HVAC business owner Hank is looking at his bank account, shaking his head. Financial documents are spread in a careless array on his desk. He's trying to determine why there doesn't seem to be enough cash in the bank to pay the bills despite having made an amazing amount of revenue.
"I just don't understand this," Hank says. "Why don't I have enough cash? Where did it all go?"
As we'll discuss, the problem isn't necessarily poor practices on the part of Hank or other business owners. To the contrary, more good businesses fail from bad cash flow than bad business practices.
The Gap Between Revenue Recognition and Cash Collection
During the three busiest months of the year, Hank's business made $225K in net profit. However, looking at his current bank balance he notes that the balance has only increased by about $50k, which prompts the question why isn't the revenue sitting in the bank as cash. What's going on?
As Hank digs deeper into his business's financial statements, his first realization is that there is $110K in unpaid invoices. Some are overdue but many still have 20 days before they are due. This collection gap is an example of a cash collection delay. While on paper the company is profitable; in reality the funds have yet to be collected. This is one of the major cash flow killers in small businesses.
How a Business Can Show a Profit On Paper and Still Run Out of Cash
As Hank continued to look deeper at the company's financial report for the three busy months, he discovered that the inventory and undeposited funds balances were about $20k and $10k more than at the start of the busy season. He remembered buying several standard materials in bulk because the price was good, but the materials had yet to be used on jobs. The undeposited funds were a mystery until he cleaned his desk and discovered three undeposited checks buried the paperwork.
Finally, he found that the final $35k had been used for equipment loan payments, $10k, and personal compensation. It was not that the business was unprofitable, but rather this exercise opened Hank's eyes to the danger of making decisions based on a net profit number. Additionally, it showed him that he needed to shorten his billing terms, and that buying "good deals" might make each job more profitable, but it tied up his funds and might prevent other opportunities.
More Good Businesses Fail from Bad Cash Flow Than Bad Business Practices
Armed with his research Hank looks through his bank account statements to get an idea of the cashflow cycle his business runs by. He discovers that the company will complete a job using the payment from the last job, receive customer payments for the completed job 30 days later on average, use that payment to start the next job, and so on.
This common cycle is discussed at length in our post "Cash Timing Problem", many business owners, like Hank, default to 30-day terms instead of considering when a project's expenses are due. And the good news is, there's no mandatory term length; business owners have the authority to set the terms of when they get paid. There are several ways business owners can improve the cash conversion cycle (the time it take from job completion to money in the bank), the first being to ask for a deposit before starting work. Second owners can shorten the terms on their billing, changing from due in 30 days to due in 20 days will have a significant impact on the conversion cycle. Finally offering discounts and penalties; discounts for full payment up from and penalties for late payments.
Not all of the adjustments need to be enacted at once, but they should be evaluated and employed in a way that improves the company's cash flow. Traditionally the first adjustment is requiring a deposit before work begins.
What This Looks Like Practically
Hank pulls out financial statements for the past year and a calculator. Now that he knows what his monthly carry number (unused inventory plus the costs to store it), overhead cost, and debt service are, he now has a minimum that the company needs to make in net cash flow each month.
If the profits are there but the cash conversion is not he will struggle to cover his costs during the slow season. Using the prior year financial statements Hank can determine what the company's average cash flow was during the slow months. The difference between the slow month cash flow and the necessary cash flow gives Hank a target amount to set funds aside during the busy season. He can now allocate, or build into the pricing, the funds needed to cover the slow season costs in advance of the slow season.
Call to Action
Calculate your carry number. Take your average monthly operating expenses, and multiply that number by 2.5. That is the minimum cash reserve to carry a 10-week slow season without cutting payroll.
If you need additional assistance, here's the link to our Debt Service Capacity Calculator. You can also book a complimentary consultation with Joseph.
Disclaimer: The information in this post is intended for general guidance purposes. For advice specific to your business finances or taxes, consult a licensed accountant or financial advisor.
