Most accountants advise business owners to manage their businesses on an accrual basis. It provides a more accurate depiction of the long-term performance of a business. It recognizes revenue when earned and expenses as incurred so that revenue and expenses are properly matched. A more meaningful and correct understanding of a company’s financial performance results with accrual, versus cash, basis accounting.
Based on experiences in small to mid size companies, I learned to appreciate the importance of managing to cash-based results as a priority. Managing cash, and other liquid assets, became a vital element of my duties to assure the business could continue to operate (as in paying 1,800 employee bi-weekly). Here are a few lessons I learned along the way.
1. Successful companies manage cash and working capital as a priority at least as aggressively as leveraged or cash-challenged companies. It’s obvious that a company carrying a lot of debt or not performing well will need to focus on husbanding its cash. But growing companies that appear to be thriving can easily be crushed under the weight of their own success if they are not equally sensitive to controlling their working capital. Growth usually mandates increased expenditures for people, capital assets, inventory, etc.; customer receivables from expanding sales also rise. Without careful planning and appropriate financing, the creditors’ payment demands can quickly outstrip the rate at which cash is being collected from sales.
I knew a company some years ago that decided to grow rapidly through acquisition of regional competitors nation-wide. As a private company, it used cash and debt to pay for these acquisitions, without adequate consideration given to the working capital requirements of acquired companies. It largely exhausted its borrowing capacity on the front-end to make the acquisitions, and subsequently had to downsize its operations significantly when there was insufficient cash to support the on-going operations. Slower growth and better planning would have avoided this undesirable outcome.
2. Obtaining information about current and new customers is essential. Many companies operate in industries where credit and payment information about a common customer base is shared. A client sells specialty hardware to construction contractors; its distributors’ council, comprising companies selling goods to the same or similar customer base, issues a periodic report of members’ customers who are notably slow payers or non-payers. If a contractor is on the list, the company declines to do business with it and thereby avoids the risk of a significant credit loss. In the absence of industry-specific data, companies can turn to more general credit reporting sources, such as Dun & Bradstreet. At the very least, before extending credit, businesses should request basic financial information (company history, trade references) that can be checked in deciding to accept a new customer and set a credit limit.
3. Adhering to credit policies and limits is critical. Having established credit limits and payment terms, it’s vital that a business not succumb to the fear that a customer will go elsewhere if the company insists that its credit policies be observed. A client with standard payment terms of 30 days has a policy that any customer with an unpaid invoice exceeding 60 days will be placed on credit hold. There is a strong inclination to relax the rule when a large customer is involved. However, the company has held firm and found that, faced with a credit hold, a customer will address the delinquent invoice rather than have to regenerate a purchase order or find an alternate supplier.
If large customers use market leverage to force unprofitable outcomes on your company, drop the accounts, get out of business quickly or find ways to innovate product and services to re-establish your company as the preferred vendor. This is not easy. It requires courage, commitment and perseverance. Thereafter, the customer is also generally attentive to paying more timely. If a customer resists paying overdue invoices or is regularly placed on credit hold, it’s a sure sign that there are financial issues and the company should tighten rather than relax its credit for that customer and incur an even greater risk of loss.
4. Negotiating terms with vendors can provide significant advantage. Many companies simply accept their suppliers’ standard terms. A profitable client operates in an industry where it’s well known fact that customers are notoriously slow payers. In addition, the territory in which the client distributes its products is has an average customer payment period that is significantly slower than the national average. The client has capitalized on this well-known knowledge and convinced most of its vendors to offer significantly more generous payment terms than are the norm; currently, most of their suppliers allow them 90 day payment terms against the standard 45 day terms, giving them ample financing. By the way, the client also closely manages its receivables, such that its average collection days are less than 50 (against an industry standard over 70). As a result, the company has never needed to use a bank revolving line of credit to meet its cash flow requirements, saving considerable interest cost.
5. Continuous forecasting of cash flow provides the opportunity to anticipate a squeeze on cash. As part of annual budgeting, companies often prepare a projected cash flow by month as an outgrowth of their operating and capital budgeting. But the typical format and period of such a projection is not useful for managing cash flow. Fewer small and medium sized companies have a tool for forecasting cash on an on-going basis over a near-term time frame.
Creating and using rolling 8- or 13-week cash forecasts allows a company to focus not just on whether its cash flow will be adequate but also on all components of managing cash and working capital. Assumptions and data about sales, receivables, collection cycles, headcount and payroll, operating and capital expenditures, and financing options and obligations all have to be assembled and combined in a system to forecast cash inflows and outflows. Where the forecast indicates a crash crunch, management can consider options that may be available to mitigate the issue before it becomes a crisis. Options include identifying opportunities to accelerate collection of significant customer receivables ahead of normal payment cycle; determining which vendors’ invoices can have payment delayed (with appropriate communication to the vendor); deferring expenditures and/or implementing cost reductions; and utilizing sources of financings, such as a revolving line of credit.
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A CEO I knew used to say, “We can outgrow our problems.” No company ever solved its problems, particularly with cash flow and working capital, through growth; indeed, growth usually aggravates the very issues that result in weak cash flow. Get control of your company’s cash and working capital because it is the key to sustainability and long term viability.