5

Cash Flow Management

Introduction

Nothing is as important to a business as positive cash flow. As I often tell my students, “For any business, depending on the entrepreneur’s gender, positive cash flow is King or Queen!” Without cash, an entrepreneur will not be able to buy inventory or equipment, make payroll, pay bills and utilities, or repay debt. Cash is necessary not only to keep a business going, but also to grow the business. Seth Godin, who is renowned for his digital marketing insights, founded Yoyodyne, an online direct-marketing company that he later sold to Yahoo! for $30 million. As an entrepreneur who bootstrapped his business for the first few years, he notes that happiness for a business owner boils down to one simple thing: positive cash flow.¹ Companies that cannot achieve positive cash flow are essentially involuntary not-for-profit organizations that eventually become insolvent. Negative cash flow leads most high-flying digital companies to become duds.

Types of Cash Flow

On the financial statements, a business’s cash flow is its EBITDA, which is an acronym for earnings before interest, taxes, depreciation, and amortization. EBITDA is the cash available to service debt (make principal and interest payments), pay taxes, buy capital equipment, and return profits to shareholders after paying all of a company’s operating expenses. A company’s EBITDA is calculated as shown in Equation 5-1.

EBITDA

Note that a company’s true cash position includes the adding back of depreciation and amortization. While these two items are expensed on an income statement, they are noncash expenditures. Their usefulness is to reduce taxable profits on an income statement, which increases the company’s cash flow. This practice of adding back depreciation and amortization explains why a company with negative net earnings on its income statement can still have a positive cash flow.

While EBITDA (also known as cash flow from operations, or CFO) is important for the entrepreneur to understand, he must also understand that this is simply a cash flow calculation used for cash flow statement purposes. It illustrates what the company’s cash flow should ideally be. Unfortunately for entrepreneurs, the ideal and the actual are often miles apart. It is common to hear entrepreneurs say, “On paper, my cash flow numbers show the company to be rich and making plenty of money, but in reality, we are cash-poor and starving.” The reason this comment is so often made is that money owed to the company has not been paid. For example, the company could have had such an extraordinary amount of growth in revenues in one month that all of the actual cash had to be used to finance that growth by paying overtime to employees and paying for the raw materials used to make the product. About 90% of the month’s products were shipped on the last day of the month, and the terms are net 30. Such a scenario describes a situation in which, on the income statement for that month, the cash flow looks strong, but the reality is that the cash will not actually arrive until at least 30 days later. This “paper-rich, cash-poor” situation resulted from taking advantage of the opportunity to increase profitable revenues.

A paper-rich, cash-poor situation is related to poor cash flow management when money from customers is past due. To succeed, the entrepreneur must be an absolutely vigilant bulldog about maximizing the actual day-to-day cash flow of the business.

Ensuring that a company has adequate cash on hand to fund its operations and pay off its obligations is essential. It is important to put a system in place that enables the entrepreneur to properly monitor and manage both expected cash receipts (cash inflows) and payables (cash outflows). The lack of an efficient cash flow management system can have severe negative consequences for a company. The importance of managing a company’s cash needs accurately is highlighted by the following example. The Gartner Group was a high-tech consulting firm that generated $1.62 billion in annual revenues. While cofounder Manuel Fernandez and his partners (including the firm’s namesake, Gideon Gartner) were raising capital for the company, they decided to limit the capital they raised to $30 million, even though they could have raised twice as much. They placed this limit because they wanted to restrict the amount of equity they would have to give up. However, they did not anticipate the problems that they would face as they tried to develop a new product for their company, nor did they adequately assess their cash needs during this crucial period.

One problem that arose was that the manufacturer of a component for the company’s hardware product went out of business. Given that, at the time, this was the only company that was equipped to manufacture the component, Gartner had to delay the production of its hardware until a second manufacturer could be found. Once this manufacturer was identified, Gartner had to spend several months redesigning the component so that the new manufacturer could produce it. In the meantime, the company had been paying its fixed costs, so it ran out of money and filed for Chapter 11 bankruptcy. The lesson that Fernandez learned, the hard way, is that it is essential to focus on cash flow. As he notes, “We were obsessed with revenues and profits and trying to hold on to the equity,” rather than on cash flow.² Looking at daily cash flow is a practice that all entrepreneurs should embrace.

There are endless examples of entrepreneurs who neglect to pursue prudent cash flow management. During good economic times, when a company is growing fast, it is easy to overlook cash flow controls, sometimes without suffering immediate negative consequences. But during challenging downturns in the economy, inattentive entrepreneurs may face a cash crunch. As a CPA once told me, “The best thing about volatile economic conditions is that they remind managers to refocus their attention on the basics.” In fact, during a cash flow crunch, fast growth usually exacerbates the problems because companies are spending cash on inventory, supplies, and additional payroll—often at an accelerated rate because of the fast growth—while waiting long periods to collect receivables.

A case in point is Douglas Roberson, president of Atlantic Network Systems, a data and voice systems integrator, whose company’s revenues quadrupled from $100,000 in its first year to $460,000 in the next. During this growth period, the members of his staff did not concern themselves with cash flow because sales were growing at such a phenomenal rate. “I actually believed that the more money companies owed us, the better shape we were in,” Roberson confessed.³ It was not until his company went through an extended period in which it was unable to collect its receivables that he realized the importance of managing cash. The company had to use all its existing lines of credit to keep its operations going while waiting for bills to be paid. It was a real-life lesson. He, like most entrepreneurs, learned that managing cash flow was different from just accumulating sales. As he noted, “If you don’t do serious projections about how much cash you’ll need to handle sales—and how long it will take to collect on invoices—you can wind up out of business, no matter how fast you’re growing.”⁴

Cash Flow Forecasts

Preparing a cash flow forecast allows an entrepreneur to determine a company’s financing needs. If an entrepreneur finds that the business has a forecasted cash shortage as a result of rapid growth, then it might be necessary to raise external money to meet the company’s financial needs. A good cash flow forecast will allow the entrepreneur to determine the exact amount of cash needed and also when it is needed.

In general, there are several reasons why businesses raise outside capital. First, seasonal needs, such as holiday sales, may require the purchase of additional materials and the payment of additional production expenses to meet this temporary increase in demand. Second, more capital may be needed to finance long-term sales growth. As a company’s sales grow, more inventory must be purchased, and additional workers will be needed. All these activities will require additional cash, which may not be on hand. A good cash flow forecast will allow an entrepreneur to forecast financing needs for these activities. Third, an entrepreneur may have to purchase expensive capital equipment or make expensive repairs to existing equipment.

Entrepreneurs must know that projected cash flow determines the amount of capital a company needs in the future. The following steps should be taken to make that determination:

•  Prepare a 36-month or 60-month cash flow forecast in a spreadsheet, based on 12 months of historical financial results (or as many months as are available).

•  To make the projection, use CFO plus debt obligations (interest and principal payments), which is called net cash flow, and add a row to calculate cumulative monthly net cash flow.

•  Find the largest cumulative negative cash flow number—this is the amount of capital required.

To better illustrate these steps, let us look at the five-year net cash flow numbers for the ANR Company, shown in Table 5-1. With the information in Table 5-1, the ANR Company can easily determine its capital needs by completing the chart in Table 5-2.

TABLE 5-1 Projected Net Cash Flow Calculation

TABLE 5-2 Cumulative Net Cash Flow Calculation

By plugging in the numbers from the cash flow projection, the ANR Company would determine that $260 is needed because that is the largest cumulative number over the projected time frame.

The obvious question now is when should you get the cash? There are two schools of thought on the answer to this question. The first is that you should get only what you need from year to year, or a “series of funding.” The second is that you should get the maximum that you will need at once. Both have advantages and disadvantages, as shown here.

Series of Funding

Pros

•  It keeps the entrepreneur disciplined and minimizes wasting money.

•  The entrepreneur is paying only for current expenses.

•  The new series of capital comes in at a higher valuation, thereby allowing less equity to be surrendered.

Cons

•  There is no certainty that more capital will be available in the future.

•  Resources must be allocated to securing additional funding.

All Funding at One Time

Pros

•  There is no need to allocate resources to raising future funding.

•  It avoids the risk of capital not being available in the future.

Cons

•  Forecasts may be wrong. For example, incoming cash flows may occur earlier than Year 4, so that less up-front capital is required. If this should happen, in the case of an equity capital investment, too much equity is surrendered, or in the case of a debt capital investment, interest on unnecessary capital will be paid.

•  Receiving too much capital at one time spoils the inexperienced entrepreneur and could lead to unnecessary waste of the capital.

•  Invested capital comes in at a lower valuation.

Cash Flow Management

Cash flow management can be as simple as preserving future cash by not spending as much today. For example, in order to deal with seasonal sales, a company may choose not to spend as much in October if December—when October’s bills come due—is traditionally a poor sales month and will not generate enough receipts to cover those bills.⁵ Cash flow management can also involve making somewhat complicated decisions about delaying payments to a supplier in order to use cash resources to temporarily increase production. Or it can involve making decisions about borrowing or using factoring companies to generate cash quickly to meet short-term cash shortages.

The relationship between the sources and uses of cash is shown in Equation 5-2.

Sources and Uses of Cash

Sources of Cash or Cash Inflows

•  Accounts receivable

•  Cash payments

•  Other income (income from investments)

•  Borrowing

Uses of Cash or Cash Outflows

•  Payroll

•  Utilities—heat, electricity, telephone, and so on

•  Loan payments—interest plus principal

•  Rent

•  Insurance—health, property, and so on

•  Taxes

Key Cash Flow Goals

The goal of good cash management is obvious: to have enough cash on hand when you need it. The major goal of prudent cash flow management is to ensure that there is enough cash on hand to meet the demands for cash at any given time. This is done by getting cash not only from operations (managing cash inflows, including accounts receivable) and disciplined spending (managing accounts payable), but also through the use of external capital (borrowing). While this may appear to be a simple concept, in reality, it is a process that even the most experienced financial officers and executives find difficult to carry out successfully.

The trick to handling cash flow is in the timing—as an entrepreneur, you want your customers to pay as soon as possible (if possible in advance), while you pay your suppliers and vendors as late as possible without jeopardizing your relationship with them or your credit standing. The idea is that money that is collected in receivables today, and that does not have to go out as payables, is, in fact, an important source of internally generated working capital.

While it may not be the most fun thing to do, it is important for an entrepreneur to spend time (at least an hour a day) working on cash flow. It is without a doubt one of the most crucial things an entrepreneur can do for a business. This exercise forces an entrepreneur to think about what he is doing in terms of cold, hard cash.

Cash Flow Ledgers and Projections

The cash flow ledger provides important information about the balance of the cash account, enabling the entrepreneur to assess the company’s ability to fund its operations and also meet debt payments as they come due. It indicates, on a transaction basis, all cash received and disbursed during a month’s period. Successful entrepreneurs are those who know their company’s actual cash position on any given day. Therefore, it is recommended that entrepreneurs, especially those who are inexperienced or those who are in the early stages of their ventures, review their cash flow ledger at least weekly.

In addition to the ledger, a weekly cash flow projection summary should be prepared when opening a business and every month thereafter. This projection indicates the anticipated cash inflows during the month along with the cash payments to be made. By doing this kind of projection each month, the entrepreneur can schedule payments to suppliers to match expected cash receipts. This allows the entrepreneur to be proactive with regard to the money owed to suppliers and enables her to let specific vendors know in advance that a payment will probably be late. The cash flow ledger and projections are simple and very useful tools that should be used to manage cash flow successfully. It is important to be consistent and work through each line item so that forecasts can be as accurate as possible.

To prepare cash flow forecasts, the entrepreneur should first look at historical cash flow, if this information is available. Construct monthly historical cash flows for at least the past year—if possible, for the past few years. It will be easier to forecast many items, such as utility bills, if what has been spent in the past is known.

Using these historical figures, prepare forecasts for the weekly cash flows for a month at a time. First, determine the cash inflows for each month—usually cash sales and accounts receivable. Then determine the cash outflows—utilities, payroll, and other employee-related expenses, inventory, equipment purchases, and so on. Compare inflows with outflows to determine the company’s net cash position.

The cash flow forecast allows an entrepreneur to track actual performance against forecasts and plans. Each month, an entrepreneur should compare the forecast with the actual results and calculate the variance between the actual amount incurred and the forecast line by line. Then calculate the percentage variance (the actual minus the forecast divided by the forecast). Focus on the areas where overspending occurred, looking at the dollar amount and the percentage over the budget. Where the difference is significant, determine whether the expenditure was justified, and, if it was not, how to reduce it. By doing this every month, an entrepreneur will find that he can control expenses much more effectively.

Accounts Receivable

The major area of vulnerability for many entrepreneurs is accounts receivable. On any given day, it is estimated that 5 million businesses are behind on their bills.⁶ As stated earlier, many entrepreneurs, particularly in the early or fast-growth stages of their business, focus more on generating sales than they do on collecting receivables. While this is never a good idea, it is worse during slow economic times, when more customers take longer to pay their bills—usually the result is a cash crunch for a company.

This problem is not unique to American entrepreneurs. In Australia, a survey conducted by Dun & Bradstreet and Roy Morgan Research showed that the majority of small and medium-sized enterprises no longer expect to be paid on time. As for the old standard 30-day payment period, only 30% of these firms expect their customers to pay them within that time. In the United Kingdom, 67% of small businesses indicated that late payment from other businesses was a cause of cash flow difficulties.⁷ Every year, Pepperdine University surveys small-business owners. The survey is designed to give an overview of current issues and problems facing these business owners, as well as a brief look at their expectations for the coming year. In 2018, small-business owners were asked about their priorities. For example, in the coming year, would they put more of an emphasis on increasing sales? What about collecting debt? The answers given are shown in Table 5-3,⁸ and they suggest that collecting debt is not a primary concern.

In a similar study, the National Federation of Independent Business (NFIB) conducts a survey every five or six years to establish the priorities of small businesses. The results of the most recent survey are enlightening: cash flow was not even a top 10, nor top 20 concern. In fact, it was number 25!⁹

TABLE 5-3 Business Owner Priorities

Alan Burkhard, president of The Placers, Inc., a Wilmington, Delaware–based temporary placement and permanent job search firm, initially did not recognize the importance of having good financial controls for accounts receivable. He notes, “I always told myself that accounts receivable didn’t create sales, so they weren’t worth paying attention to.”¹⁰ He held this belief until a time when, although his company was generating record sales, he was having difficulty running his company because of cash problems. The root of the problem: an inefficient accounts receivable system.

“None of our customers paid us in any kind of timely fashion. And 60–70% of our delinquent accounts were actually owed by our regular customers. Every single week we had to pay salaries and payroll taxes for every temp we placed on a job. But it was taking us 60 or 90 days or longer to collect our bills from the companies that were hiring those temps.”¹¹ By allowing its customers to take so long to pay, The Placers was actually giving them an interest-free loan to cover their own payroll costs.

Unfortunately, it is quite common for entrepreneurs to complain about their need for more working capital when in fact the company already has the money in accounts receivable. When you are an entrepreneur, you had better be an absolutely vigilant bulldog (as noted at the beginning of this chapter) when it comes to collecting your receivables. This is the lifeblood of the business—collecting your receivables as quickly as possible. Candidly, when I first owned my business, I was a bit of a wimp. I was afraid that if I called my customers and said something, well, they would no longer do business with me. I learned very quickly that if you do not say something, you are not going to be sitting around for very long saying, “Where’s my money?” Instead, you are going to be saying, “Where’s my business?” The money simply needs to be collected by whatever means necessary. As one entrepreneur stated, “I get on the phone and beg.”¹²

Accounts Receivable Systems

A good accounts receivable collection system is proactive. It also allows the entrepreneur to do business with customers who may not have a credit history, or even those who have a bad credit history. The major components of an effective system include these steps:

•  Before you go into business, perform an analysis of the industry’s payment practices. Is this an industry characterized by historically slow-paying customers, such as the government or health insurance companies? If an industry is characterized by slow-paying customers, this does not necessarily mean that you should not enter it; it simply means that you should be even more diligent about developing and maintaining a disciplined system.

•  Have all new customers complete a credit report before you provide any services or products. The report should be simple but thorough and should contain the following information:

•  The age of the company

•  The owner(s) of the company

•  Whether the company has ever declared Chapter 7 or 11 bankruptcy and whether the owner has ever declared Chapter 13

•  The current name of the company and any previous names

•  The maximum credit level desired

•  The telephone numbers and the fax numbers and/or addresses of three supplier references, along with the length and terms of the relationship with these suppliers

•  The name of the company’s primary bank, its account number(s), and a contact number for the bank officer responsible for managing the company’s accounts

•  Whether or not the company agrees to pay invoices according to your terms

•  Consider the following options if a potential customer does not have a credit history or has a bad one:

•  At the time of order receipt, require an up-front payment equal to the cost of goods sold for the order, with the balance due at the time of shipment. This ensures that your costs are covered if the customer cancels the order after production has begun.

•  Obtain a 100% payment before work on the order can begin.

•  Require a 100% payment before or at the time of delivery (COD).

•  Request a 33% payment at order receipt and 33% at the time of shipment, with the balance due 30 days later.

•  Contact all references immediately and inquire about their credit experience with the prospective customer. Questions should include:

•  How many years have they had this customer?

•  What is the maximum amount of credit they have provided this customer? Have there been any increases or decreases in the credit limit? If so, why?

•  What are their invoice terms?

•  Does the customer typically pay within 10, 30, 60, or 90 days?

•  Have they ever received any checks from this customer, and have any of them bounced?

•  Do they recommend this company as a good customer?

•  Have they had any problems doing business with this company?

If all the references are satisfactory, inform your customers that their orders will be processed immediately. Also remind customers of the company’s invoice terms and ask if they have any problems adhering to them. Specifically, ask customers how they normally pay their bills. The reason behind this question is that some companies have their own system for paying bills, regardless of the supplier’s invoice terms.

Successful entrepreneurs know how their key customers pay their bills. For example:

•  Some customers pay their bills once a month, typically on the thirtieth or thirty-first. For the company to be paid on the thirtieth the merchandise must be received by the tenth; if it is not, the payment will be made on the thirtieth of the next month.

•  Some customers pay 30 days after receipt of the goods or services. Therefore, the supplier is penalized if the shipment is delayed by the carrier.

•  Some customers pay 30 days after products that were damaged during delivery have been replaced.

It is also important to ask customers for the name of the accounts payable clerk who will be responsible for paying invoices. When I operated my business, you had better believe that I knew every accounts payable clerk at every one of my customers. I knew their names, their kids’ names, the flowers they liked. Heck, their employers must have wondered why we were so cozy. You know why? Any edge I could gain in getting my bills paid earlier was well worth a few timely cards, a few nice words, and flowers on a birthday.

Other important key steps toward the effective management of accounts receivable include the following:

•  All invoices should be mailed or sent electronically on the same day that the product is shipped or the services rendered. Do not hold invoices until the next day or the end of the week, and do not wait and send invoices once a month. Such a practice will certainly delay payment.

•  Make sure that the invoice highlights the payment terms in bold capital letters or in a different color from the rest of the invoice. The terms should be printed at the top of the page of the invoice. The most common invoice terms are “2/10, net 30.” This means that if the customer pays within 10 days of the invoice date, she is allowed a 2% discount. Otherwise, the entire invoice amount is due within 30 days of the invoice date.

•  Manage the collection of accounts receivable. It is naive to expect all customers to pay in a timely fashion. In the business of collecting receivables, the squeaky wheel does in fact get the grease.

•  The entrepreneur should have a weekly receivables aging report showing the customer accounts that are outstanding for 30 days or more.

•  For invoices that have not been paid seven days after the due date, automatic action of some kind should be taken.

•  Excellent payment history is no greater than 10 days more than the invoice terms. If the terms are net 30 and payment occurs in 50 days, then no future orders should be sent before receipt of some kind of payment, as mentioned earlier.

Collecting accounts receivable can be an intimidating experience, especially for the inexperienced entrepreneur. In many instances, the new entrepreneur is afraid to implement a system similar to the one discussed here because of the fear of losing revenue if the customer gets offended. Such a concern is foolish and naive. It is also a good idea to have someone other than you send the strong letters and make the tough phone calls. At my company, a woman named Angela—our CFO—was our resident pit bull. We had a system in place where our terms were net 30, and if we were not paid by the thirty-fifth day, an automatic reminder went out to the customer—a neon green sheet of paper in a neon green envelope. It said, “Just a reminder if you’ve forgotten us.” If we had not been paid five days after that, another notice—this one hot pink—went out. I had one customer call me to say, “Steve, every time I open one of these doggone notices, I get blinded by the sheets of paper. Why don’t you stop sending them to me?” I replied, “Listen, I just own the company. Angela runs everything out there. Now the way that I can get Angela to stop is for you to simply pay on time. It’s a simple solution.”

But everyone has his own system, and occasionally the entrepreneur needs to show a little “tough love.” I love the story that Bette Wildermuth, a business broker in Richmond, Virginia, tells about one of her clients. “This gentleman owns an excavation company. He always does excellent work, meets the developers’ time schedule, and makes sure his crews clean up after themselves. Usually he gets paid within 10 days of completing the job. But every once in a while, a developer really drags things out. The excavator’s solution: he puts on his muddiest contractor boots and goes to the developer’s fancy office with the nice oriental rugs. When he arrives, he announces in a very loud voice that he has come to pick up the overdue check and plans to sit in the lobby until it is ready. Needless to say, this does tend to speed up the process.”

For the entrepreneur who just does not have the stomach for collections, one option is to get “credit insurance,” where the insurer pays the claim within 60 days and then assumes the responsibility for collection. Baltimore, Maryland–based Euler Hermes (formerly known as American Credit Indemnity Company), the world’s largest issuer of trade-related credit insurance, charges 1% of the sales insured and will insure only receivables from customers who historically have paid within 30 days.¹³

Remember, good customers typically expect to pay their bills within 5 to 10 days after the due date unless they have a special payables system, as was mentioned earlier. Even those customers plan to pay, but according to their system. A bad customer is one who is very cavalier about paying bills. These types of customers will pay only when they are forced to do so, even when they have the money. Ultimately, the experienced entrepreneur sees that these are not profitable customers and does not mind losing them.

When such a decision has been made, extreme action should be taken within 60 days, such as hiring a lawyer, at a cost of approximately $2,000, to get a “writ of attachment” against the delinquent customer’s corporate bank account. This action generally gets the customer’s immediate attention for settling the delinquency.¹⁴

Before leaving the subject of an accounts receivable system, here are a few don’ts:

•  Don’t be rude to customers. Do not threaten them.

•  Don’t assume that a slow-paying customer is a thief or a bum. It may be that the customer has fallen on temporary tough economic times.

•  Don’t take legal action against a customer until the bill is at least 45 days past due and you have personally spoken to the customer and tried to get payment.

•  Don’t pay independent sales representatives until you receive payment from the customer. Some sales representatives do not care if a customer is a known delinquent payer. Taking an order from such a customer may not bother the salesperson, since he is not the one who is investing in raw materials. Therefore, discourage such action with a policy that specifies that sales representatives will not receive their full commission if payment is received more than a certain number of days late. For example, if the payment is 15 days late, the commission is reduced by 15%.

To check on the quality of accounts receivable, several ratios can be used. The first step in checking the quality is to determine what the company’s collection ratio, or “days receivable” or “accounts receivable turnover,” is. This ratio measures the quality of a company’s accounts receivable. It shows the average number of days it takes to collect accounts receivable. To look at it another way, this ratio indicates the number of days, on average, that it takes a business to convert its receivables to cash. Equation 5-3 shows the equation to calculate days receivable.

Days Receivable

The same formula can be restated as Equation 5-4.

In this case, average daily sales can be calculated using Equation 5-5.

Average Daily Sales

The goal is to get the customers to pay as soon as possible. Therefore, a low days receivable number is desirable. At a minimum, a company’s days receivable should be equal to the industry’s average. Also, it should not exceed the company’s days payable ratio, because if it does, this indicates that bills are being paid faster than payments are being received.

For example, a company with $5 million in annual revenues and $800,000 in accounts receivable has an accounts receivable turnover ratio of 58.4 days, calculated as shown in Figure 5-1.

FIGURE 5-1 Receivables Turnover Ratio Calculation

This number would indicate that, on average, it takes the company approximately 58 days to convert receivables into cash. Is this good or bad? Well, most important, it depends on the invoice terms. If the terms are 30 days, this is bad even if the industry average is higher. This says that customers are paying almost one month later than they should. That is money that could be reinvested and could generate returns if the company received it closer to the invoice terms.

Entrepreneurs sometimes ignore the costs of inefficient collection systems because they do not really understand the effects of these inefficiencies on the company’s bottom line. However, it is easy to quantify the benefits of faster collection of accounts receivable in terms of dollars saved. Faster collection means that the company will not have to use external financing for current payables. Equation 5-6 is the formula for calculating dollars saved as a result of faster collection of accounts receivable.

Dollars Saved

In calculating dollars saved, use the most recent complete year’s sales figures unless the company is growing rapidly and has a good projection for the current year. For the annual interest rate, include the cost of debt capital. To find the days saved, subtract the company’s improved days sales outstanding (DSO) from its original DSO. The equation for DSO is shown in Equation 5-7.

Days Sales Outstanding¹⁵

For example, suppose a $4 million company, borrowing at the prime rate of 6.75% plus 200 basis points (2%), improves its days sales outstanding by 5 days. The total amount of dollars the company saves by improving its collection of accounts receivable is shown in Figure 5-2.

FIGURE 5-2 Accounts Receivable Collection Savings

Accounts Payable

The ideal situation is to collect all your receivables quickly while paying your outstanding bills as late as possible without jeopardizing the service you get from your suppliers. However, delaying payables is not always necessarily a good thing. If you have cash on hand or can borrow at low rates, should you take discounts? Yes. As Jay Goltz, the author of The Street Smart Entrepreneur, explains:

Suppose your supplier terms are 2, 10 net 30—2% discount if you pay in 10 days; the entire balance is due in 30 days. You do not take a discount and pay in 40 days instead of 30. You have borrowed from your vendor for 30 days, which is essentially one-twelfth of a year. The loan cost equals 2% (i.e., the 10-day discount) of the invoice annualized, which is 24%. If every month you lose a 2% discount, it is like paying 24% over the course of a year.¹⁶

To determine whether or not the company’s accounts payable are what they should be, analyze the accounts payable turnover ratio and compare it with the industry average. This ratio measures the average number of days it takes the company to pay its bills. The ratio can be calculated as shown in Figure 5-3.

FIGURE 5-3 Accounts Payable Turnover Ratio Calculation

Management of Accounts Payable

To improve the accounts payable days, the entrepreneur can take the following actions recommended by several professionals:

•  Negotiate better payment terms, such as net 45 or net 60, instead of net 30.

•  Time payments according to their due dates, such as 30 days following the receipt of material, rather than on some artificial schedule.

•  Plan cash flow realities. For example, to avoid big cash outflows, some companies pay their employees’ payroll biweekly and then pay their outstanding bills during the other two weeks of the month.

•  Avoid interest penalty charges. If you have to stretch out your own payables because of temporary cash flow problems, make sure you are not late with those bills that incur additional interest charges.

•  Communicate with your suppliers. If you establish a good working relationship with a supplier and make regular payments, you can usually avoid paying late charges by contacting the owner in advance if you expect to make a late payment or if you need to request a payment extension.

•  Set scheduling goals. Try to establish a final date by which all payables are to be paid. While it is unrealistic to assume that you will always be on schedule, it is important to keep the accounts payable as close to the scheduled goal date as possible.

•  Be organized. Keep a paper trail, and keep close track of details, especially of the aging of bills. Invest in a good accounts payable system.

•  Look for warning signs, including low cash levels that could result in future problems paying vendors and suppliers. Reevaluate your collection controls to ensure that you are collecting cash as soon as possible.

•  Prioritize. You cannot devote the same amount of time to all payables. Organize your payables based on some type of priority rating. For example, fixed expenses such as rent may be paid first, utilities second, and then other bills.

•  Identify problems early. Verify the accuracy of the information on invoices from suppliers.

•  Provide supervision from the top.

•  Have specialists monitor the accounts payable daily.

•  Try to stretch your accounts payable as much as possible without hurting your relationships with vendors and without damaging your credit status.

The Cash Gap

You now own a business. Whether it is a manufacturing, retail, or service firm, you soon discover a simple truth: first, you pay for the goods or services, and then eventually someone else—your customer—pays you. The period between the payment of cash and the receipt of cash is called the cash gap or cash conversion cycle. How long do your goods sit in inventory? How many days is it before you have to pay your suppliers? Finally, how many days does it take your customers to pay you? The answers to those three questions are plugged into the cash gap formula, shown in Equation 5-8.

Cash Gap Calculation

That interval between the payment of cash and the receipt of cash must be financed. The longer the time, the more interest a company must pay on capital borrowed from a lender, thereby using working capital. The wise way to reduce the need for working capital is to decrease the gap. The entrepreneur’s goal must be to continually shorten the gap, because for each day that it is decreased, the daily interest cost saved goes entirely and directly to pretax profits.

Let us explore this concept in more detail, using an example and illustrations. We can make the following assumptions for the Palmer Company:*

•  Days inventory carried: 40.5

•  Days payable: 40

•  Days receivable: 35

•  Annual revenues: $50 million

•  Gross profit: 30%

•  Cost of debt: 6%

Therefore, the cash gap can be calculated as shown in Figure 5-4.

FIGURE 5-4 Cash Gap Calculation

To determine the savings from reducing the cash gap by one day, the calculation shown in Figure 5-5 should be made.

FIGURE 5-5 Cash Gap Reduction Calculation

As you can see from the figure, for every day that the cash gap is reduced, the savings of $5,753 will go directly to profits before taxes, thereby increasing the Palmer Company’s cash flow. Using the Palmer Company’s information, Figure 5-5 illustrates the cash gap concept.

There are only three ways in which a company can reduce its cash gap: (1) increase the number of days it takes to pay for inventory, (2) decrease the number of days it takes to collect receivables, or (3) increase the inventory turns. Let us analyze each.

Increase Days Payable

Most companies allow their customers up to two weeks past the due date before they consider the invoice seriously delinquent. Therefore, every entrepreneur should take advantage of these extra days by paying no earlier than two weeks after the due date. This shortens the cash gap because it extends payments that may have been due in 30 days to 44 days. Using the information from the Palmer Company, if days payable were increased by 4 days, to 44, the cash gap would be 31.5 instead of 35.5. Such a decrease would save the company $23,012 in interest payments (4 days × $5,753).

Decrease Days Receivable

Some industries historically have lower days receivable than others. For example, manufacturing companies typically expect payment in 30 days, whereas retailers such as Amazon.com usually get paid immediately upon sale. They have no receivables because payment is required at the time of the order. In fact, a few years ago, Amazon.com reported 15 days receivables, 76 days payables, and 44 days of inventory. The result was that Amazon.com’s cash gap was a beautiful negative 17 days (15 + 44 – 76 = –17), which means that it raised interest-free money from its customers for half a month. Specifically, given its average cost of sales, which at the time was $114 million, the company raised $1.9 billion ($114 million × 17 days), which it used to help pay overhead expenses.¹⁷ Using the Palmer Company data again, if the days receivable were reduced from 35 to 29, the effect would be a 6-day reduction in the cash gap and therefore a $34,518 cash savings.

Increase Inventory Turnover

The faster a company can convert its inventory into cash, the less cash it needs because it can reduce its days of inventory carried and decrease its inventory carrying cost. A company that has successfully increased its inventory turns is Walmart, known in some circles as the world champion of lean. Its inventory turnover improved in 12 years from 4.1 to 8.3, an average increase of 3.3% per year. Another company, Dell, when it was on its way to its best performing years of sales, was successful in improving its cash flow by turning inventory faster. One year, Dell turned its inventory an amazing 83.7 times, compared with less than 5 times for traditional computer manufacturers.¹⁸

The hope is that, as a result of this rich discussion, it is now clear that every entrepreneur must know why cash gap analysis is important and how to use it as a proactive tool for operating the company. Every entrepreneur should do the complete analysis explained in this section at least annually and use the information for strategic planning for the next year.

What is the ideal cash gap? It varies by industry. An industry comparison should be made annually using the Risk Management Association (formerly Robert Morris Associates) guide. A few of the industries are highlighted in Table 5-4.

TABLE 5-4 Cash Gaps by Industry

Working Capital

The procurement, maintenance, and management of working capital seem to be some of the most common and challenging tasks facing entrepreneurs. Therefore, let us devote a little more time to the subject.

As was stated earlier in this chapter, the interval between a company’s payment and receipt of cash must be financed. The money for this is called working capital, which consists of funds invested in all current assets, including inventory, accounts receivable, and cash. Gross working capital is used to finance only the company’s current assets. Net working capital, which is a measurement of a company’s solvency, is current assets minus current liabilities. The goal is to have positive net working capital. The greater the net working capital, the stronger the company’s cash position relative to its ability to service its other expenses, including long-term debt.

Very few companies are able to finance their working capital needs internally. Therefore, external financing in the form of debt or equity is inevitable. How much working capital is ideal? One expert, Skip Grandt, a commercial lender with 20 years of experience, says that he likes to see a company have net working capital levels of 3 to 6 times its annual fixed costs.¹⁹ A great resource for finding working capital levels for different industries is CFO magazine’s annual working capital survey, which can be found on CFO’s website (www.cfo.com).

Finding Cash

Entrepreneurs have frequently asked me to help them raise external financing from debt and/or equity investors. Most of the time, after reviewing their financial statements, I have told them that they do not need outside capital. They simply need to reduce their inventory and/or accounts receivable levels. That is right. Cash is often readily available to entrepreneurs who carry excessive amounts of these two assets.

What is the ideal level of inventory that an entrepreneur should carry? The formula to make this determination is shown in Equation 5-9.

Ideal Inventory Calculation

Let us use the information from the Hoy Company to show how an entrepreneur can raise internal cash by applying this formula. The Hoy Company had the following numbers for 2018:

•  Revenues: $30,848,000

•  Cost of goods sold (COGS): $13,989,000

•  Inventory: $9,762,000

•  Inventory turns: 1.43 times

•  Average industry inventory turns: 2 times

•  Accounts receivable: $5,996,000

•  Days receivable: 71

•  Average days receivable for industry: 40

If in 2019, the revenues and COGS remained the same as in 2018, but the entrepreneur was able to turn inventory 2 times rather than 1.43 times, the cash savings would be dramatic. The ideal level of inventory is $6,994,500, determined by $13,989,000/2. The actual savings based on the 2019 inventory level would be $2,767,500 in cold, hard cash!

What is the ideal level of accounts receivable that an entrepreneur should carry? The formula to make this determination can be seen in Equation 5-10.

Ideal Level of Accounts Receivable

Using the same information for the Hoy Company, if days receivable can be reduced from 71 to 40 days, the cash savings would be significant. To compute average daily sales, the annual revenue must be divided by 365. Therefore, $30,848,000/365 generates average daily sales of $84,515. This figure multiplied by 40 days receivable shows that the Hoy Company’s ideal level of receivables should be $3,380,600. The actual savings based on the 2018 accounts receivable, or $5,996,000, would be $2,615,400 in cold, hard cash!

* The formulas for these ratios can be found in Chapter 4.