By Henk Engelbrecht

You have started your own business and your products are flying off the shelves, but you are struggling with cash flow.  How can this be, when you are generating a profit every month?  Many people confuse the concept of being profitable with generating positive cash flow.  THE DEVIL IS IN THE DETAIL – let’s unpack this further, focusing on the trading cash flow of the business.

1. Timing of cash flow

A sale today does not necessarily mean an inflow of cash today, unless you are a business that sells for cash only.  Most businesses provide their customers with credit terms, such as payment 30 days after statement.  This implies that the customer will only settle his/her account at the end of the month following the month in which you sold the product to him/her, resulting in a credit period of between 30 to 60 days, depending on the time of the month when the sale took place.  Assuming that sales occur evenly during each month, you will need to have funds available to cover your costs for around 45 days before you start to receive payments from your customers.

Similarly, you have to consider the timing of the cash outflow from your expenses and the extent to which you can utilize suppliers to provide some of the funding you require for your business.  Some expenses, such as purchases of products, can be done on payment terms similar to what you offer your customers, which will provide some of the funding you require for your business.

Other expenses, such as staff costs, are payable monthly in arrears, while others, such as property rental, are payable monthly in advance, both of which have a direct effect on your cash flow requirements for each month. In these instances, there are no credit terms you can utilize to help you fund your business, you have to ensure that you have the necessary funds available to service these expenses.

While you may have some control over the terms you offer to your customers, the same does not always apply when it comes to expenses, where the supplier or regulator determines the payment terms. Your ability to negotiate more favorable terms is influenced by how important you are to your suppliers, i.e. whether you are their largest customer or one of many.

Then there is cash flow related to the purchase of fixed assets, such as plant and machinery, store shelves, and delivery vehicles, to name a few, as well as the payment of interest and capital on any loans you may have incurred when you started or purchased the business, and lastly the dreaded taxes you have to pay.  This a subject for another day, in this article we want to focus on the trading activities and related cash flow of the business.

Let’s look at the example below, focusing only on the trading activities of a business.  We present two cash flow scenarios, the first where you sell on credit and the second where you sell for cash only:

  Profit and loss Cash flow – +/(-) Credit sales Cash flow – +/(-) Cash sales
Sales/(Debtors – 30-day payment terms) 1,000 (1,150) 1,150
Cost of sales/(Creditors – 30-day payment terms) (500) 575 575
Gross profit/(cash flow) 500 (575) 1,725
Operating expenses – (cash payment terms) (300) (300) (300)
Net profit/cash flow 200 (875) 1,425

The example excludes any funding that may be required for the acquisition of fixed assets or the servicing and repayment of loans, as well as the effect of any taxes you may have to pay as well.

As illustrated in the above example for credit sales, the business would require funding of R875 from own cash resources or banking facilities at the end of the month to meet its obligations, even though it reported a profit of R200.   If however, your business is a cash sales business, your cash flow position is significantly better in that you have a cash balance of R1,425 at the end of the month, while you only have to pay some of your creditors 30 days later.  The above illustrates how decisions around your terms of sales and purchases affect your cash flow.

2. Nature of your expenses – businesses typically categorize expenses into:

  • Variable expenses are expenses that are directly linked to the products you sell and increase or decrease in line with your sales. This category will typically include the cost of purchasing the products from the suppliers; and
  • Fixed expenses represent expenses you will incur whether or not you are selling products.  This typically includes expenses such as staff costs and other administrative expenses, property rental and utility costs such as electricity, water and refuse removal.

Understanding the nature of your expenses and each category’s contribution to total expenses will help you understand the flexibility you have with your cash flow when sales fluctuate from month to month, or when the business is not doing well and you have to reduce expenses to remain profitable.

A business with a higher percentage of variable expenses will have more flexibility to withstand a fluctuation in sales than a business with a higher percentage of fixed expenses.  This is an example of the break-even analysis every business owner should calculate for his/her business.

Break-even analysis indicates the minimum sales you need to generate each month to cover both your variable and fixed expenses.  This is based on the gross profit margin you generate and the operating expenses you need to cover with the revenue you earn.  In the above example, your operating expenses are R300 and your gross profit margin is 50%, which indicates that you will require sales of at least R600 per month to be able to cover your cost of sales and operating expenses. 

Let’s assume that your gross profit margin remains at 50%, but your operating expenses are R400, you will then require sales of R800 per month to cover your cost of sales and operating expenses.  The increase in your fixed expenses therefore requires an additional R200 of sales each month to ensure that you break even.

3. Inventory

Unsold inventory is a cost for the business, cash flow that is tied up for as long as the inventory remains unsold.  The longer the inventory remains unsold, the more the cost to your business of funding it.

In the example above, if you carry one month’s sales in inventory, your investment will be R500, assuming that you do not have any slow moving or obsolete inventory items, which need to be funded from own resources or borrowings.

4. Working capital cycle

Measures the amount of cash tied up in your debtors, inventory and creditors.  The objective of any business is to keep this cycle as low as possible, to be able to convert purchases and products to cash as soon as possible. The shorter this cycle, the better your cash flow position.

In our example above for credit sales, the working capital cycle will be 30 days, calculated as follows:

  • Debtors days – 45;  Inventory days – 30;  Creditors days – (45); equals Working capital days – 30

Compare this with the working capital cycle for cash sales, where you are effectively being funded by your creditors:

  • Debtors days – 0;  Inventory days – 30;  Creditors days – (45);  equals Working capital days – (15)

Most businesses are somewhere between the two scenarios above, with elements of both cash and credit sales.

5. How do you optimize your cash flow

For your sales and debtors, there are a number of options you can pursue:

  • a certain discount if they pay cash for their purchases;
  • change the terms of credit to payment within 15 days from date of statement;
  • payment within 30 days of date of invoice;  or
  • offering customers an incentive to pay earlier, such as a discount of say 1% of the invoice amount if they pay before a certain date.

For your purchases and creditors, you can:

  • push for longer credit terms; or
  • request a discount on the invoice price if you pay earlier.

A 1% discount on an invoice amount per month is equal to earning/saving interest at a 12% interest rate per year, much better than what you can achieve in a savings account.  This strategy is especially effective for purchases and payment of creditors, where you can benefit from a payment discount.

For inventory, you can look at ways to reduce the lead time from ordering the products from your suppliers to selling it to your customers through better inventory management and planning.  Again, this is dependent on the industry you operate in and the terms you can negotiate with your suppliers.

In this article we have only focused on the trading activities that affect your cash flow.  Other cash flow items, such as the investment in property, plant and equipment, other businesses and borrowings have not been considered, all of which could have a material effect on your cash flow.

Our objective was to illustrate how your decisions and strategies to manage the trading activities of your business affects your cash flow and how you can improve your cash flow through pro-active management of the respective activities.

For more information on how we can assist you in improving cash flow in your business, please contact us at Franchising Plus.