disaster. Analysis of your cash flow will allow you to predict and control how much you will have available for R&D and business expansion without seeking outside capital.

If you want to expand faster, you have to figure out how to make up the difference. You, your chief financial officer or your accountant must figure out how much cash your company will need, and when. That may mean an additional investment in the company by its owners or by other investors. It may mean getting a loan for working capital from a bank, seeking additional trade credit from your suppliers, discounting (factoring) your receivables, or using a combination of several approaches. Rigorously pursuing past-due accounts can bring in needed cash, and offering discounts for early payment can get good customers to get their checks in faster.

You can also take your foot off the gas. You can control your growth rate by moderating demand for your product in any number of ways. You can cut back on your sales and marketing activities, raise prices, toughen your credit standards or even turn away business. No one likes turning business away, but it beats seeing your business smash into a wall.

REAL-LIFE EXAMPLE [top]

A West Coast manufacturer of engineered trusses struggled during the slow home-building market of the early 1990s. But when construction activity picked up later in the decade, the two brothers who owned the company saw a sharp increase in demand for their products.

Keeping up with that demand meant adding new production facilities to manufacture the roof trusses. Most were custom-designed, which meant the company had to find or train design technicians and equip them with costly computerized workstations. The company increased its stockpile of lumber, bought additional trucks and hoisting equipment, and added more salespeople, delivery drivers and other staff.

One of the brothers had taken some classes in accounting and business management, and during the slow period had built computerized spreadsheets that modeled the company’s costs, profitability and cash inflows and outflows at various activity levels . Those models were not very sophisticated, but they gave an early warning that an upturn in the highly cyclical home-building industry would cause a cash crisis.

The brothers arranged for a revolving line of credit with a local bank. They scrutinized the creditworthiness of the homebuilders who placed orders for trusses and demanded payment with each order or on delivery from those with poor credit. They offered discounts for prompt payment and told all their customers that future deliveries would be cut off if invoices were not paid on time. Because builders needed the trusses to complete their homes, this was a strong incentive.

The result: the company managed to grow fast enough to satisfy the demands of its customers while maintaining adequate cash flow.

DO IT [top]

1. Make cash flow forecasting a priority, and integrate it into your growth planning. Don’t accept a proposal or forecast unless it includes an analysis of impact on cash flow.
2. Check your expenses and cash flow needs against industry averages published in Dun & Bradstreet’s Industry Norms and Key Business Ratios and in the Risk Management Association (formerly Robert Morris Associates) Annual Statement Studies.
3. Control your receivables and speed up collections. Require credit applications from new and existing customers, and run credit checks before shipping. Require partial payment from poor risks or slow-paying customers. State payment terms clearly on invoices, make sure required information (e.g., purchase order numbers, correct department) is included. Offer a discount for prompt payment; and if the invoice is unpaid on day 31, phone to request a commitment for payment in full.
4. Deposit checks daily, in time for same-day credit. Use a bank lockbox to speed deposits.
5. Look for peaks and valleys in your cash needs. Postpone outlays to match peak inflows. Run sales promotions to help fill in the valleys.
6. Smooth out periodic expenses. Ask vendors (e.g., utility companies) to annualize your bills to 12 equal monthly payments. Set aside cash monthly for R&D, insurance, pension and other recurring expenses.
7. Line up financing in advance for your upcoming cash-flow needs — from your bank, private investors or a receivables financing company (factor).
8. Ask your key suppliers to extend your terms for payment.
9. Use outsourcing and temporary employees to meet peak loads. You can add these faster than hiring permanent workers and can cut the expense as soon as demand lightens.
10. Get additional opinions on your market’s size and potential for expansion using the methods outlined in the Quick-Read titled Issues to Consider When Outsourcing Market Research.

RESOURCES [top]

Books

Managing Explosive Corporate Growth by Steven M. Bragg (Wiley, 1999).

Understanding Cash Flow by Franklin J. Plewa and G. Thomas Gottlieb (Wiley, 1995).

Ernst & Young Guide to Financing for Growth by Daniel R. Garner, Robert R. Owen and Robert P. Conway (Wiley, 1994). A primer on ways to raise capital for growth.

Internet Sites

10 Tricks to Keeping Your Cash Flow Healthy

Cash Flow Budget Worksheet Template: Aid for Projecting Availability of Cash

LiveCapital.com

Why a Cash Flow Plan is Vital to Strong Financial Management

Preparing a Cash Flow Forecast

Preparing Your Cash Flow Statement

Making Cash Flow Forecasts

Article Contributors

Writer: Alex Auerbach