Cash flow should be the number one concern for all businesses with ambitions to grow.
Focussing on turning a profit is of course important, but even profitable businesses can run out of cash – especially if they are growing fast. If you do run out of cash, finding funds to invest in growth is not impossible as they can be bought. This is the main purpose of external funding such as bank loans or equity injections. But such cash can be hard to find and always comes at a cost, be it payment of interest or worse a dilution of ownership.
A preferable approach is to strike the proper balance between generating cash and consuming it through business operations – in other words optimising the cash flow from your operations.
By understanding and then optimising the operating cash cycle in your business you can self-finance a level of growth and create a more flexible, secure and dynamic operation in the process. The keys to adopting this approach are to recognise the three levers available to maximise cash, and then to understand the rate of growth achievable using the optimum combination of these levers in your business.
The Operating Cash Cycle
Every business has an operating cash cycle. This is the length of time between receiving inventory (or providing a service) and eventually getting paid for it by your customers. For most OCC’s cash is tied up for a significant proportion of the cycle where you have to pay suppliers before you receive cash from customers. The cash required to fund this period is known as working capital.
Focussing on turning a profit is of course important, but even profitable businesses can run out of cash – especially if they are growing fast. If you do run out of cash, finding funds to invest in growth is not impossible as they can be bought. This is the main purpose of external funding such as bank loans or equity injections. But such cash can be hard to find and always comes at a cost, be it payment of interest or worse a dilution of ownership.
A preferable approach is to strike the proper balance between generating cash and consuming it through business operations – in other words optimising the cash flow from your operations.
By understanding and then optimising the operating cash cycle in your business you can self-finance a level of growth and create a more flexible, secure and dynamic operation in the process. The keys to adopting this approach are to recognise the three levers available to maximise cash, and then to understand the rate of growth achievable using the optimum combination of these levers in your business.
The Operating Cash Cycle
Every business has an operating cash cycle. This is the length of time between receiving inventory (or providing a service) and eventually getting paid for it by your customers. For most OCC’s cash is tied up for a significant proportion of the cycle where you have to pay suppliers before you receive cash from customers. The cash required to fund this period is known as working capital.
Some businesses have a positive cycle, where they receive cash from customers before they have to pay anything out to suppliers. These businesses are extremely lucky as they should never be short of cash! Retail businesses like supermarkets that take cash payment from customers, but negotiate lengthy payment terms with suppliers are a classic example.
Businesses that provide a service, architects or solicitors being good examples, are often cited as having a positive cycle as well. It is perceived that they do not have to pay suppliers, instead internally generating the service they are selling. However, it is important to carefully consider what the real cost of a sale includes. For most service businesses employee wages and advertising costs are normally a direct cost of sales, and they must normally be borne before a service can be delivered. In such circumstances they should be considered a part of the OCC.
Whatever your business it is critical to carefully consider and understand your OCC. Only then can you target ways of reducing its length and improving your cash flow.
The Three Levers
So what options are available for improving the amount of cash in your business?
Excluding taking out costly loans and selling equity or assets there are just three levers you can use to boost cash.
Lever 1: Speeding Cash Flow
Our favourite! By reducing the components of your OCC you will free up cash for your business at a faster rate. Target extending the terms on which you pay suppliers and shortening the terms you give to your customers to minimise the period over which cash is tied up.
Lever 2: Reducing Costs
A tough one! By performing a careful review of costs in your business and challenging suppliers to reduce them wherever possible you will create more profit, which will flow through into cash.
Lever 3: Raising Prices
The toughest one! On the other side of the equation are the prices you charge your customers. If your customers, or maybe just a segment of your customers, will accept a price rise and you can achieve this at little or no extra cost you will create more profit, which will flow through into cash.
Optimising the levers
But which lever, or combination of levers, should you target? And what will the impact of any change be on the cash in your business? Which option gives you the best return for your efforts?
The best way to answer these questions is to model different scenarios and compare the output self-financeable growth rates.
Businesses that provide a service, architects or solicitors being good examples, are often cited as having a positive cycle as well. It is perceived that they do not have to pay suppliers, instead internally generating the service they are selling. However, it is important to carefully consider what the real cost of a sale includes. For most service businesses employee wages and advertising costs are normally a direct cost of sales, and they must normally be borne before a service can be delivered. In such circumstances they should be considered a part of the OCC.
Whatever your business it is critical to carefully consider and understand your OCC. Only then can you target ways of reducing its length and improving your cash flow.
The Three Levers
So what options are available for improving the amount of cash in your business?
Excluding taking out costly loans and selling equity or assets there are just three levers you can use to boost cash.
Lever 1: Speeding Cash Flow
Our favourite! By reducing the components of your OCC you will free up cash for your business at a faster rate. Target extending the terms on which you pay suppliers and shortening the terms you give to your customers to minimise the period over which cash is tied up.
Lever 2: Reducing Costs
A tough one! By performing a careful review of costs in your business and challenging suppliers to reduce them wherever possible you will create more profit, which will flow through into cash.
Lever 3: Raising Prices
The toughest one! On the other side of the equation are the prices you charge your customers. If your customers, or maybe just a segment of your customers, will accept a price rise and you can achieve this at little or no extra cost you will create more profit, which will flow through into cash.
Optimising the levers
But which lever, or combination of levers, should you target? And what will the impact of any change be on the cash in your business? Which option gives you the best return for your efforts?
The best way to answer these questions is to model different scenarios and compare the output self-financeable growth rates.
The SFG is calculated by looking at three factors:
You can combine these factors to understand how much growth is sustainable. By comparing how many additional sales can be funded by the excess cash generated from existing sales you can calculate how much growth your working capital can sustain. By multiplying this value by the number of cycles in a year you can calculate the annual growth rate achievable without running out of cash. The higher you can get your SFG % the more flexibility and security your business has, and the more ability you have to grow without resorting to costly loans, dilutions to your equity, or selling your house and car!
- The length of the operating cash cycle
- The amount of cash needed to finance each £ of sales
- The amount of cash generated by each £ of sales
You can combine these factors to understand how much growth is sustainable. By comparing how many additional sales can be funded by the excess cash generated from existing sales you can calculate how much growth your working capital can sustain. By multiplying this value by the number of cycles in a year you can calculate the annual growth rate achievable without running out of cash. The higher you can get your SFG % the more flexibility and security your business has, and the more ability you have to grow without resorting to costly loans, dilutions to your equity, or selling your house and car!
Our advice: whatever your ambitions for growth, understanding and optimising your cash flow should be high up your list of business priorities. Take the time to do this today, and reap the rewards of a more flexible, secure and dynamic business in the future.
This post uses concepts that appeared in a classic article in the May 2001 edition of the Harvard Business Review by Neil Churchill and John Mullins (Churchill & Mullins, ‘How Fast Can Your Company Afford to Grow?’; HBR, May 2001). The article is well worth searching out for a more in depth discussion of self-financeable growth.
Venta Partners can provide help and support to review and optimise cash flow, including specific consulting on achievable self-financeable growth rates and the full range of options for funding growth. Contact us today for an introductory discussion.
Venta Partners can provide help and support to review and optimise cash flow, including specific consulting on achievable self-financeable growth rates and the full range of options for funding growth. Contact us today for an introductory discussion.
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