The Effect of Sales Growth on Cash FlowPosted on May 30th, 2016
Owner / President
Outsourced Accounting Department, Inc.
Continuing in this series of articles, in my previous article, “Which is More Important, Profit, or Cash Flow?” I demonstrated that Profit on an accrual basis is actually a critical component of Cash Flow. So, looking at Cash Flow on a cash basis doesn’t tell the business owner (or anyone else) what he or she really needs to know about the health of their business. So now let’s see what effect sales growth, every business owner’s dream, can have on cash flow. For purposes of this discussion, we’ll now call the company “Larry’s Growth Strategies, Inc.”
In this scenario, I started with what the company’s financials looked like after Larry restored profitability, and assumed from there that his sales quadrupled over a 12-month period from (rounding) $98,600, to almost $395,000. At the same time, I assumed that the company’s cost of goods sold increased from 7.7% to 25% of sales, reflecting this exciting new product line that stimulated sales growth. I also assumed that Payroll Expenses increased significantly (let’s call it “sales” salaries), such that the company’s Profit remained the same as the prior year, or about $15,000.
The first thing that needs to be explained is that on a month-to-month basis, the turnover ratios (see “The Relationship Between Turnover Ratios and Cash Flow”) remained the same as before, except for accounts receivable which I assumed slowed from 30 to 45 days (see Turnover Ratios, Monthly Assumptions). However, when the annual turnover ratios are calculated, they all appear to be much slower. This is just a mathematical anomaly that results due to the large increase in each of these accounts at year-end that distort the turnover ratios. But this phenomenon is extremely important to keep in mind when calculating turnover ratios.
Now, note in the Pro forma Cash Flow Statement the changes that occur due to the increases in accounts receivable (uncollected sales) and inventory to support this sales growth (uses of funds), which were only somewhat offset by the increase in accounts payable (source of funds). The bottom line change in cash flow was a negative $115,000, which absorbed all of the company’s previous cash surplus and put it into an overdraft situation.
This is precisely the kind of funding scenario for which specialized factoring (accounts receivable finance) companies exist, as funding situations like this are usually not “bankable.” However, to ignore this funding requirement way ahead of the time it’s needed is almost a sure recipe for bankruptcy, or worse, total business failure. In my next article in this series, we’ll look at a “turnaround” scenario assuming that our budding “entrepreneur” Larry had to learn this lesson the hard way.