The economy is going like gangbusters. You know it because you are racing to keep up. Employers everywhere are reporting difficulty hiring and retaining people. And that is driving up the cost of business, which means profit margins are going down. As a result, understanding your cash situation is more important than ever.
High-performing businesses generate cash over the long term. They’ve figured out the secrets to being successful through the good times and the bad. And you can too. Here’s what you need to know:
Know your monthly out-of-pocket cash requirements
Forget your income statement and cash flow statement. They suffer from too much non-cash activity, delays between when cash is spent and when it shows up on the income statement, and condensed cash flow statement categories offer limited visibility.
Instead, understand where your cash is going and when:
Create a budget on a cash basis showing all of your cash payments each month.
Don’t forget things that don’t show up on your income statement like taxes, insurance, equipment purchases, expansion plans, loan payments, etc.
Include all seasonal costs in the period you expect to pay for them.
A construction company takes this approach for each of their projects and is able to set a billing structure to stay cash positive throughout the life of the project. Being in a highly cyclical industry, this approach minimizes the need for a significant cash infusion when multiple projects are starting at the same time.
They are successful because they know when the cash is coming in and going out. They look at cash every day to make sure they are on track with what they expect to happen and what is actually happening. I’ve also seen a few companies who don’t do this and have wound up in bankruptcy, resulting in many people losing their jobs.
Volume only matters if your gross margin is positive
Have you ever heard (or said): “If we just sell more, we’ll become profitable”? It sounds true, but it’s only true if gross margins are positive. If you aren’t making money from the sales price less the direct cost to produce it (gross margin), you are actually losing money on every item you sell.
A local manufacturing firm identified margin by product. They found some products were profitable and others weren’t. For those that weren’t, they were either able to lower the cost or increase the sales price to bring them to profitability. A number of products were eliminated because they were never going to be cash flow positive.
After rightsizing the portfolio, the company ramped up volume and dramatically increased cash flow and profitability.
In contrast, another company was convinced the solution to cash flow issues was increasing volume. Their gross margin was positive, but the debt load was so high, the increased volume didn’t cover the total cash cost on a per unit basis. They didn’t look at cash break-even for their products. So, for each product they sold, they lost money causing an ever increasing need for cash.
To avoid being in this situation and understand your cash break-even, take all cash outlays for the year and divide by your average unit selling price. That will tell you how many units you need to sell to break even on a cash basis.
Whether you are close to the break-even line or not, you need to know where the line is. When the economy cycles down, knowing your break-even point will help you manage the business to stay cash positive.
Be clear about your liquidity sources
Many businesses experience a gap between when products or services are sold and when cash is collected. This gap can be a few months, or even longer.
If you don’t have a pile of cash in the bank, you’ll need a credit facility that allows you to ride the seasonality of your business. The size of the facility should accommodate any gap between the outflows of cash to run the business and the inflows that come months later.
A local firm was able to generate significant cash by looking at how much inventory they carried and reducing it. They also looked at their supply chain and in conjunction with suppliers, reduced the need for significant build ups in raw materials. Between these actions, their cash requirements were reduced.
They were then able to find a credit facility that provided adequate liquidity (cash plus cash available on a line of credit) through seasonal and cyclical ups and downs. Part of the evaluation was modeling best and worst case needs at various points in time, as well as whether they would be in compliance with the agreement at each point along the way.
The most successful businesses focus on these three aspects of managing cash. They pay close attention to cash coming and going, and, as a result, lower the cost of running their businesses. Do you have your eyes on your cash? If not, it’s time to start.
Heidi Pozzo, founder of Pozzo Consulting and author of Leading the High-Performing Company, helps business leaders dramatically increase their organization’s value. To contact her, visit www.heidipozzo.com or call (360) 355-7862.