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Planning for Rapid Sales Growth

Posted on May 14th, 2019

Cash Flow for Growing Businesses

Jack Kern
Owner, President
Outsourced Accounting Department, Inc.

What if your company has an opportunity to grow fast? That’s every small business owner’s dream, right? But if you don’t plan for it, you may quickly find that cash flow is strained, and you’re having a difficult time keeping suppliers current, or making payroll, or both, even though your business is profitable. So how do you avoid this financial catastrophe?

To start, your method of accounting is critical here. If your books are maintained on a cash basis, that will tell you if you have a positive or negative cash flow, but it won’t tell you WHY? In order to get to the root of the problem, your books need to be maintained on an accrual basis of accounting.

Under accrual accounting, your sales include uncollected invoices (accounts receivable), and unpaid bills (accounts payable). Your material costs are recorded first to inventory, then “matched” to related revenues at the time you invoice your customer. And that last point is extremely important, as that’s the only way you know if your business is truly profitable.

Assuming then that your books are maintained on the accrual basis, the next step is to look at the various components on your cash flow statement to see what may add to or take away from your profit, and then look at the underlying causes. These may include:

  • Your projections show losses: Profit is a critical component of cash flow (as defined above regarding matching of costs and revenues). If your business is losing money, this will eventually drain all of the cash out of your business until it can no longer operate.
  • Increases in accounts receivable: Higher sales mean higher accounts receivable, and some customers may also pay slow.
  • Increases in inventory: As sales increase, so does the amount of inventory you must purchase so support the higher level of sales.
  • Increases in accounts payable: As inventory increases, so do accounts payable, and thus is a source of cash.
  • Fixed-asset purchases: Capital expenditures typically produce revenues (cash flow) over the long-term, and thus should not be funded out of short-term cash flow.

In a growth stage, the above increases in receivables and inventory represent “permanent working capital.” The increase in accounts payable provides some cash relief. But the permanent portion of accounts receivable and inventory, as well as the fixed-asset purchases, must be financed with long-term sources of funds such as long-term bank debt, financing of the receivables and inventory portion through a commercial finance company (asset-based lender), or owner equity.

Funding any of the above cash requirements out of your day-to-day cash flow will quickly eat up your checking account balance. Then at that point, you will not be able keep suppliers current, and you risk being put on payment terms of cash-on-delivery (C.O.D.). Or worse, you may be completely cut off by suppliers from new inventory purchases.

Now that you know what might cause your company to have cash flow issues, how can you plan ahead to avoid a financial crisis?

In addition to traditional cash flow forecasts, my firm developed a tool that expresses cash flow in terms of borrowing availability against accounts receivable and inventory, which I refer to as “Asset-Based Credit Facility — Borrowing Availability.” Beyond borrowing availability, it forecasts the company’s total funding requirements, as well as helps to identify the most appropriate sources of funds based on the company’s financial structure and circumstances.

To illustrate, the below wholesale distributor is expected to experience significant sales growth.  If you refer to the Cash Flow Statement, projected sales are assumed to be accompanied by major increases in accounts receivable and inventory of $123,288 and $99,669 respectively, ultimately resulting in a $76,030 cash requirement. This is then met by a $53,268 advance on its line of credit, and a $22,762 reduction in the company’s cash balance, leaving a (forced) minimum cash balance of only $1,000. However, if you then look at the Asset-Based Credit Facility, the company still has $46,434 available under its line of credit (i.e., in this case, limited to 75 percent of eligible receivables as defined by the lender).

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In the above example, if the company’s growth rate is too fast and it did not arrange adequate financing ahead of time; or, if receivable and inventory turnover is projected to be slow; and/or, if projected profits are too low — then an “over-advance” occurs in the forecast. If so, most lenders will not fund that gap, and therefore, it represents a potential bank overdraft and a serious cash crisis. For that reason, it’s not enough to look only at your annual statements. To avoid any surprises, you need to forecast your cash requirements on a monthly basis.

To demonstrate, the below manufacturing company, XYZ Company, is expecting a sales increase of nearly 150 percent in the coming year. Notice the over-advance that occurs in January through September, until its cumulative profit begins to enable principal reductions on its $400,000 line of credit, thus freeing up borrowing availability. But then also note in some months that the $400,000 line itself is less than projected collateral availability, thus further constraining cash flow.

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And therein lies the importance of anticipating your funding needs before they occur.

To recap, before you blindly launch your business into a period of rapid sales growth, do your projections. Then these are some critical items you need to factor into the assumptions:

  • Will new customers require credit terms, and how does that translate into the amount of accounts receivable you will need to carry?
  • How much inventory will you need to have on hand to support the projected level of sales?
  • What about deposits up front from customers to purchase the inventory? Is that feasible? Are customer deposits even customary in your industry?
  • Will your suppliers grant my company extended credit terms?
  • Do you have sufficient liquidity personally to support these cash requirements, or do you need to prearrange a larger bank line of credit?
  • Is your company even bankable, and exactly what is “bankable,” and how do I get there? Or should you be considering alternative financing such as an SBA loan, or an asset-based credit facility (accounts receivable financing) through a commercial finance company?

To ignore this planning process is almost certainly a plan to fail.

Related Articles:

Profit vs. Taxable Income

Analyzing the Components of Cash Flow

The Relationship Between Turnover Ratios and Cash Flow

Strategic Financial Planning vs. Crisis Management 

Securing a Small Business Loan Revisited

 


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