Tackling the Cash Flow Problem - Part 1 of 3

The challenge with variable costs is that they are variable. When your sales go up you need to spend more. When your sales go down you need to spend less. If you are selling more things then you have more money to pay for the parts and labor, or in other words the variable costs. So what's the problem?

The biggest challenge in controlling variable costs is that you often need to make the decision to spend before the actual sale is made, and you often need to pay your bills before you can collect payment. To top it all off, if you guess wrong on your planned income you still need to pay your vendors and your staff.

The Cash Flow Problem

Let's look at the typical flow of cash inside a small business. A similar situation applies to most businesses, regardless of the size. The only real difference is the amount of money and the number of people affected. For the sake of illustration we will track a small business that plans to do $10,000 in sales this month at a 40% profit margin. The plan looks like this.

Planned Sales: $10,000
Materials: - $3000
Assembly Labor: - $3000
Profit Margin: $4000

Let's watch what happens to our balance sheet and to our cash as we progress through the month.

Day 1

The first thing we need to do before we can start producing anything is to purchase some labor and materials for our business. In an ideal business scenario you could sell the products first, and then find all the materials and staff, but in the real world you need some assurance of available labor and raw materials before booking an order. So you predict your sales as best you can, and go hire the required number of factory workers. Then you put an order in for the minimum amount of materials you think you will need. You just made a hard financial commitment, and maybe even had to make a small down payment up front.

To keep our example simple we'll assume our small business is really good and managed to negotiate 30 day payment terms with no down payment from our vendors. Let's say we also booked an order for the entire month's sales projection on day 1. Next we ran out and lined up staff and raw materials the next day. You have to agree a business scenario can't get much better than that. This would be a pretty good situation to be in. Let's see how the money flows in a positive situation like this.

Balance Sheet Money
Day 1 Order Taken for $10000, Balance = $10000
Day 2 Get materials from vendors (-$3000), Balance = $7000
Day 2 Sign assembly staff contract (-$3000), Balance = $4000

Real Cash
Day 1 Order Taken for $10000, Balance = $0 (not collected yet)
Day 2 Get materials from vendors (-$3000), Balance = $0 (not paid yet)
Day 2 Sign assembly staff contract (-$3000), Balance = $0

Our financial sheet shows that we are right on track to make our $4000 this month, and although we have agreements in place, no hard cash has changed hands yet.

While we are looking at this let's consider what happens if we don't have all the orders for the month yet but we have completed everything that has been ordered so far? This is a very practical management decision point. You can stop using materials, but your staff is going to keep coming to work. Do you pay them to do nothing, do you send them home, or do you take your best guess at what you are going sell and get them started building things you hope you will need?

If you put your assembly staff to work you won't have them sitting idle, but they will start using up materials. If you guessed wrong on what they should build, you will have to buy more materials to build what actually gets ordered, and either store or scrap what they've already made. Either way, your materials costs go up if you guess wrong. If you guess right, you save the company a lot of money. The right answer depends entirely on the business you are in, your confidence level, and the cost mix of labor, materials and storage space.

Day 15

So let's go back to our small business example and assume we completed building the order on day 15, and pay the assembly staff for the 2 weeks work. Since we have 30 days to pay our materials vendors, we keep that money for now.

Balance Sheet Money
Day 1 Order Taken for $10000, Balance = $10000
Day 2 Get materials from vendors (-$3000), Balance = $7000
Day 2 Sign assembly staff contract (-$3000), Balance = $4000
Day 15 Product Delivered, Balance = $4000 (already accounted for)
Day 15 Pay staff the $3000 we owe them, Balance = $4000 (already accounted for)

Real Cash
Day 1 Order Taken for $10000, Balance = $0
Day 2 Get materials from vendors (-$3000), Balance = $0
Day 2 Sign assembly staff contract (-$3000), Balance = $0
Day 15 Product Delivered, Balance = $0 (not collected yet)
Day 15 Pay staff the $3000 we owe them, Balance = -$3000

Our balance sheet is looking good: $10,000 ordered, paid out $3000, promised to pay $3000 more later.

But look what's going on with our real cash. We had to write checks for $3000, but we haven't collected any money yet. In fact, if our customer agreed to pay us 30 days from delivery like we did with our vendors, we are not going to see that cash for another month!

If this is a real business, we need to finance that $3000 somehow and make good on our promise to pay $3000 today. We won't get into the financing options here, but it basically comes either from a company bank account, the owner's personal account, or from a lender in the form of a short term loan.

Day 30

Let's skip ahead another 15 days; it will still be two more weeks until we get paid by our customer. It's also the day our materials vendor needs to be paid for the materials we bought on day 2. Let's take another look at the cash flow analysis.

Balance Sheet Money
Day 1 Order Taken for $10000, Balance = $10000
Day 2 Get materials from vendors (-$3000), Balance = $7000
Day 2 Sign assembly staff contract (-$3000), Balance = $4000
Day 15 Product Delivered, Balance = $4000
Day 15 Pay staff the $3000 we owe them, Balance = $4000
Day 30 Pay vendors the $3000 we owe them, Balance = $4000 (already accounted for)

Real Cash
Day 1 Order Taken for $10000, Balance = $0
Day 2 Get materials from vendors (-$3000), Balance = $0
Day 2 Sign assembly staff contract (-$3000), Balance = $0
Day 15 Product Delivered, Balance = $0
Day 15 Pay staff the $3000 we owe them, Balance = -$3000
Day 30 Pay vendors the $3000 we owe them, Balance = -$6000

Nothing much has changed on our balance sheet. We had already written off the money we knew we'd need to pay, and are still showing a $4000 profit. But again we find ourselves having to pay our bills before we collect any money.

If you are a small business like the one in our example making $4000 a month profit, $6000 is a lot of money to be financing every month.

Day 45

Today is finally the day we get paid. Assuming our customer pays on time we will finally be able to get our cash flow out of the red.

Balance Sheet Money
Day 1 Order Taken for $10000, Balance = $10000
Day 2 Get materials from vendors (-$3000), Balance = $7000
Day 2 Sign assembly staff contract (-$3000), Balance = $4000
Day 15 Product Delivered, Balance = $4000
Day 15 Pay staff the $3000 we owe them, Balance = $4000
Day 30 Pay vendors the $3000 we owe them, Balance = $4000
Day 45 Collect payment owed to us for $10,000, Balance = $4000

Real Cash
Day 1 Order Taken for $10000, Balance = $0
Day 2 Get materials from vendors (-$3000), Balance = $0
Day 2 Sign assembly staff contract (-$3000), Balance = $0
Day 15 Product Delivered, Balance = $0
Day 15 Pay staff the $3000 we owe them, Balance = -$3000
Day 30 Pay vendors the $3000 we owe them, Balance = -$6000
Day 45 Collect payment owed to us for $10,000, Balance = $4000

Finally our cash flow catches up to our balance sheet, and we are showing a positive picture on both sides of the equation.

Summary

Cash flow management is very practical business, and is well understood by all strong business leaders. To succeed you must understand not only how much money you will make from a project, but how the money will flow along the way.

In parts 2 and 3 we will do a more detailed analysis of our cash flow picture, take a look at the "big order problem", and lay out some very practical management tips for managing cash.