Six Warning Signs of an Impending Cash Crisis

Cash management should be an obvious priority when a company is not performing well (slowing or declining revenue, unusual increases in expenses, etc.).  However, when a company is in a fast growth mode it is not quite so obvious that it is in a dangerous position as well.  Since most companies will need to self-finance growth opportunities, great care should be given to the decisions regarding the amount and timing of the use of cash (investment).  It is absolutely critical that you do not run out of cash.  There are a number of warning signs that would indicate you are heading for trouble.  This is by no means a comprehensive list, but it should serve as a general guide and possibly help orient your thinking to identify areas that may be more specific to your company’s operation. 

1. Cash discounts are being missed.
2. Vendors are being stretched beyond normal payment terms.
3. Late fees are being incurred on lease payments or trade accounts.
4. The age of your accounts receivables is increasing and/or it is getting more difficult to collect accounts.
5. Debt is increasing without a corresponding increase in collectable revenue.
6. Deposits of payroll or other taxes are being delayed beyond filing deadlines.

If you find these conditions occurring more and more often, you should take preventive action immediately.

Payroll: Get the Whole Picture

Payroll is a (if not the) major area of management focus for controlling operating expenses in most businesses.  If staffing is managed closely and kept at optimum levels (or better) profit dollars will drop to the bottom line in relatively large amounts.  If payroll is not managed as a priority, it will most assuredly have an extremely negative effect on the profitability of the company.

Everyone knows and understands very clearly the obvious expense associated with payroll is the salaries component.  However, in addition to the obvious cost, there are the less obvious “hidden” costs such as payroll taxes, workers’ comp insurance, health and other group insurance, vacation and sick leave, 401(k) or other retirement plans, training, etc. that are not so well understood.  For example, if you are paying an employee $12.00 per hour and have a relatively standard benefits package, the total cost of that individual is far more than the base $12.00 per hour rate.  The sample table below illustrates the affect these less obvious components will have on the base payroll dollar. 

As you can see, the final number is more than 33% higher than the base rate and can be much higher.  Although the rates will vary and the extent to which you are affected by other circumstances will be specific to your company, the basic elements are consistent with possible exception of health and related insurance or other benefits such as 401(k).  Therefore, it is absolutely critical that the total cost structure be fully understood when making operating decisions or bidding/quoting new business.  Otherwise, you could be in for a very big and unhappy surprise.

Types of Accounts Receivable Financing

Accounts receivable financing involves either pledging the company’s accounts receivable as collateral against a loan or selling the accounts outright.  Although hybrid forms of A/R financing exist, the basic types are asset based lending arrangements with commercial banks and factoring arrangements with specialty firms.

•         Under the terms of a commercial arrangement, a loan is made against a predetermined portion of the company’s receivables while the responsibility to collect the funds remains with the company.  The terms of such an arrangement will most likely exclude a certain portion of accounts with balances over a specified age (usually 90 days), a limitation on the percentage a single account can represent of the total receivables (probably 20% to 30%) and a limit of the loan amount to a percentage of the eligible balances (most often 70% to 85%).  Provisions and restrictions similar to those identified above will be included in the formal documents for a commercial accounts receivable loan and specific reports will be required each month to substantiate the borrowing base.  The borrowing base is the maximum amount of funding that can be advanced under the loan agreement as determined by applying the exclusions and limitations identified above.

•         Factoring arrangements represent a form of financing where the accounts are sold to a specialty firm at a discount.  Unlike a standard commercial arrangement, in most cases it is the responsibility of the lender to collect the accounts without recourse.  In other words, the factor assumes all the risk and cannot come back to you if the funds are not collected.  Also, a continuing agreement is made between your company and the factor under which it contracts to perform credit checks on customers and to purchase all of the accounts receivables as they are generated from your sales.  The factor pays the company an agreed percentage each month based on the face value of all accounts acquired and retains the difference as its compensation in the transaction.  There may be slight variations of the specific terms, but the overall theme is basically the same.  Although factoring is an expensive form of financing, it eliminates the need for a credit and collection department and, as long as the quality of the accounts is sufficient and your billing cycle is relatively short (daily or weekly), it offers a fairly stable source of financing.  Because of the cost, this form of financing should only be used when other accounts receivable financing is not available or where the cost of managing the credit and collection functions internally exceeds the fees charged by the factor.

•         Like receivables financing, inventory financing is essentially a secured, revolving loan whereby a predetermined percentage of the inventory value is advanced to the company under specific negotiated contract terms.  It is possible that the terms of such an arrangement could exclude certain inventory items from the eligible balance.  Also, because inventory is less liquid than accounts receivable, the advance rate will be lower (usually in the range of 50%).  Provisions and restrictions similar to those identified above for accounts receivable loans may also be included in the agreement for inventory loans.  Specific reports will be required each month to substantiate the inventory borrowing base.

•         It is not uncommon to have a financing agreement that combines both accounts receivable and inventory into one asset based lending contract.  Under such an arrangement, the bank would make funds available to the company on terms similar to those described above using the combined value of the accounts receivable and the inventory as the borrowing base.  All other terms and conditions are the same and would apply to each asset as would be the case for the separate individual contracts. 

DSO: The Essential Measure of Accounts Receivable Management Success

A fairly simple measure that is very useful for monitoring the effectiveness of A/R management is Days Sales Outstanding (DSO).  DSO indicates the average age of the receivables, which basically shows the average number of days it takes to collect your A/R.  The lower the DSO the more quickly you convert revenue to cash.   For example, a DSO of 45 indicates a much more effective A/R collection process than does a DSO of 65.  It’s important for you and your financial team* to regularly run “what if” scenarios to better understand the cash flow impact of an increasing or decreasing DSO. 

DSO is calculated as:

D = r / (s1 / 365)

or

D = (r / s2) x 30

where r is Accounts Receivable, s1 is the annual revenue (trailing 12 months) and s2 is the average monthly revenue.  Each formula will give you a slightly different answer because of the number of days used in each, but the difference is not significant enough to cause concern.  The reason both formulas are given here is that in some cases it is more time consuming to determine annual revenue for 12-month periods that cross over two accounting years.  Also, situations where revenue is increasing or decreasing dramatically will often cause the annual revenue number to be less representative of the average than a shorter period that corresponds more directly to the age of the A/R (maybe three or four months).  In cases where the annual revenue is easily determined and is fairly consistent it would be better to use the first formula.  However, in cases where the annual revenue is difficult to determine and/or there are significant revenue fluctuations, it would be better to use the second formula and determine the best average revenue number to use.

The industry in which your company operates will have certain conditions present that influence the ability to collect the amounts billed within a reasonable period of time.  In some businesses a DSO of 60 would be completely unacceptable where in others it would represent an excellent collection rate.  You must establish the appropriate targets for your company and maintain the consistent effort that is required to optimize the cash cycle.

*Explore your options for beefing up your financial team by visiting The Profit Experts.

Quick and Dirty: The Flash Report

A flash report provides the elements of operational condition (metrics) to management for immediate review and decision prior to completion of the formal accounting period.  Having key information on a regular basis is essential to maintaining a “feel” for the business.  It is quite reasonable to expect that knowledge of the general condition of the company can be obtained very quickly with only a limited amount of information reported daily or weekly.  You only need to identify the items that are important to report – items such as cash balances, cash receipts, inventory levels, production volumes, products shipped, sales or marketing activity, revenue generated, or any other metrics deemed important to gauging the successful operation of the business.  The only thing left is to do it…!

When the information is tracked on regular basis you will undoubtedly begin to develop a keen sense about the general trends.  Any reasonably significant fluctuation in the numbers will indicate a shift in the business that should prompt you to question why the change is occurring.  A shift in the general direction of key metrics should cause a more detailed review to be conducted in order to fully understand the dynamics of the changes underway.  This should lead you to certain decision points to counteract a negative trend or to facilitate and maximize the benefits of a positive trend.
Although there is no predefined format for reporting and there is no particular time requirement for generating the information, a daily report is normally used for some items where a weekly cycle is used for others.  The numbers should be compared to daily or weekly targets that have been set in the forecast in order to fully understand the significance of the values reported.  As mentioned above, small fluctuations are normal, but once you track results for a while you will get a feel for those fluctuations that should be of more concern. 

There really are no hard and fast rules; it basically comes down to implementing whatever works best for you and your company.  Again, you just have to make it happen.  Your company’s metrics may or may not be important to other similar companies and will likely be very different from those companies operating in different industries.  What is important is that you identify the items key to your business then consistently and diligently track them according to an established timetable.  The rewards are almost immediate and can be considerable over time.

An Ounce of Prevention

Too often companies do not pay enough attention to cost control until they run out of cash.  By then it’s too late to take the action necessary to avoid the problem.  It is far too late to try and manage cash when you don’t have any.  And anyone who has ever tried to raise capital knows that the absolute worst time to get cash from banks or other funding sources is when you desperately need it.  It takes disciplined planning to avoid the inevitable outcome of an unforeseen cash crisis.  Certainly, some companies have survived in times of significant cash difficulties without planning.  However, the most likely result of a severe cash shortfall without some advanced notice and no access to additional capital is very ugly.  Do you really want to play the odds?

How do you know in advance when there is going to be trouble?  The only sure way of avoiding or at least managing through a severe cash flow problem is to estimate the company’s future performance – profit – and the cash flow generated and required by that performance.  By knowing when a cash crunch will develop you can take the necessary action to manage through it BEFORE it has materialized.  It may mean you will need to reduce expenses (payroll, travel, etc.), cut back or delay capital expenditures (equipment, etc.) or borrow the necessary funds to get through the cash shortage.  Although it can be a painful process, it is possible to “weather the storm” when you are prepared.  Being prepared could be the difference between life and death for the business.

Your most important tool in this effort is a budget.  A budget can be as simple as writing an estimate of revenue with the expenses you expect to incur while generating and supporting that revenue on a napkin.  As long as it gives you an idea about what the target is and what it will take to get there, you at least have something to compare your actual performance to each month.  When you compare the actual performance to the “budget” you can then determine what action, if any, must be taken to get back on track with the plan.  Over time, as you continue to make the comparisons, you will begin to refine your estimates to incorporate a much more significant level of detail.  After only a little time you will have developed a very sophisticated and useful tool.  The knowledge you gain and the “feel” for the business you will develop will significantly improve your effectiveness thereby increasing the value of the organization.  You only need to start at the beginning and maintain the determination to continue the process.  If that is done, you cannot help but improve the performance of your company.

Good Heuristics Make Good Intuition

The Merriam-Webster dictionary defines heuristic as “involving or serving as an aid to learning, discovery, or problem-solving by experimental and especially trial-and-error methods."  The danger is that unless a well-grounded system is in place to provide sufficient objective information, over time a heuristic approach to decision-making in your business can very easily give rise to a certain mind-set, thereby establishing a pattern of behavior that leads to consistently undesirable results.  Without the proper frame of reference from which to form any decision, a successful outcome cannot be expected.

However, when the frame of reference is grounded with a solid profit mentality, the odds of producing positive and desirable results improve significantly.  Understanding the relationships that exist between the various types of information presented in the P&L is invaluable for understanding the true nature of the business.  Unless you understand the global impact of the decisions you make (and every decision has a very definite financial affect), you can never fully understand the business and you are in danger of fatal mistakes at almost every turn. 

Developing a better “feel” for your company requires an improved, properly grounded, intuition regarding the underlying dynamics that affect the various parts of the business.  When you understand the relationships that exist you will better understand how your decisions ripple through the organization.  Although financial issues are specifically being addressed here, the affect of each decision will be felt on every level and in every area; financially, operationally and organizationally.  It is a fact that the environment in poorly managed cash strapped companies is entirely different than that of well run cash rich organizations.

What do you do to make sure your business intuition is grounded in reality?

Actively Managing Your Lending Relationship Is Critical to Your Success

It is extremely important to manage the company’s banking relationship(s) very carefully.  As with any relationship, trust is a major issue.  You must communicate with your bank officer often and with as little “spin” on the truth as possible.  It’s fairly simple, the more often your story is proven true by actual results, the more trust you gain from the bank.  Unfortunately, the opposite is true as well. 

Understanding there are times when, in order to avoid any undue anxiety, you cannot tell the whole story to anyone outside of the company,* it is critical to maintaining the availability of capital that the information given to the bank(s) be as complete and accurate as possible.  Do not wait until after the fact to give your banker bad news.  Bankers DO NOT like surprises – if you think about it, not many people do.  Also, it is possible that with enough notice, the bank might be in a position to help avoid or certainly mitigate the ultimate outcome of a difficult situation.  Remember, you have the bank’s money, if they want it back (and they do), they will do whatever they can to help you resolve problems if they trust you.  If they feel you are not trustworthy, difficulty in the business could (and most likely will) result in termination of the relationship.  An untimely cancellation of funding could place the company in a very dangerous operating position.

You must know the lender does not necessarily have to wait until a default actually occurs to begin to take action.  Even if the loan agreement remains in place and the funds are technically available, if the lender feels the loan is being compromised they may begin to protect their position.  Certainly there are stated remedies that are available to manage the situation when covenants are in fact broken, but there are also certain options that exist before a default occurs.  Although it is impossible to identify every potential action, a partial list of steps that might be taken prior to a default could include:

• the request for additional (and onerous) reporting,
• a forced reduction of the available credit line,
• a refusal to honor requests for additional advances,
• or possibly continuous pressure for corrective action.

These actions can severely limit the availability of additional capital and will be a serious distraction at a time when all your attention should be on operating the business and solving problems not managing the banking relationship.  The situation becomes even more problematic if the relationship was not managed properly prior to the difficulty in the business.

Profitable companies successful in managing cash flow generally are considered low credit risks and that’s generally reflected in a more positive banking relationship.  This is just another reason for initiating a relentless focus on profit management.  The better your historical profitability the better the interest rate will be on loans to the company.  Consistency is the key.

*Add a knowledgeable insider to your team and put razor-sharp focus on profitability. Talk to The Profit Experts.

Cash and Profits Are Not Interchangeable

The Merriam-Webster dictionary defines profit as “a valuable return” which would imply there is actually something being received at some point in the process.  However, the reality is that you cannot actually “spend” profits. You must have sufficient cash available to fund the company’s operations until conversion occurs.  Since there is nothing tangible returned by profit alone, the logical conclusion is that without cash conversion there is no REAL profit: CASH IS THE LIFEBLOOD OF EVERY ORGANIZATION. Generating it is the most important aspect of profit management and conversion of profit into cash in the shortest possible time frame should be a goal of every organization.

Back to Basics: Breakeven Point

The breakeven point is the volume in dollars of revenue at which revenue and expense are equal (there is neither profit nor loss).  Any revenue above the breakeven point will provide net profits and any revenue below the breakeven point will produce losses.  The breakeven point is not static and can move from time to time depending on changes in the revenue mix and/or the company’s expense profile.  For example, if one of your fixed cost elements were to increase (let’s say rent), this would move the breakeven point to a higher revenue level.  In contrast, if the revenue mix changed to include a larger percentage of high margin component(s), the breakeven point would move to a lower revenue level.

It is very important to know at what level of revenue your company reaches its breakeven point.  An understanding of the breakeven concept will help you to quickly determine the level of action required and in which areas you should focus your attention in order to improve the financial performance of the company.  In some cases it will be revenue that must be impacted and in others the expense structure must change.  The ultimate decision will depend on the specific environment you are operating in at any given point in time.

Back to Basics: Workers Comp

Workers' compensation is a form of insurance providing wage replacement and medical benefits to employees injured in the course of employment.  Workers’ compensation insurance costs are based on a rate per $100 of payroll.  Although it is a fairly complex calculation involving a number of variables, the rate is determined primarily by your company’s type of business, the various types of job classifications present within the employee population and its experience with regard to medical expenses and replacement wages resulting from on the job injuries.  For example, in the State of Texas the rates range from a low of about $0.20 to a high of approximately $60.00 per $100 dollars of compensation that will then be adjusted for the experience modifier and other discounts or adjustments that might apply.  As you can see, the range is quite large and, depending on the company’s type of business, it can be a very expensive benefit. 

Remember that workers’ compensation is mandated by most states in the U.S.  The only effective way to manage this expense is to control the number and severity of on-the-job injuries.  Left unmanaged, this expense will drain very large amounts of cash from the operation through unnecessarily high payments for insurance premiums (penalties can be well in excess of 50% to 75% per year through the experience modifier).  To further complicate the situation, because the modifier is determined by the injury experience from a number of years, your ability to fully affect the cost is incremental over that same number of years (usually 3 to 4).  The difficulty will be in managing the timing of costs associated with changes in operating conditions (near-term) relative to the benefits derived from lower insurance premiums realized progressively over several years.  You should consult with a risk management professional to determine what can and should be done in your organization to control this exposure.  If the work environment and operational process are managed properly from the outset the risks can be mitigated, and therefore, the costs are contained.  However, if these issues are left unmanaged it will take years to recover and the relative cost to the company will be significant.

Found Money!

Deposits are recorded when an amount is required to secure a long-term arrangement for operating the business.  Examples include rent, utilities, large orders for certain special order items such as preprinted materials, uncommon equipment or unique inventory items, etc.  These accounts represent hard cash that has been placed with another party for a period of time.  A regular review should be conducted to ensure that all amounts due to be refunded are done so in a timely manner.  Remember, it is your cash and it should be managed as such!

When Is Expired Inventory Acceptable?

Some items will have a limited time in which they are useable due to a time-induced deterioration in their physical qualities.  This “shelf life” should be considered when determining the reorder process for replacement inventory.  It is fairly obvious that you would not order a six-month supply of an item that has a shelf life of 120 days (approximately four months).  This would be true even if there were certain discounts associated with the purchase volume for a particular item unless the discounts are so significant that it would not matter that a portion of the inventory would be discarded from time to time.  For example:

•          Assuming product A has a shelf life of six months and a usage rate of 62 per month.  If you had the option of placing one order of 500 for $3.20 each or multiple orders of 200 for $4.50 each as necessary, what would you do?  The total purchase price for the quantity of 500 would be $1,600.  However, at a rate of 62 per month you would actually use only 372 before the shelf life expired.  The 128 time-expired items will have to be discarded resulting in waste and then be replaced with an additional expenditure of $409.60 (assuming the same purchase price).  On the other hand, if you placed two separate orders for 200 each (three months apart) at the higher rate of $4.50 the total cost would be $1,800 without the waste associated with time expired items.  And you would still have 28 items in inventory with an additional shelf life of three months.  Would your decision be different now?  The cost of the discarded expired items is high enough to make it more economical to purchase the lower volumes at the higher unit price.

Purchase Qty	Original Purchase Price	Additional Cost  for Time Expired	Total Cost
500	$1,600.00	$409.60	$2,009.60
200 x 2	$1,800.00	$0.00	$1,800.00
Net savings in purchasing two orders of 200 items			$209.60

•          Now assume product B has a shelf life of six months and a usage rate of 75 per month.  If you had the option of placing one order of 500 for $3.20 each or multiple orders of 225 for $4.40 each as necessary, what would you do?  The total purchase price for the quantity of 500 would be $1,600.  At a rate of 75 per month you would use 450 before the shelf life expired.  The 50 time-expired items will have to be discarded resulting in waste and then be replaced with an additional expenditure of $160.  On the other hand, if you placed two separate orders for 225 each (three months apart) at the higher rate of $4.40 the total cost would be $1,980 without the waste associated with time expired items – you would have zero items left in inventory.  What would your decision be this time?  The higher usage rate reduces the number of items left to be discarded when the self life expires.  Therefore, the overall cost of discarding the 50 items relative to the purchase price is sufficiently low to justify the larger purchase quantity and allowing the remaining time expired items to be wasted.

Purchase Qty	Original Purchase Price	Additional Cost  for Time Expired	Total Cost
500	$1,600.00	$160.00	$1,760.00
225 x 2	$1,980.00	$0.00	$1,980.00
Net savings in purchasing one order of 500 items			$220.00

Need help discovering hidden gems like this one in your own organization? Visit The Profit Experts.

Why Are You in Business?

Why are you in business?  After a quarter century interacting with hundreds of companies and observing many thousands of people, it appears to be a question that, surprisingly enough, many people do not fully appreciate.  There are nearly as many reasons given for being in business as there are people having been asked the question.  Notwithstanding the fact that many individuals employed by the same companies will often give somewhat similar answers, they are rarely exactly the same and, in a disturbing number of cases, more than a few are vastly different.

Some people say they are in business to deliver a certain product.  Another group might say they are in business to provide a unique or special service.  Many might say they are developing a breakthrough technology or the next “killer app.”  Then others would say that delivering the highest quality is the reason for being in business.  Although these are all very important aspects of running a successful business, they are NOT the reason you are in business.  A company is in business to make a profit.  It’s that simple.  There is no other higher priority, period.