Q. Dear Zenagos, my business is going well and growing quickly, but there’s one thing I can’t understand. It seems like the more my business grows, the less money I have in my bank account. What am I doing wrong?
Even a profitable business can run out of cash, so you are wise to be paying attention. In fact, the fastest growing businesses may be at the most risk. Your business is most likely experiencing cash flow issues, which are caused by timing differences between when you receive and spend cash. For example, if you frequently need to pay vendors before you receive payment, then you can end up in a cash crunch.
The business term for this concept is “Working Capital,” which is a measurement of how much of your company’s money is spendable and accessible to you (“liquid”). In general, it is best if Working Capital is a positive number, and the higher the better. The formula for calculating Working Capital is Current Assets minus Current Liabilities.
Working Capital = Current Assets – Current Liabilities
What is a “Current Asset”?
Cash is the best current asset. Other things that count as Current Assets are items that you have already built and/or could sell immediately (“Inventory”) and money that people owe you for products or services you have already provided (“Accounts Receivable”). So, if you want to increase your Current Assets (and therefore your Working Capital), you could collect from customers who owe you (send out those invoices, or offer discounts for early payment), or you could create more inventory. (However, creating inventory can be a Catch-22, since it usually means spending even more money.)
What is a “Current Liability”?
Money that you owe to vendors (“Accounts Payable”) is the most common Current Liability. Other examples are short-term loans (such as credit card debt) and any other expenses that are due within the year. If you reduce your Current Liabilities, you will increase your Working Capital. Paying off your credit cards or paying bills would reduce your liabilities, but that is another Catch-22, since it also reduces cash. (Sigh!) A couple of ways that businesses can reduce their Current Liabilities over time are to eliminate all expenses that aren’t strictly necessary and to negotiate for better prices on supplies.
Isn’t fast growth supposed to be good?
As you can see, there are a lot of Catch-22’s around Working Capital. That’s why rapid growth can be risky. It usually takes cash to make inventory; then, you need to wait for customers to purchase the inventory (while you keep spending cash on things like rent and utilities); finally, you need to wait for customers to pay (while. . .you guessed it. . .you keep spending cash). So, before you decide to grow really quickly, make sure you have planned your cash at least 12 months in advance. When will you spend, and when do you expect the incoming cash to land in the bank account? Map it out, month by month, and then assume some things will go wrong and leave yourself some extra leeway. Growing a little more slowly may be the smart decision.
Why is this so hard?
Managing cash is hard because cash flow matters to everyone. Your customers may want to pay you at the last possible minute, and that will make you want to pay your vendors at the last possible minute, too. The challenge can cascade and endanger your payroll, as well. It’s not enough for your business to be profitable: Even if your revenue is higher than your costs in the long term, you also need for your revenue to come in at a faster pace than your expenses go out. Getting caught in a cash crunch is scary, and cash problems tend to spiral, since your vendors (or even worse, your employees) will refuse to work with you if you start having trouble paying on time.
What’s up with that weird Cash Flow Statement?
Lots of small business owners print the Income Statement from their accounting software and then ignore the other two statements (Balance Sheet and Cash Flow Statement) because they don’t know what they mean. (They do look weird!) However, there’s a reason why businesses are required to create those statements. Cash flow is critical to business success, so don’t just throw the Cash Flow Statement away. Instead, find an expert you trust who can walk you through it and help you figure out if you have any additional opportunities to maximize your cash flow. Cash truly is king!