There’s an old saying – profit is opinion, cash is fact. That’s because despite making a profit, some businesses still don’t have enough cash to pay the bills. At the end of the day, a lack of cash will kill a business.
Banks and other creditors are paying increased attention to the cashflow position of their creditors, in particular their ‘free cashflow’. So what is free cashflow?
Regardless of size, the principles of running a business are the same. Simplistically, a business is just a pot of money. That “pot” gets invested in holding stock or jobs in progress, providing credit to customers (debtors) and acquiring fixed assets. In return, the business usually gets credit from its suppliers (creditors). Each year, as the business grows, so does the size of this “pot” – more stock and jobs in progress, more debtors and more plant and equipment.
The increase in the size of the pot has to be funded from one of two sources – debt or equity.
Usually, it is funded from after tax profits (or equity) and after payment of any dividends to the owners. If this profit is not sufficient to fund the increase in size of the pot then this results in negative free cashflow. Banks and other creditors are concerned about this because if the extra funding isn’t coming from the business profits then it has to come from the bank or from new or existing shareholders (by way of increased share capital). For most privately owned businesses, the latter is usually not an option – which leaves the bank to fund the shortfall.
This means the growth rate of the business is not sustainable (sometimes called “over trading”). Whilst it may be okay for a year or two, eventually it will catch up with you. Over trading has ruined many potentially good businesses. There are three main reasons why a business will feel the pinch on cashflow:
1. The business is not profitable. Sometimes business owners think they have a cashflow problem. When you look further, the problem is not cashflow per se. Rather, the business is not profitable. This requires an analysis of the drivers of the business to determine if and how, the profitability of the business can be increased. It may be that some product lines are unprofitable so prices need to be increased or that product line discontinued. It may be that the business model is not sustainable.
2. The business has used operating working capital to fund long term assets (e.g. fixed assets). This is a common mistake and can be fixed relatively easily if the business is profitable. Unless a business has a proverbial bucket load of cash, it should buy long term assets (e.g. fixed assets) using long term finance. If there is solid profit and positive cashflow most banks will fund this, usually through leases or asset based financing.
3. The business is over trading. That is, the business is growing too fast. Again, if the business is profitable this problem can also be fixed. A fast growing business is a nice problem to have but there will be a limit to which the banks will provide the funding. If you don’t have access to limitless amounts of cash then operating within your sustainable growth rate is crucial. Once you know your sustainable growth rate you can limit your growth to within this range. Often this can be done by increasing profits which provides yet more free cashflow, but business owners find it very difficult to consciously slow the growth rate of their business.
In summary, some tips to better manage your cashflow:
- Make sure your cashflow projections are well managed and enable you to clearly foresee and prepare for potential shortages
- Maintain sufficient cash reserves to pay bills, grow the business, invest where appropriate and develop new products and services
- Managed borrowing will help to reduce interest costs
- Consider bulk purchasing to bring individual item costs down
- Keep communication with clients a priority, by providing them with a quick email updates or calls about the product or service, or simply keeping in touch to ensure they are still satisfied
- Keep customer service consistent and remedy any issues without delay
Our SME business experts at Beavis Morgan are available to structure your business with cashflow and profit forecasting to measure performance and maximise opportunities. We work to a pre-determined plan, to help you avoid any nasty surprises.
Through our partner businesses, BM Structured Finance and BM Advisory, we are also able to help with sourcing and restructuring debt finance for SME businesses, as well as assisting with resolving issues which can impact on business performance and success, and finding innovative solutions for businesses and individuals in distress.