The recent announcement that President Obama is urging large companies to make faster payments to their small-business vendors has shed light on an important topic. Through the proposed initiative, “Supplier Pay,” the federal government is acknowledging one of the central issues that American businesses face: namely, getting paid on time. Whether or not you think the initiative will have a significant effect, it is an important conversation starter. At the very least, it allows for an opportunity to discuss the critical nature of cash flow in a business, especially as driven by the Accounts Receivable.
When you sell a product or service and generate a dollar of revenue, that economic good for your business is captured through either the receipt of cash or through selling “on account.” When you sell “on account,” you create accounts receivable—i.e. revenue earned, but not yet collected in cash. Most business owners understand the difference between cash and accounts receivable, but there are subtle differences in managing the two that many businesses slip up on. When I was consulting small businesses on their finances and business plans (now decades ago), I learned, what was to me, an incredible fact: Most businesses are profitable. They actually do generate more sales that are higher than their expenses. However, profitability and cash flow are two very different things. I was, and remain, amazed at how many profitable companies are strangled by negative cash flow.
There is a strong tendency among business people to manage companies from the “bottom line.” Unfortunately, you don’t pay bills from the bottom line — you pay them from positive cash flow. Take a lemonade stand: Let’s say daily sales for the stand are $100 and current expenses are $50. Further, let’s assume that all expenses are cash expenses— items such as lemons, sugar, and water. That’s a 50 percent Net Profit Margin. Not bad, right? Here’s the distinction: If the stand’s proprietors are asking for cash sales only, aside from their healthy profit margin, they’re generating positive cash flow of $50 (sales of $100 cash minus expenses of $50). If, however, the stand is making sales exclusively “on credit,” they’ll have negative cash flow of up to $50 (sales of $0 cash minus expenses of $50). A 50 percent net profit margin on paper means nothing without positive cash flow.
Now, despite the simplicity of this concept, this is an area where it’s very easy to slip up. Generally, in my experience, I’ve found that small businesses struggle to manage this dynamic well. Here are some tips on how to manage your accounts receivable and cash flow properly:
1. Beware of becoming a banker. Remember that when you give credit to customers, you are now in the banking business, as well as your core business. Ask yourself: Do you want to be a banker? I find that many small businesses automatically give credit to customers without any consideration if this will really increase their sales.
2. Get someone to walk through your cash flow statement with you slowly.Ideally this would be your CFO, accountant, or someone with a background in reading financial statements. Look carefully at one line item, which is the cash flow from operations. After 25 years of running a business, stumbling, and being in finance, I believe this is the single most important metric to any company. There shouldn’t be any red on this line.
3. Keep your AP Days shorter than AR Days. If you must sell on credit, make sure that the time it takes to get paid (accounts receivable days) is always substantially less than the time it takes to pay your obligations (accounts payable days). If you don’t know the terminology, find someone who does—preferably the person who walked you through your cash flow statement.
You always want to be collecting money at a faster rate than the rate at which you pay money. This seems obvious, yet I’ve seen two fast-growth large companies, run by extremely smart people, go out of business because they were upside down on this dynamic. For the accounting- and finance-inclined, a differed revenue account offends me way less than a large AR balance. After several memorable fumbles on this point personally, I can tell you that not having this balance in your favor will lead to a lot of anxiety and poor decision making borne of scarcity.
4. Use your CPA for more than bookkeeping. Most large and small businesses vastly underutilize their accountants. This is for two reasons: First, accountants often view themselves as only glorified bookkeepers. Second, business owners don’t challenge their accountants to give them advice. At Sageworks, we have worked hard to bridge the gulf between business owners and accountants, but we have only moved the needle a little bit. If you don’t view your accountant as a friend and advisor, you need to get a new one.
Whether it’s your accountant, your CFO, or someone with a finance background who you trust, I’d strongly urge you not to tackle these issues alone. Believe me, you do not want to learn these lessons about cash flow through trial and error. In this case, “error” could collapse your business.