Managing cash flow in the growth stage

| April 19, 2011

For many medium businesses, growth is the barometer for success. But expansion can present challenges and one of the critical issues in any company when it is experiencing a healthy level of growth is cash flow.

In this article, I look at the reasons why cash flow is important and why growth often contributes to a lack of funds. 
Cash flow basically means ‘Do I have enough cash in my bank account to cover my expenses?’ Sounds simple, but you’d be surprised at how many people ignore this. And not just small business either!  Medium sized businesses have often achieved the desired levels of sales and growth but fail to realise what effects that growth has had on cash flow.

So why is cash flow critical in growth? Because that growth is often represented by increased investment in debtors and infrastructure.  Growth in sales sometimes leads to an increase in inventory holdings in order to meet those sales on time, so the amount of cash tied up in debtors and stock is increased.

While these assets may represent the profits earned, they can’t be used to pay the wages bill each week. It’s all a matter of timing – if your debtors pay on average within 30 days, you still need to have enough cash on hand to pay your trading expenses for those 30 days. And if you can’t meet your ongoing expenses you can’t continue the growth.

The term “working capital” is one that’s well known but perhaps not always understood. It’s the difference between your level of current assets (debtors and inventory) and your current liabilities (creditors and tax accounts) and is the amount of capital that you need (i.e. cash) in order to continue working from day to day.

So why don’t companies realise the importance of cash flow?  Probably because:

1. Companies aren’t realistic in their budgets and cash flow projections – they often overestimate sales revenue and receipt of same and underestimate their expenses.

2. They often confuse profits with revenues and outgoings and don’t understand the timing difference.

3. They don’t see a cash shortage in the near future and they run out of money as by then it’s too late to arrange short-term financing etc.

4. Companies sometimes believe they can push back creditor payments to free up cash for expenses, but then they can experience difficulties in ensuring supply of materials.

You can have the most amazing service or product in the world, but if you run out of cash, it won’t matter.

Most businesses understand the relationship between sales and direct costs, but many overlook the fact that most fixed costs are finite in their capacity to support that growth. Take the rental of premises as an example – a company has that fixed cost which will enable it to generate production only up to a certain level. Any more growth, and the company will be forced to move to larger premises and incur higher rental costs.  These sorts of costs are incurred in ‘steps’ and it is important to know at which point the business faces its next step, because that’s when cash flow will become critical as higher costs are incurred.

Analysis of ‘what-if’ situations will enable you to easily see what the effects are of moving to those stages, and also of, say, losing a client or bringing in a large one-off order.

I always try and look ahead at least 12 months and preferably 24 months.  That way, if you see a cash shortage on the horizon, you have sufficient time to explore avenues to cover that shortage. Develop an expansion plan and make sure that it covers both short- and long-term goals, and that the cash flow projection supports the plan. This is the time to determine not just how you’re going to expand, but why. If you feel that you don’t have a strong business case once you actually see it in writing, you might want to put your plans on hold.

Once you’ve identified the gaps in your working capital, put plans into place to fund those gaps. Shareholders and other investors can sometimes provide this cash injection or it may be sourced from banks and other finance providers. Short term needs may possibly also be funded from manipulation of working capital, but that has its limits!

Short-term financing such as a line of credit (LOC) can be used to make emergency purchases or to bridge the gap between month’s-end payables and receivables. An LOC can be negotiated with your financial institution, and this should be done before any need actually arises. It’s usually easier to negotiate an LOC when you don’t really need one.

Match the debt structure with your needs and limitations. For example, if you are financing your sales invoices, remember that retentions of around 20% to 30% are usual – if your gross profit margins are only 10% you will run short of money very quickly!

In my next blog, I will cover some of the ways in which you can monitor and take care of your cash flow needs.

Suelen McCallum
is the CEO of dVT Consulting, a member of the de Vries Tayeh group.  dVT Consulting specialises in corporate strategy and turnaround management, particularly in the SME sectors, as well as due diligence, litigation support and business succession.