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Strategic Financial Planning vs. Crisis Management

Posted on September 24th, 2018

Jack Kern
Owner / President
Outsourced Accounting Department, Inc.

In my article, “The Effect of Sales Growth on Cash Flow,” our fictitious entrepreneur, Larry, got himself into quite a predicament by growing his business too fast, and not having sufficient profit or external funding to finance that growth.  So now let’s see what his cash flow would look like if he had planned ahead and done things a little differently.

In this scenario, which I now call Larry’s Turnaround Strategies, Inc., I assumed that Larry does a much better job of managing in two areas: 1) payroll, and 2) receivable collections:

Note on the pro forma P&L that his Net Income is now (rounding) $118,000, or 30% of sales, versus only $15,000 previously, and his monthly receivable turnover is reduced from 45 to 30 days, thus producing an additional $37,000 in cash flow as a result of improving receivable collections.

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Now, refer to the Statement of Cash Flows to see the impact these two improvements had.  The company goes from a cash deficit of about $11,500, to a cash surplus of $129,000.

The point is this: sales growth for the sake of sales growth is dangerous. Yes, there are times when a business can take on aggressive sales growth.  But from purely a financial perspective (vs. operational which is a whole different issue), doing so without having either adequate profitability, or outside capitalization in the form of financing from a receivable finance company (or other specialized lender), or investors, or both, is a sure “plan to fail.”  At the very least, you may wind up in a highly stressful turnaround situation where you are unable to obtain materials from critical past-due suppliers, and a bank breathing down your neck everyday either pressuring you to restore profitability, or worse, calling your loan and threatening to liquidate your company.

So the moral of the story is, if you’re going to grow the business, focus first on profitable growth, and then plan on how you’re going to fund that growth ahead of time, not after-the-fact when it’s too late.

Related Articles:

Larry’s Exit Strategies, Inc.

Larry’s Funding Strategies, Inc.

Larry’s Debt Repayment Strategies, Inc.

Larry’s Fairy Godmother Strategies, Inc.

 

 


Which is More Important, Profit or Cash Flow?

Posted on September 16th, 2018

Jack Kern
Owner / President
Outsourced Accounting Department, Inc.

In my previous article, “The Relationship Between Turnover Ratios and Cash Flow,”  I demonstrated the impact of improving receivable collections and reducing inventory levels on cash flow.  In this article, I will take it one step further and illustrate the effect profitability has on cash flow.  (And note, in this article I have now appropriately changed the name of the company to “Larry’s Survival Strategies, Inc.”)

In this scenario, I assumed that Larry has very little control over sales, so he needed to control expenses instead, and mainly, Payroll Expenses (and presumably, HIS).  Below is a comparison of his original P&L, with a Pro forma of what it would look like by holding down payroll so as to target a Net Profit of about $15,000 (i.e., 15% of sales):

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The Pro forma Cash Flow Statement now reflects the impact of  the company’s profit, in addition to the improvement in turnover ratios, on its cash position.  Note that by eliminating the cash drain created by the loss and producing a small profit, the company’s cash flow increased $117,000 (rounding) from a negative $232,000, to a negative $115,000, thus leaving a positive balance of nearly $104,000 in its operating account.

So the short answer to the question as to which is more important, profit, or cash flow, is BOTH.   However, “profit” is a critical component of cash flow that is required for the long-term survival of your business. For this particular company, even though the owner paid himself back over $175,000, if the business had been profitable, there was still sufficient cash in the business to allow him to do that.  So the most important thing was to stop (prevent) the “bleeding” due to the operating losses, as that is the most difficult cash flow issue to fix. And unchecked operating losses will, over time, drain all of the company’s cash, so that eventually, it will no longer be able to operate.

And once again, in order to know if your business is profitable, you need to maintain your books on the accrual basis of accounting.  If your books are maintained on a cash basis, you are only seeing the symptoms of your cash flow issues, not the true underlying causes, so you won’t know what needs to be fixed (or, is working well, as the case may be).

Related Articles:

Analyzing the Components of Cash Flow

Managing Cash Flow is the Key to Business Success

 


The Effect of Sales Growth on Cash Flow

Posted on September 12th, 2018

Jack Kern
Owner / President
Outsourced Accounting Department, Inc.

Continuing in this series of articles, in a previous article I demonstrated that Profit on an accrual basis is actually a critical component of Cash Flow.  Further, 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.  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.

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The first thing that needs to be explained is that on a month-to-month basis, the turnover ratios 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.

Related Articles:

Profit vs. Cash Flow Made Easy

Which is More Important, Profit, or Cash Flow?

Analyzing The Components of Cash Flow

The Relationship Between Turnover Ratios and Cash Flow

Managing Cash Flow is the Key to Business Success