Sunday, May 10, 2009

Plan Now for Your Upcoming Needs for Cash and Credit

Thankfully, the popular press has decided that the recession is beginning to moderate and that a recovery is beginning to show itself. I'm not an economic forecaster. I am, however, listening to business owners across the country every day, particularly at events like the recent national Summit of Chief Executive Boards International. And I'm hearing business owners say things like "My quote volume is up", "I'm hearing from customers who had projects on hold", and "Our backlog is holding steady, rather than shrinking."

While admittedly not highly scientific, our recent Main Street Economic Survey of over 100 small-to-midsize businesses revealed an anticipated upturn in 3rd or 4th quarter 2009, with 2010 being a return to an "average" year of growth in both revenue and profitability.

Regardless of the timing, as a recovery picks up steam, businesses that are still standing are positioned to grow remarkably. That is, if they've prepared themselves to do so.

Most business owners focus on their income statements. While the income statement will look great during an upturn, when business is growing and accrual basis profitability is growing. Key words in that sentence -- "accrual basis". Many business owners neglect forecasting their balance sheets. And it's not directionally hard to predict that a business that's steadily growing both revenue and profitability will, in fact run low on cash. Why is this counter-intuitive statement true?

It's the lurking devil of timing. Here's the scenario:

Revenue turns up, requiring more labor, which needs to be paid for weekly. It requires more overhead, which needs to be paid for monthly. It requires more material and/or inventory, for which most businesses get 30-day terms, but is generally needed around 30 days before it gets turned into revenue.

The upturn in revenue, therefore, produces a "giant sucking sound" on the bank account, as those resulting cash needs have to be met before customers pay.

Most healthy businesses run an average of 45 days between billing and collection of receivables (Days Sales Outstanding = DSO). And that 45-day average is from the date billed. Generally the additional material, inventory and labor required at least some cash even prior to that 45-day clock starting.

So, the collection of not only the cost but also the margin resulting from these increasing sales lags the cash outlay by roughly 60 days (if you're on top of your receivables, and maintaining a DSO of 45 days or less). That produces what I call a "bow wave" of receivables -- for each month's growth in revenues, the receivables grow by double that amount (since they take almost two months to collect). Example: If revenues grew $100 last month, that money is still in receivables and adds to this month's additional increase of $100 in receivables for a total growth in receivables of $200. And next month will be the same, assuming your continued growth month-to-month.

And then what? Continued for any period of time, the accrual basis income statement continues to look great, and the balance sheet looks like:

  • More Inventory

  • More Receivables

  • Less Cash -- (it became inventory and receivables) and subsequently less and less cash, the more prolonged and successful your growth cycle becomes

    which can also result in the need for:

  • More Fixed Assets (machinery)

    resulting in

  • Even Less Cash

So, what's the solution? Granted, some of your growing cash requirements can be met by profit, collected through receivables, although delayed by the DSO. Sustained long term, however, you're going to need cash from elsewhere to fund these working capital accounts. That's where banks and credit lines come in. They're in the business of providing that working capital, so the owner doesn't have to put even more of his own capital at risk in the business, and can, in fact, harvest some of that increasing profitability into his own personal investment portfolio. Why not, since you're probably paying taxes on it already (if you're an S-Corp or LLC)?

Perhaps an upturn for your business isn't just around the corner. Perhaps it is. Either way, you're going to need some more cash to fund that success whenever it happens, and now is a great time to get that Line of Credit (LOC) secured and in place. It's more of a hassle and takes more calendar time than you think, so don't wait until you actually need the money.

And how much? Your CFO could forecast it for you. Or, given the simple example above of funding just the additional receivables for a 60-day estimated lag, if you expect your business to grow by, say, $1 million annually (roughly $80,000/month), you'd need about $160,000 to cover just the additional receivables. Perhaps securing a $200,000 LOC would be a good start. That way, instead of the business being strapped for cash, you can distribute the expected $100,000 in pretax profit to yourself and invest it in something outside the business.

Oh, yes, there's an additional counter-intuitive dimension to this. As your growth subsequently flattens, even at a higher level, that "bow wave" of receivables flattens also, and, in fact, the checking account grows, as those prior months of previously-growing revenue become cash. Likewise, it grows even more if the business takes a dip -- you actually begin harvesting cash out of the reduced receivables that result from the reduced revenue. That's when the need for the line moderates or goes away and you pay it down.

If you've learned some things about how to effectively use debt in your business, please click "Comments" below and share those lessons with others.

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Terry Weaver

Chief Executive Boards International

Chief Executive Boards International: Freedom for business owners & CEOs -- Less Work, More Money, More Freedom to enjoy it

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