There’s an old saying – profit is opinion, cash is fact. That’s because despite making a profit, some businesses still don’t have enough cash to pay the bills. At the end of the day, a lack of cash will kill a business.
Since the GFC, banks have been paying increased attention to the cash flow position of their business customers – more particularly ‘free cash flow’. So what is free cash flow?
Regardless of size, the principles of running a business are the same. Simplistically, a business is just a pot of money. That “pot” gets invested in holding Stock, providing credit to customers (Debtors) and acquiring Plant & Equipment. In return, the business usually gets credit from its suppliers (Creditors). Each year as the business grows so does the size of this “pot” – more stock, more debtors and more plant and equipment.
The increase in the size of the pot has to be funded from one of two sources – debt or equity. Usually, it is funded from after tax profits (or equity) and after payment of any dividends to the owners. If this profit is not sufficient to fund the increase in size of the pot then this results in negative free cash flow. Banks are concerned about this because if the extra funding isn’t coming from the business profits then it has to come from the bank or from new or existing shareholders (by way of increased share capital). For most privately owned businesses, the latter is usually not an option – which leaves the bank to fund the shortfall.
This means the growth rate of the business is not sustainable (sometimes called “over trading”). Whilst it may be okay for a year or two, eventually it will catch up with you. Over trading has ruined many potentially good businesses.
Apart from the level of stock and debtors blowing out, there are three real reasons why a business will feel the pinch on cash flow.
- The business is not profitable. Sometimes business owners think they have a cash flow problem. When you look further, the problem is not cash flow per se. Rather, the business is not profitable. This requires an analysis of the drivers of the business to determine if and how, the profitability of the business can be increased. It may be that some product lines are unprofitable so prices need to be increased or that product line discontinued. It may be that the business model is not sustainable.
- The business has used operating working capital to fund long term assets (e.g. plant and equipment). This is a common mistake and can be fixed relatively easily if the business is profitable. Unless a business has a proverbial bucket load of cash, it should buy long term assets (e.g. plant and equipment) using long term finance. If there is solid profit and positive cash flow most banks will fund this, usually through leases or HP’s.
- The business is over trading. That is, the business is growing too fast. Yes, that can be a bad thing. Again, if the business is profitable this problem can also be fixed. A fast growing business is a nice problem to have but there will be a limit to which the banks will provide the funding. If you don’t have access to limitless amounts of cash then operating within your sustainable growth rate is crucial. Many businesses don’t know what their sustainable growth rate is. Once you know this, you can limit your growth to within this range. Often this can be done by increasing profits which provides yet more free cash flow but business owners find it very difficult to consciously slow the growth rate of their business.
- Think of your business as a pot of money.
- Recognise that the main source of funding for the growth of the business is the business itself (i.e. profits).
- If you have a fast growing business, don’t be greedy. Focus on profitability and free cash flow, not just growth.