Everyone has heard the saying “Cash is King”, but how well do you understand your cash flow, and is it working for or against you? Let’s take a look at three scenarios that show how a solid understanding of your cash flow can put you ahead of the game, or help you avoid disaster.
Joe has a successful business and has decided he’s going to sell it and retire. He goes to a business broker who says, “Sure, I’ll list your business for $70,000”. Joe says, “Like fun you will, I took home $200,000 last year – I want you to list it for $300,000”. The broker laughs at Joe and tells him it’s not worth his time to list it at that price because it won’t sell.
Joe isn’t lying about his income from the business, so why this discrepancy in the perceived value?
It all comes down to cash flow
Joe has been working hard for many years to minimise his tax payments by minimising his reportable income. He’s taken advantage of every tax treatment in the book (and a couple that weren’t) and in fact, he’s done such a good job that although he has the lifestyle of someone who earns $200,000 a year, on paper he only has an annual income of about $50,000. Now over the years this has been great for Joe and has saved him a lot of tax, however, Joe was so focused on doing all he could to minimise his tax that he failed to see how this could impact the sale of his business.
For SMEs, business valuation formulas basically boil down to how much cash can sustainably (and legitimately) be derived from business operations going forward. So Joe is left in the situation that on paper his business is worth a fraction of what it’s actually worth. A better understanding of his cash flow and the impacts it can have would have allowed Joe to start planning for the sale by transitioning from a tax minimisation focus to a cash flow focus that maximised the real value of his business.
The overdraft on Steve’s business is always overdrawn and he’s had to go to the bank three times already this year to ask for increases. The bank has said they won’t increase it any further, but Steve isn’t too worried. Although he can’t figure out why the account keeps getting overdrawn his business has a loyal customer base, strong sales, and shows a healthy profit each year.
Then one of Steve’s major customers goes bust with a reasonable account balance outstanding. Suddenly, Steve finds he doesn’t have the cash to reduce the balance on his overdraft, wages are due this week, and he is informed that his bank manager no longer has the authority to approve an excess on the account. If the business was reporting healthy profits, how has Steve found himself in this position?
It all comes down to cash flow
An analysis of his cash flow cycle would have highlighted for Steve that while he was giving his customers 60 day terms (which often turned into 90 day terms), most of his creditors imposed 30 day terms (and Steve usually paid within 20 days to receive discounts). It also would have highlighted seasonal cash trends that would have helped Steve negotiate payment terms with the bank that matched his cash cycle.
A cash flow forecast/budget would have shown Steve that although his cash account looked great at the beginning of the year, he actually should have leased his new machinery instead of paying cash. On top of this, the business was experiencing a period of significant growth and really needed an overdraft facility with a $100,000 limit, instead of the $50,000 limit Steve originally applied for. A cash flow forecast would have picked this up and the irony is, had Steve applied for a $100,000 limit to begin with the business was in good shape and it probably would have been approved. Instead, by repeatedly overdrawing the account and requesting frequent small increases, the bank now sees the business as a risky proposition and will not extend further credit. Steve’s limited understanding of his cash flow situation may have cost him his business.
the irony is, had Steve applied for a $100,000 limit to begin with… it probably would have been approved.
Carol’s business is well established and trading strongly. It has a reliable income stream and bankers are competing for her business. Carol has been offered different products and pricing by several banks and wants to know what is the best fit for her business.
You guessed it – it all comes down to cash flow
Carol undertook a complete cash flow analysis of her business including cash cycles and forecasting. This information not only helped her to identify the best offer from the banks, it also highlighted that her current stock levels were not as efficient as they could be, and identified that debtor days had been slowly lengthening over the last nine months coinciding with staff changes. She also applied this information to a potential new project she had been considering and discovered that although she had estimated it would require a 10% increase in sales, it actually only needed a 7% increase, making it a viable proposition.
Regardless of your industry, the stage of business you are at, your risk appetite, or your asset base, your cash flow has a major impact on your activities and outcomes. The old spidey senses should be tingling if you are showing a great profit but are always short of cash. And even if your business is strong and not under financial stress, cash flow analysis can help identify unhelpful trends before they become issues, highlight opportunities to improve that you didn’t realise you had, and help you plan confidently for the future in good times and in bad.
In 2017 we re-branded to better reflect our services, changing our name from CAV Consulting and Analytical Services to Insight Business Plans & Analysis. This article was originally published under our previous name. An abridged version of this article was also published in the Feb-April 2015 edition of Business Broker Magazine.