It’s ironic that after years of a struggling economy and firms doing whatever they can to survive, a big threat lies in the signs of recovery.
That’s because growth can cause financial problems.
It’s another reminder of the adage:
Turnover is vanity, profit is sanity but cash is reality.
As A Business Shrinks, Working Capital Was Released Back Into Cash
When businesses traded as the economy went into recession, profit reduced and some may have even slipped into the red before overheads could be trimmed back.
However, it’s likely that they received a cash boost which more than compensated for the loss at the bottom of the Profit and Loss Account.
Working capital is normally defined as:
- Stock and work in progress (or inventories); plus
- Debtors (accounts receivable) and payments in advance; minus
- Creditors (accounts payable) and other obligations to pay in the future
The way money flows across these elements in the balance sheet is known as the working capital cycle. Money invested in working capital increases as the business grows and reduces as sales revenue declines.
Provided stock turn (inventory turnover), debtor days (days sales outstanding) and creditor days (days purchases outstanding) remain consistent, the change in working capital is inevitable.
This may have been an unrecognised benefit of the hard times.
The problem will become very clear if the economy picks up and carries businesses with it.
If you’re a service business and you sell person hours rather than products, it’s likely you will have some kind of work in progress that can grow quickly as business grows.
This represents work down for clients but not yet invoiced. Because your main cost is labour, your potential cash problems may be even worse than for a stock business. You don’t have the benefit of delayed payment terms as your employees need to be paid each week or month.
As The Business Grows, Working Capital Increases
Depending on your terms of trade, you know that if you sell this month, you won’t get paid for two, three or four months time.
That timing difference between goods going out of your stock and money flowing into the bank causes problems.
If you think the increase in demand is going to continue and not be a one-off, you will want to replace what you’ve sold and increase your stock.
You will buy more.
This is the systemic effect of changes in demand that ripples through the supply chain and unfortunately amplifies the effect.
If you’re not familiar with this effect, please read
The Beer Game: Systems Thinking When Systems Bite Back
This can over-exaggerate the growth which causes demand to be stopped dead in its tracks as customers realise they are seriously over-stocked.
Is The Cash Problem Industry-Wide Or Company Specific?
If everyone is experiencing growth, then the problem is likely to be widespread.
The impact on individual companies depends on:
- The length of their own working capital cycle. The shorter the better.
- Their relative profitability. Profit will eventually put money into the bank so businesses with higher profit margins will have less of a problem than the lower profitability businesses.
Both factors can be measured in relation to sales revenue:
- Working capital to sales %
- Profit before tax to sales %
If growth isn’t spread throughout the industry, the individual business still risks the same growth in working capital and cash crisis. There is also the risk of price wars which carries very different risks to long term profitability.
In fast growing businesses, this shortage of working capital is known as over-trading and has caused many seemingly successful businesses to suddenly collapse into bankruptcy.
What Can Be Done To Manage The Cash Problem Of Business Growth
The first suggestion won’t surprise you.
Do a cash flow forecast and update it regularly.
Importance Of Cash & Cash Flow Forecasts
Look for ways to reduce your working capital cycle.
- Can you reduce the stock to sales revenue?
- Can you collect your debtors (accounts receivable) faster?
- Can you negotiate delayed payments to your suppliers (accounts payable)?
The first sign of an increase in demand from your customers might not seem to be the appropriate time to squeeze their credit terms. In fact, you might be tempted to do the opposite and agree to their request for extended terms.
Just as an upturn in business can put your cash flow under pressure, so it can with your customers.
There will be plenty of businesses who survived the recession but can’t survive the upturn when it comes.
My advice is to credit check every customer whose non-payment would cause you the slightest difficulty.
It’s not infallible but it gives you information to make decisions.
Stick to credit limits and combined with your agreed credit terms, actively manage your customers’ debts. If necessary, take action on overdue debts.
If you try to sneak extra credit from your suppliers by delaying their payments, I recommend that you monitor this creditor stretch. Your bank balance and cash flow forecast are no longer showing the underlying position.
If creditors suddenly tighten up (as they hit their own cash crisis) or even go bust and you have to find a new supplier who holds you rigidly to agreed terms, your cash management can change dramatically.
Look at your stock / inventory levels and make cautious decisions about increasing minimum and maximum stock levels. These should be based on the lead times for supply and the variability of demand.
It might be worth paying a small premium in price to buy from a company who can delivery the next day rather than in four weeks time for some proportion of your supplies.
The last issue to consider is the profitability of the growth.
Again, at the first hint of a big order after lean times, it can be very tempting to offer a big discount to make sure you get it rather than your competitors.
Talk it through with your management team. Pay particular attention to the margin you’ll be left with. Is the prize worth a few cash management problems? How will competitors and other customers react if they discover this low price offer?
Low profitability makes the cash problem from growth more likely. Reducing prices from a low profit base can be suicidal.
Remember, turnover is vanity, profit is sanity, cash is reality.
What Do You Think?
Have you experienced the financial problems that come from growth?
What happened? What did you do?