How more sales can cause cash-flow problems

An age-old question accountants get asked by business clients is “How come I’ve made more profit but I don’t have any more cash?”

The answer to this question can be found in the ‘Cash flow cycle’.  The ‘Cash flow cycle’ is an issue often overlooked by small business owners until business starts to grow and they begin to experience ‘cash flow squeeze’.

Let me explain how it works.

In the diagram below you can see a timeline of 365 days.

The diagram shows:

• Before you can sell anything you have to buy something. For example, stock or labour.
• Depending on your sales cycle i.e. how long the stock sits in store, you may hold onto stock for 60 days.
• Depending on the terms you get from suppliers you may have to pay for that stock after 30 days – which means you have 30 days negative cash flow.
• Depending on your accounts receivable management you could wait 60 days to get paid – which adds another 60 days negative cash flow.
• This adds up to 90 days negative cash flow.

This means your money has been somewhere other than your bank account (ie the bank account of your supplier or customer) for 90 days.  This is referred to as ‘funding the sale’.  This is also known as ‘working capital’ which means you need to have a certain amount of money to fund sales all the time.

It’s a tricky situation that causes a problem when growth occurs because the issue just gets bigger.  If a business isn’t working to minimise the number of days stock is in store and the number of days customers are taking to pay, then the problem becomes exacerbated as sales grow. This is why growth can often kill what appears to be a good business.

So before your business gets very focused on increasing sales, it’s important to ensure the issues of stock movement and accounts receivable are not ignored.

If you operate a service-based business and think you’re immune from the above, think again. Having a large chunk of ‘work in progress’ can cause cash flow squeeze if billing and payment terms are not well managed.

It pays big time to calculate a billing and payment program with customers that takes into consideration the payment for materials and labour on a job. Ideally you’d ask for a decent deposit up front to cover as much of material costs as possible, then schedule regular, progressive payments to cover labour.

A lot happens to cash on its journey from the sale to your bank account.  If you are planning to grow your business it’s important to get an understanding of the cash-flow process ahead of time as it’s easier to avoid cash flow problems than it is to correct them!

Do you have a favourite technique for avoiding cash-flow problems?