Author: Sri Srikrishna (Page 20 of 22)

For a business to be viable, money is important. Most of us understand this intuitively and deal with it constantly in our own personal lives. Yet, as runaway individual credit card debt or a cash squeeze in a large company and the occasional sovereign currency crunch demonstrate, it is not difficult to lose sight of where the money goes. Even as capital and sales revenues supply money for your business, inward and outward cash flow management is critical for survival. If you don’t track and control the cash flow in your business, you may not keep your doors open too long, unless, as in the case of Chrysler, an elected government bails you out. It makes better business strategy to understand and manage your cash flow rather than rely on the government to help you with it.

As an entrepreneur, you likely began with an idea of a product or service. Soon, you are knee-deep in building a team, pulling together the product or service, finding and servicing customers. You may even have written a business plan and try to raise money. In addition, you are still trying to keep the company rolling forward. In a previous article, I asserted that having good people on board is the first step to managing the challenges your business will constantly face. The most life threatening of these will be cash flow management. As with the advice of any personal trainer (eat less, exercise more), cash flow management is easier said (spend less than you have, collect sooner than you need) than done, as many large and even profitable companies have found out.

Profit versus cash

To understand the criticality of cash flow, it is useful to begin with a simple business scenario. Ram Charan, author of What the CEO Wants You to Know, begins his book with the example of a street vendor selling fruits and vegetables in India. He poses the question: “How does he (the street vendor) know if he’s doing well? When he has cash in his pocket at the end of the day.” In the case of a cash-and-carry business such as a street vegetable vendor, profit and cash flow are closely tied. Most companies operate on credit terms, at least with their customers. In the case of start-up firms with no track record of good credit, this can be a bigger challenge with customers wanting 30-, 60- or 90-day credit terms and suppliers wanting advance payments or cash on delivery.

Imagine that on a holiday to Hong Kong you see these adorable ceramic animal sculptures that you know every woman would want for her home. You locate a supplier in China who can supply them for a mere Rs 100 each and you know that you can sell them for at least Rs 150, may be even as high as Rs 200. After all your expenses, you’ll still make nearly Rs 50 profit!

So you beg, cajole and wheedle Rs 4 lakh from your family and get a container load of the ceramic menagerie. Unfortunately, you have to pay your Chinese supplier up-front by wire transfer but the thought of that Rs 50 profit per ceramic animal keeps you rolling. Your largest buyers, unfortunately, also pay you only 120 days after receiving their supply of ceramic animals (what accountants refer to as net 120-day terms).

In other words, you have spent Rs 4 lakh on day one for the first container. The products are selling like hot cakes and you have sold all the ceramic animals you had bought within the first 30 days. Your customers, though, are yet to pay you (for another 90 days). Worse, they want to order even more animals from you. You scrape together another Rs 4 lakh and order that second container, whose contents too fly off the shelves.

Your accountant and books tell you that you are profitable, having bought Rs 8 lakh worth of animals, selling them for nearly twice that and making a net profit of Rs 4 lakh. However, your customers owe you nearly Rs 16 lakh and are not likely to pay you for another 60 days. You still have to continue to pay rent, the phone and electricity companies and salaries for your employees, not to mention returning the money you borrowed from family. Thus, despite being profitable you have run out of cash! And if you want to continue in the business, you need even more money.

So even simple and profitable businesses can get into trouble. Most real businesses rarely have products flying off the shelves, so they have cash tied up in goods bought but not yet sold (inventory); if the goods are perishable (vegetables) or time constrained (fashion) they may totally lose their value, resulting in losses or reduced profits. Most real businesses have to pay banks or lenders interest on the money they borrow; their profit margins are rarely as high as in this illustration. All of which means managing cash even in the simplest and, yes, profitable businesses is critical.

Capital as cash

Capital, and adequate capital at that, is the surest way to ensure that you don’t run out of cash. In the above example, if your customers are likely to pay you only on 120-day terms, that means you need capital for at least four months to be able to buy your goods, pay your routine running expenses and have some room to spare for unforeseen issues such as delayed shipments, broken animals or returned goods. So suddenly, you see that you need nearly half-a-year’s worth of cash outlay as capital — and this is for a simple trading business. As every entrepreneur has found, there are no simple businesses and you always need more money than you think.

The downside to capital, particularly equity capital, as the answer to cash flow is twofold — raising sufficient money may prove non-trivial and result in a dilution of your equity early in the life of your business. Debt and other methods of raising working capital might be more fruitful ways of planning and managing your cash flow. Banks offer various working capital funding mechanisms such as packing credit (a credit limit or a loan against orders you have secured from your customers) and bills discounting (providing you cash against bills you have raised on your customers). For a start-up, banks may require personal guarantees of either the company directors or third-parties before extending working capital facilities. Once you have built a track record and, more importantly, a relationship with your banker, it will be easier to grow and leverage such working capital mechanisms.

Cash flow is in the details

Even when you have raised what you deem is adequate equity and got your local banker to extend you various credit facilities, it is critical to pay attention to cash flow. More importantly, you need to build a culture where your entire organisation is well-educated about cash flow and comprehends the need to manage it. Every time a sales person makes a sale for net 60 days rather than net 120 or a purchase manager buys supplies on net 30- or 60-day terms rather than advance payment, they are managing cash flow.

Most entrepreneurial firms, especially in their early days, understand managing to cash. As they grow, a balance is needed between continuing to manage for cash flow and the need to spend money to sustain growth. There have been instances where companies have paid heavily due to their failure to educate employees adequately. An employee in trying to save Rs 10,000 (to buy a testing tool), delayed the shipment of a product to the customer who was ready to pay Rs 2.5 lakh for it, within 30 days. Of course, there have been times, as in the infamous Chrysler case or, more recently, the US Federal Reserve having to guarantee the bailing out of investment firm Bear Stearns, when the lesson of having to watch your cash regardless of your size is brought home hard.

This article first appeared in the Hindu Business Line in April 2008