Profits, Growth and Cash Flow: Which is Most Important to Success?
By Gene Siciliano
Business growth and profitability. Most entrepreneurs would consider these to be the Holy Grail of business ownership. So it's not too surprising that many are surprised to learn that instant profits and rapid business growth aren't always a cause for celebration.
"How can this be?" you might be wondering. The best way to explain it is to tell the story of the Wonder Widget Company. This is a fictitious company to help explain business financial concepts in an easy-to-understand way.
A Hot New Launch
Wonder Widget Co. launched last year with $100,000 in cash and the hottest new product in its market, the amazing Wonder Widget. It was so hot that the owners had sales and profits the very first month of operations. So they quickly leased and outfitted a factory, production equipment and furnishings (all with minimal initial cash outlay), bought materials, hired workers and manufactured and shipped widgets. Then they mailed invoices totaling $50,000 to customers in the first month. Amazing!
They paid their bills as they came due and collected from customers in the normal course of doing business. Meanwhile, sales continued to grow, increasing by $50,000 every month with no decline in margins and no serious competition, and profits climbed without a pause.
But a strange thing happened on the way to the bank: The owners were shocked to find that they didn't have enough cash to pay their bills. Soon, they couldn't buy any more raw materials to manufacture Wonder Widgets or make their payroll. Instantly profitable Wonder Widget Co. was insolvent six months after they opened the doors.
On the surface, it's hard to see how something like this could happen to a profitable and growing business. But when you dig a little deeper, it becomes clear that there's a whole lot more to running a successful business than just profits and growth — namely, cash flow.
The Cash Flow Cycle
Understanding what happened to Wonder Widget Co. starts by understanding what's known as the cash flow cycle. This is the time lag that exists between when cash is paid out by the business for things like equipment, raw materials and salaries and when accounts receivable are collected. In manufacturing, the cycle usually consists of converting cash into raw materials, finished goods, receivables, and then back to cash again.
At the beginning of the cash flow cycle, nearly every business starts out with — you guessed it — cash. But from that point on, the central purpose of the business is to convert that cash into other kinds of assets or to leverage or extend it with liabilities, and ultimately to turn it back into cash again — but this time, more cash than the business started with. This process continues indefinitely and simultaneously throughout the life of a business.
When the company started up, its first activities revolved around setup — renting facilities, getting phones and utilities installed, etc. At the same time, it was purchasing assets so it could start operations. These included office equipment, computers and the like. Of course, the company also needed employees to answer phones, run the office, and produce and sell Wonder Widgets. The owners financed some of these costs, but obtained credit via bank loans to cover most of them.
With all this in place, the company was ready to begin production, or the manufacture of Wonder Widgets. Unfortunately, the process consumed even more cash: wages, taxes, sales and marketing, more raw materials, and so on. In fact, this is the period of greatest cash consumption for most companies, as they are in full production mode but no cash is coming in yet.
Finally, Wonder Widgets was ready to sell its products and begin the process of recovering all the cash it has been spending (or investing) in the business. However, while sales were brisk, they were made on "net-30" day terms, which means the company won't actually receive cash from these sales for another 30 to 45 days, at least.
To add to the challenge, growing sales means the company had to buy more raw materials than they did the first time around. Since they were selling more each month than the prior month, they needed to not only replace inventories consumed but also buy additional goods to satisfy their growing sales demand. Purchases can actually exceed sales in such a fast-growing environment.
Collections are the final step in the process. While this might seem like a minor activity in comparison to production or sales, it's actually the most critical task in making every other step pay off. Unfortunately, it's the step that many businesses, including Wonder Widgets, neglect — and that leads to their ultimate demise.
Don't Give It Away
Are you starting to see how Wonder Widgets failed despite having strong profits and sales right out of the gate? Nolan Bushnell, the founder of Atari and Chuck E. Cheese Restaurants, put it this way: A sale is a gift to the customer until the money is in the bank. This final step is the one that turns the entire effort — setup, purchasing assets, hiring employees, obtaining credit, and producing and selling products — back into cash again.
At this point, the answers to some important questions will begin to surface, like: Did the company ultimately make a profit on its business activities? Did it plan adequately for the working capital it would need to finance the cash flow cycle in it's entirety? As the Wonder Widget story makes clear, answering "yes" to just the first question isn't enough to ensure business survival. There are three key takeaways from this story:
1. Fast growth is a double-edge sword. Fast-growing companies need more working capital than those growing more slowly or not at all. When incoming cash flow is delayed while fixed costs continue and paydays come every week, there's a limit to how long a company can operate comfortably, even if it's profitable.
2. Cash flow needs must be forecasted months in advance. This is especially critical during the early months of a startup. And cash flow results must be tracked separately from profits.
3. Business goes with the flow. The health of a business depends on the health of its cash flow. As Wonder Widget Co. makes clear, more businesses fail due to a lack of cash flow than a lack of profits.
Gene Siciliano, CMC, CPA, is an author, speaker and financial consultant. As "Your CFO For Rent" and president of Western Management Associates, Gene has spent more than 23 years helping his clients build financial strength and shareholder value. His book, "Finance for Non-Financial Managers" (McGraw-Hill, 2003), and his new book, "Financial Mastery for the Career Teacher" (Corbin, 2010), are both available in bookstores and online. Visit www.GeneSiciliano.com to learn more.
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