Understanding Your Business’ Cash Flow

Blog_-_VCF-2.pngDo you ever ask yourself why you have no cash to pay bills even though your monthly sales continue to increase?

Whether you are a service provider, distributor, or manufacturer, managing your company’s cash flow process is all about time. From the point of ordering inventory for distribution, raw materials or components for manufacturing, or sending your employees into the field for service, knowing how long it takes for the sale of goods or services to be converted into cash is critical for all businesses. The inability to fully understand this process and identify the factors that may delay customer payments can make the difference between success and failure.

Understanding your business’ cash flow cycle is essential to successfully operating your business and securing financing. If a business owner cannot clearly articulate their cash flow process to a Lender, it may be the difference in being approved or turned down for a loan. No one knows your business like you do – the lender needs your expertise, so be prepared to present and explain your company’s cash flow cycle.

The Cash Conversion Cycle

One measure of cash flow is provided by the cash conversion cycle (CCC).  A business owner’s understanding of, and ability to explain their business’ cash conversion to potential lenders can increase the chance of loan approval.

CCC is the amount of time it takes to produce, sell, and be paid for your products and services. The cycle is calculated in days as shown below:

CCC = Inventory Days on Hand + Accounts Receivable Collections Period – Accounts Payable and Compensation Payable Payment Period

The formula is a mere reflection of how many days your company’s cash is tied up in inventory and accounts receivable, and how many days it takes you to pay your vendor bills and wages. For a company that provides only services, inventory is not part of the formula. The resulting number of days represents how long a company’s cash is tied up in operations and unavailable for other uses.

Simply put, for a company that has inventory on hand for 20 days, collects its receivables in 45 days, and pays its vendors and employees in 30 days, the CCC is 35 days (CCC = 20+45-30). This means that the company’s cash is tied up for 35 days, and financing may be needed to provide the necessary cash to temporarily meet vendor payments and payroll.

If a company can pay its obligations at the same rate that it holds inventory and collects on its receivables (assuming its sales are profitable), it will likely not need to borrow money. However, this is not the case for most small businesses. Your vendors usually want to be paid faster than your customers are willing to pay, which means that you may need to borrow money for short periods of time.

The amount of cash needed to fund the cash flow gap, before receivables are collected can be derived as:

Cash Need = Cash Conversion Cycle x (Annual Sales/365)

The CCC is essentially a measure of your company’s liquidity.

Understanding how cash flows in and out of your business, will help you to improve your cash flow, determine how much money you need to request from a lender, and make a credible case to support your loan request.

Common reasons for cash flow shortfalls include:

  • Long inventory turnover
  • Slow collection of AR
  • Relatively fast payment of AP
  • Low or negative profitability
  • Excessive growth pace
  • Seasonal sales fluctuations

Opportunities to generate additional positive cash flow include:

  • Vendor Financing – Negotiate with your vendors to increase your payment terms, which commonly range from 30 to 60 days
  • Faster Inventory Turnover – Determine and implement changes to better motivate your sales force or make staffing changes. Change your purchasing patterns by stocking just enough inventory to meet anticipated sales
  • Improve Collections – Institute an aggressive collection process without turning customer away. Improve record keeping for your receivables. Read more about improving collections here.

If these immediate solutions are exhausted, it may be time to consider a cash injection or obtain financing from a lender to bridge the gap to positive cash flow. As a business owner, if you have a good handle on your company’s cash flow and understand your cash conversion cycle, your ability to speak the Lender’s language is increased, as well as your ability to qualify for a loan.