One of the biggest financial mistakes many small business owners make is focusing too heavily on profitability at the expense of cash flow. There’s an old saying that sums it up well: “Profit is Queen, but cash is King.”
This is especially true in the post-financial-crisis world that continues to linger, with economic growth remaining tepid and most banks still reluctant to loosen the purse strings. Unfortunately, many small businesses that were enjoying record profits, at least on paper, back before the financial crisis hit didn’t have sufficient cash flow to see them through the downturn.
Regardless of where your small business stands today, it’s critical that you understand the difference between profit and cash flow. Doing so may be the difference between whether your business survives, much less thrives, in today’s challenging business and economic environment.
Understanding the Cash Flow Cycle
If sales were made “cash on the barrel,” then cash flow wouldn’t be much of an issue. You’d sell your product, collect payment at the time of sale and deposit your cash in the bank. No fuss, no muss.
But that’s not how most small businesses operate. Instead, most operate on what’s known as a cash flow cycle, which is the time between when cash is paid out (for raw materials, equipment, salaries, etc.) and when accounts receivable are collected from customers. For a manufacturing business, the cycle usually works like this:
- Cash is used to buy raw materials.
- Raw materials are converted into finished goods.
- Goods are sold and accounts receivable are generated.
- Accounts receivable are collected and converted back to cash again.
A simple example helps show what a lack of cash flow can do to what appears, at least on the surface, to be a thriving small business:
XYZ Company launched with $100,000 of cash on hand and a hot new product. The product was so popular, in fact, that it flew off the shelves during the first few months of operations, and the owners were reaping profits right out of the gate—at least on paper. Buoyed by their success, the owners opened a second manufacturing facility to increase production and sales even more.
Six months after starting production, sales were still booming, averaging about $50,000 a month, and the profit margins remained healthy. But a problem was looming: The owners discovered that, rather than collecting accounts receivable in 30 days like they had projected, it was taking closer to an average of 60 days. And a few customers were taking as long as 90 days to pay their invoices!
From here, the dominos quickly started falling: The company fell behind in paying its suppliers, who soon refused to ship raw materials. Without materials to manufacture more products, sales soon plummeted. And when it started missing payroll, key employees walked out the door. Less than one year after opening with so much potential, XYZ Company shut its doors—another victim of the destructive effects of a lack of cash flow.
Commercial Financing Alternatives
In a perfect world, small businesses would be able to access a bank line of credit to provide the working capital they need to see them through cash flow shortfalls like the one experienced by XYZ Company. But in the current economic environment, many companies that would have qualified for bank financing a few years ago no longer meet banks’ more stringent underwriting guidelines.
Instead, many are now turning to alternative financing vehicles to provide the financing boost they need to manage their cash flow cycle. These alternative financial vehicles include factoring, accounts receivable (A/R) financing and asset-based lending.
With factoring, small businesses sell their outstanding accounts receivable to a commercial finance company (or factor) at a discount. Instead of waiting 60-90 days or longer to get paid, the business receives most of the cash (usually 70-90 percent of the receivable) when the invoice is generated. The factor remits the balance (less the discount) after it collects the invoice.
A/R financing is similar to a bank loan or line of credit. The business will submit its invoices to the lender, which establishes a borrowing base of usually 70-90 percent of the qualified receivables—this is the amount the business can borrow against the eligible A/R. The lender will usually charge a collateral fee and interest on the amount borrowed.
With asset-based lending, the loan is secured by business assets (e.g., equipment, real estate, accounts receivable and inventory) with interest also charged on the amount borrowed, as well as certain fees. The business is able to borrow against more of the assets of the company, giving it access to more capital.
The business collects and manages its own receivables, instead of selling them to the factor, while submitting a monthly aging report to the lender. There are usually tighter constraints by the lender due to the greater leverage that is allowed.
Real or Paper Profits?
The takeaway is simple: Don’t focus disproportionately on all the profits that are showing up on your profit and loss statement. Sure, every business wants to make money, but make sure your profits are real, not just on paper.
You also need to anticipate and forecast your cash flow cycle. Understand both the constraints that can be placed on you by key suppliers and the ramifications of expansion, and where that capital needs to come from. Anticipate what challenges key customers can throw at you with slow pay, disputes, etc. And always over-estimate the cash gap so that there will be no unpleasant surprises.
If you’re experiencing a cash flow crunch, or see one coming down the road, don’t hesitate to take steps now to secure working capital financing, including alternative financing vehicles like factoring, A/R financing and asset-based lending. Such vehicles may be the lifeline that helps ensure your business’ survival.
Tracy Eden is the National Marketing Director for Commercial Finance Group (CFG), which has offices throughout the U.S. CFG provides creative financing solutions to small and medium-sized businesses that may not qualify for traditional financing. Further information on the company and their services offered can be found at www.CFGroup.net and www.fvf.ca or e-mail email@example.com.