My good friend and colleague, Bill Douglas, at EssentiaLink has a saying that really makes a point. "Cash flow is oxygen!"
I think that really puts the subject in perspective. I have seen large companies go years with out making a profit. Even though they were losing money they were able to stay a float until better times because they had a workable cash flow.
Also, I have seen profitable companies go down the tubes in a matter of months that had bad cash flow.
So how can cash flow be more important that profit?
This is best answered by an example that may ring true to some of you.
There is a small CNC job shop that specializes making in small precision parts
for the food, medical and aerospace industries. Let's call them Quality Widget Company, QWC for short.
Their work is excellent and they have a 95% on-time delivery. As a result, they can command a higher price than their competitors and are very profitable.
The parts QWC makes are usually out of exotic stainless steel or aluminum. They make a lot of parts and have to buy tons of raw materials. In order to get the best prices and maintain product consistency, they buy large lots of certified materials.
So far so good. If you read the previous article on the Break Even Analysis you know that lowering variable expense goes a long way towards increasing the contribution towards fixed expenses. The company breaks even on the jobs around the 15th day of the month.
Here is a breakdown of their problem:
So far $31,485 has gone out the door and not a cent has come in!
If QWC pays for their raw materials when due, then $71,885 will have gone out the door with no cash expected for another 22 days. In that 22 days, another $39,435 will be spent. That's $111,320 spent with nothing coming in.
Now things begin to get ugly. If they do not pay the raw materials bill QWC is likely to a) pay late payment fees, b) get put on COD only with vendor or c) get cut off by supplier altogether.
By day 37, another payroll is due. If that is not paid, not only will employees get upset, the company could be in a world of hurt with the government. If taxes and benefits are not paid more trouble on the horizon.
By day 44, cash starts to come in for the parts shipped on the 16th day. If lucky $75,000 will come in to replenish the coffers. But that still leaves $26,000 uncollected that must be carried by QWC. And, the bills keep coming in. If bills don't get paid, QWC's credit worthiness declines which can lead to higher interest, adding additional stress on cash flow. In the worst case, they will not be able to get short term loans at all.
In a perfect world, within a year or so profits will be placed in a liquid account to cover future operating and variable expenses. But there are always the unexpected things that come up like repairs, equipment purchases, new hires and so on. The cost of benefits and other business expenses can increase. All of this makes it very difficult to hang on to cash, even with QWC's respectful profit margins.
In the next article, I will be discussing some strategies that may be useful for managing your cash flow.