As a business analyst, much of my daily job involves working with companies in a cash crisis. Often, a call coming into Vertices for Business Consulting, C-Suites Requests, or Business Analyst comes at a time when a client is already well behind the cash curve.
As I begin my analysis of the company financials, I often see the same attempt at a solution: Increase sales. While increasing sales can be a good idea, it is quite regularly the wrong solution to a cash crunch.
Many companies end up in a cash crunch due to poor understanding of their company’s cash conversion cycle. In essence, the cash cycle is the time it takes you to invest cash in the company (think: purchasing inventory to resell) and then receive cash back from the sale of the purchased products. Throughout this process, you incur the cost of Inventory, Marketing, Salaries, Rent, Utilities, and many other normal and regular expenses of business ownership.
Most companies, other than retail companies, offer some sort of payment terms. While this can be a great strategy to increase sales and attract clients, it pushes our cash cycle out. Many of these payment terms are Net 30; meaning, in all likelihood, you are going to collect 30 days after you incurred all the costs of inventory and business.
Many small businesses feel they are too small to negotiate with their vendors, so they often pay for goods and services at the time of delivery or on much shorter payment terms than they offer their clients (Like Net 7 or Net 10 terms).
Jan
Feb
Mar
Apr
Revenue Earned
$ 10,000.00
$ 10,000.00
$ 15,000.00
$ 20,000.00
Cash Received
$ –
$ 10,000.00
$ 10,000.00
$ 15,000.00
60%
60%
60%
60%
Inventory (Expense Incurred)
$ 6,000.00
$ 6,000.00
$ 9,000.00
$ 12,000.00
Inventory (Expense Paid)
$ 6,000.00
$ 6,000.00
$ 9,000.00
$ 12,000.00
Overhead (Rent, Utilities, other fixed costs)
$ 2,000.00
$ 2,000.00
$ 2,000.00
$ 2,000.00
Profit (Rev Earned – Inventory – Overhead)
$ 2,000.00
$ 2,000.00
$ 4,000.00
$ 6,000.00
Monthly Cash (Cash Received – Inventory – Overhead)
$ (8,000.00)
$ 2,000.00
$ (1,000.00)
$ $ 1,000.00
Cash Balance
$ (8,000.00)
$ (6,000.00)
$ (7,000.00)
As viewed in this example, increasing sales in month three actually hurts the company’s cash position. The increase in sales incurred more cost of inventory for the company than will be collected that month, when Overhead expenses are added, resulting in a worse cash position. This condition is worsened with lower Gross Profits (Higher Cost of Goods as a percentage of Revenue), as displayed in the table below.
Jan
Feb
Mar
Apr
Revenue Earned
$ 10,000.00
$ 10,000.00
$ 15,000.00
$ 20,000.00
Cash Received
$ –
$ 10,000.00
$ 10,000.00
$ 15,000.00
70%
70%
70%
70%
Inventory (Expense Incurred)
$ 7,000.00
$ 7,000.00
$ 10,500.00
$ 14,000.00
Inventory (Expense Paid)
$ 7,000.00
$ 7,000.00
$ 10,500.00
$ 14,000.00
Overhead (Rent, Utilities, other fixed costs)
$ 2,000.00
$ 2,000.00
$ 2,000.00
$ 2,000.00
Profit (Rev Earned – Inventory – Overhead)
$ 1,000.00
$ 1,000.00
$ 2,500.00
$ 4,000.00
Monthly Cash (Cash Received – Inventory – Overhead)
$ (9,000.00)
$ 1,000.00
$ (2,500.00)
$ $ (1,000.00)
Cash Balance
$ (9,000.00)
$ (8,000.00)
$ (10,500.00)
$ (11,500.00)
Knowing your Cash Conversion Cycle goes a long way to knowing what levers to pull, and when, in the healthy operation of your company! For the company above, slowing sales while negotiating longer payment terms with vendors would have allowed the company to work itself out of a poor cash position. Mashing on the “Sales Gas Pedal” only resulted in a worse cash position than before!
If your company is experiencing a shrinking cash cycle, reach out to Vertices! Our team is built to help!
Brad Cocheran, MAFM, CVA
CEO – Vertices Company, Inc.
www.verticesco.com
