Editor's Note: This is the second in a multi-arc series. In the following parts we will address Cash, Financial Performance, Strategy and finally pull it all together in a meaningful way. It is not all about spreadsheets, financial statements and bank loans. A company is an organization whose complexity changes as it grows. Some things become easier and others more complex. Recognizing and addressing these changes is the key to long-term success.
Managing cash is one of the most important administrative functions that a company must address to be successful. Recall that over 80% of companies that fail attribute a shortfall of cash as the primary contributing factor.
To that end, it is critical that a company have a solid understanding of both internal and external sources of cash and how cash is being used within the company.
For a company to have access to external sources of funds, the company must first have a keen understanding of the sources and uses of internally generated cash. With this knowledge, the company must establish processes within the company where items that heavily impact the cash generated in the business are monitored and measured on a regular basis in the normal course of doing business.
There are internal and external sources of cash to help a business meet its cash needs. Focusing on the internal sources and uses of funds, this is essentially the Cash Flow from Operations or CFO. CFO is the net cash that a company generates from its operations. To take this a step further is the free cash flow which subtracts the funds used for capital expenditures. While both these measures are important, the CFO indicates whether a company has enough cash to pay its bills.
Important elements around cash flow from operations include billing, collections, inventory, payables and operation expenses that must be paid. Combined, these items comprise the CFO. Monitoring billings, the billing process, receivables, inventory levels and payables is critical and must be a constant in a well-run company. It should be “muscle memory” within the finance function and should also be very process driven.
It is not uncommon for companies to get distracted. Delays in billing customers, lack of attention to receivables as well as excessive inventory levels can all have an impact on short term cash. Like billing, collections are an area of critical importance. Slow-paying customers must be monitored closely to ensure there are no unnecessary delays in collecting funds.
Inventory levels are a major use of funds in many companies. They need to be monitored to ensure seasonal and cyclical nuances are not negatively impacting inventory levels and dedicated capital tied up in inventory.
An important benchmark used to help monitor the CFO is the Cash Conversion Cycle. It measures the number of days a company requires to cash paid for inventory into collections from customers. For example, if a company has 30 days in receivables, 30 days in payables and 60 days in inventory, the company has a cash conversion cycle of 60 days.
This is calculated by adding the receivables and inventory (the two assets) of 30 days and 60 days and subtracting the payables (the liability) of 30 days.
Managing cash is one of the most important administrative functions that a company must address to be successful.
This means it takes 60 days to convert funds paid for inventory into cash flow available to the company. Put another way, if the company has $10,000 in daily sales, it would have $600,000 (60*10) tied up in working capital. Monitoring the CFO and the cash conversion cycle can be very important. Once we understand these concepts, we can then compare to industry standards and determine if a companies’ performance is in line with industry norms.
Regarding external or non-operating sources of cash, these funds come in the form of debt or equity. While these sources are generally more strategic in nature, they can be used to fund both short-term and long-term needs of the company. Seasonal and cyclical strains on Working capital may require a line of credit to help a company get through a short-term cash need. Periods of excessive growth may also require additional funds as the companies’ collections catch up with the growth.
These types of strains on a company are short-term in nature and should be matched with short-term borrowings. Long-term cash requirements such as capital expansion, capital expenditures and acquisitions should be funded with long-term sources of funds such as term debt or equity. It is a good practice to ensure that the use of debt and equity is consistent with other companies in the industry where the business operates.
A well-run company will use its cash wisely. At times, it will need additional cash to support growth, seasonal or cyclical stresses on the company. It is important to match short-term cash needs with short-term cash sources and do the same for long term cash needs with long term cash sources. A company following proper policies and procedures will have no problem utilizing the available cash from the various sources to weather the challenges that lie ahead and enable the growth profitably for years to come.
Don King is a Partner with B2B CFO® Website: My Expertise Hub™. We provide Strategic Business Advisory Services to owners of privately held companies. We focus on increasing cash and company value. By redefining the way that these services are provided, we have created a new industry, which we dominate and lead. With a nationwide presence, B2B CFO® is the largest company of its kind in this industry.
Would you like to learn more on this topic? Register for Don's webinar — "A Strategy for Success for Privately Held Companies," where he'll provide an in-depth look at the things that mean the most and are most impactful to business owners:
- Cash — where does it come from and how is it used? Are we matching short and long term financing with short and long term uses?
- Financial performance — a review of the Income Statement and Balance Sheet. How do the financials compare to related companies in the market?
- Strategic View — where do we go from here? Where is the company in three, five, 10 years and how do we get there?
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