Understanding cashflow part 1: How profitable companies run out of money.

Nobel-Prize-winning physicist Richard Feyneman said “if you think you understand quantum mechanics, then you don’t”. The same is probably true for most of us with cashflow. We think we understand it… ‘make sure more money comes in than goes out’… but most people, and most entrepreneurs, don’t.

When someone tells you about profitable businesses that either go bust or massively slow down their growth, do you wonder how and why that could happen?

When you hear about profitable businesses where the founder(s) have to bring in outside investment and dilute their shareholding, without getting any cash out, do you wonder why?

When you see that loss-making companies are growing at break-neck speeds,do you question how?

The answer to all the above could be cashflow. It’s definitely not the most exciting topic to talk about… very little about accounting is, but it’s probably the most important lesson any entrepreneur, or anyone involved in a fast-growth business can learn. When I was taught about cashflow properly it was probably the biggest “ah-ha” moment of my professional life and it dramatically changed how I run my company. 

How do profitable companies go bust?

This seems like an unlikely thing to happen, but it’s what is known as over-trading. The best way to look at this is with an example:

Let’s say you have started a drinks business and it’s going really well, you’ve got a listing in a major supermarket, in 100 stores. You’re turning over £100k a month with the supermarket and making 5% net profit. That’s £1.2m per year, with £60k profit. You pay your supplier on 30-day payment terms, you hold about 1 month’s worth of stock at any time and the supermarket has you on 60-day payment terms. All of this is pretty standard.

This means you should have about £50k of stock (assuming a 50% gross margin), £50k of creditors (money you owe to the manufacturer) and £200k of debtors (money you are owed by the supermarket) at any one time. This is £250k assets (the stock and the debtors) and £50k of liabilities (the creditors), a net position of £200k… but this £200k assets is not cash. Let’s also assume you have £50k cash in the bank.

As things are going so well the supermarket agrees to up your listing from 100 stores to 300 stores (for simplicity let’s assume rates of sale stay the same – that is too big a topic for this article). 

This means that you are going to go from £1.2m per year to £3.6m per year, and £60k to £180k profit. Great news…. Or is it?!

You still need to hold one month’s worth of stock. The value of that stock has now gone from £50k to £150k. You are in 3x as many stores, so need 3x as much stock. Even if you use all your cash in the bank you can only afford to buy two thirds of the stock you need.

The supermarket is still going to keep you on 2-month payment terms, so the value of your debtors (what they owe you) goes from £200k to £600k. And that’s assuming they pay you on time and don’t ask for additional investment, overriders etc which they deduct from your payments. You are basically lending the supermarket £600k!!

Both stock and debtors are assets, so your balance sheet looks good… but you need to cash to fund the extra £100k stock holding and £400k debtors. Where does that cash come from? You’re only making £180k per year. If you can’t answer this question you go bust, simple as that, because you don’t actually have the cash to buy the stock, or pay anyone’s salaries, or invest in marketing, or anything else. You can spend cash, you can’t spend debtors. 

The best way to answer the question is to look at the main variables that are causing the problem; How long you have until you pay your supplier and how long it takes to get paid by your customer. 

If you can get your payment terms from your customer from 2 months down to immediate, then you don’t have to fund this huge increase in debtors. Most customers will not do this (except for a fee!), as they have their own cashflow to manage. You can normally get a percentage of your payment terms to zero days using Invoice Financing. This will cost you and hit your bottom line, but in most cases is (at least in the short-term) a good solution. The main caveat being that your finance team needs to know what they are doing to make this work. The other way to get your payment terms down is to grow channels where you get paid quicker, such as online direct (DTC) where you get paid on day one, in full (minus credit card charges etc). This is one of the reasons why there has been so much growth in DTC businesses… but you have to make sure that you have the right product to do it. Products like contact lenses, razor blades and mattresses work well because these are products people have delivered to and use in their homes. For the drinks brand it could be a lot harder if sales are mainly for immediate on-the-go consumption. 

The flip side is to look at your supplier payment terms. This can be a game-changer for many businesses when they realise the value of it. The longer you get to pay your suppliers, the more cash you have in your business. The important question here is why should your supplier help you out and take a risk on you. It may be that your niche, whether market niche or geographic niche, is one that they see as being strategically important. It may be that you offer them equity in exchange for better terms. This can be beneficial for both sides as it both gives the supplier some security and most likely gets you more cash into the business than you would get selling the equity…. And that cash grows as you grow (because you are ordering more each month as you grow). The downside is that you can end up locked in with that supplier, but that’s something for the contract. It might simply be that your supplier likes you and that your business is small enough to not be a risk. It could be that they are using invoice financing themselves, so have the ability to pass on the longer terms. Whichever way you look at it, it all comes down to having a good relationship with your supplier.

Even though the 2 routes above are arguably the best routes. They are probably not the most common. Most people think first about raising outside finance, whether from Crowdfunding, VC or PE. The situation of a cash-starved, profitable, high-growth company is music to the ears of investors, especially PE, but you have to be the right size to match the investor’s mandate, if you keep the growth up the problem grows so you’ll then need more money and more importantly if you haven’t looked at the above options first, you could be giving your equity away too soon and too cheaply.

The general rule is that (unless you have a cash mountain to dig in to) if you can get paid for your goods from your customers before you have to pay money out to your suppliers things start to look rosie!

This brings me on to the second half of this article:

How do loss-making companies grow at break-neck speeds?