by Garrett Fisher
March 14, 2012
High-growth situations cause stress on cash flow and quickly on cash balances. The challenge is quickly making sense of changes in sales rates, and changes in underlying growth rates that increased sales brings. Add to it the challenge of Asset-Backed Lines of credit (ABL) and attendant floating line balances tied to percentages of different asset classes and you can see why cash can quickly become a deceptive animal that operates seemingly opposite of performance.
Companies often grow or morph into a role of limited understanding of their cash situation based on a continuation of a form of status quo. In effect, they are accommodating some of the formula assumptions below while making most criteria fixed. Hence, when something changes, the old management method does not work.
While embodying the growth finance dilemma in a formula codifies what is going on, it is not always the most practical method to manage. I.e., cramming the below formula into a spreadsheet does not substitute for skilled financial management to handle such sensitive cash issues.
Increasing Sales – The Gory Details
The first component of the growth curve is increasing sales. Cash requirements, expressed as a formula, is the following:
p = average net terms of cost of goods/labor
s = average days outstanding (average days customers take to pay you)
m = gross margin, all variable expenses factored
i = sales increase (as a percentage)
t = time, in days, that sales increase will take effect
r = current revenue amount
l = production lead time (where costs are invoiced before sale can be made as opposed to invoiced day of sale. Applicable where shipping lead times are long.)
(((s-p)/365*r*(r-m)*(i))+ l/365*(r-m))*(s-p)/t
Expressed in plain English, we are taking the difference between when customers pay and when vendors require payment multiplied times our cost (as opposed to gross revenue) times our sales increase. If there is a lead time, we add that expense to our cost basis. This represents the maximum amount of cash needed, assuming that sales increase immediately. Once maximum cash concentration is achieved, then it is a matter of receiving customer payments and henceforth gross profit to begin to replenish cash balances and lower cash requirements. Eventually (assuming the company is profitable), the need will be completely replenished followed by the collection of profits.
A complication arises when the increase is not instant, and instead rolls in over a period of time. If the increase is manifest in a period that extends beyond the difference between customer payment averages, then the cash requirement is reduced to the maximum increase obtained in one cash flow delta cycle. For example, if customers pay in 45 days and vendors require payment in 30, delta is 15. If sales are expected to increase 10% over 30 days, then cash will only be needed to finance a 5% growth in sales. Collections for gross profit on the first 5% will begin to be collected before the second 5% has a chance to take its toll on cash.
How to Make Practical Use of the Concept
Formulas unfortunately ignore voluminous quantities of vagaries that need to be considered in any complex organization. The bottom line issues are as follows:
1. Impacts on cash flow from sales need to be understood, in advance. Cash drain due to sales growth, when improperly diagnosed, can cause an organization to chase its tail and spite itself by curtailing growth. There also does not need to be a surprise factor where organizations realize cash issues only after the fact.
2. Given #1, a company’s CFO should understand the growth finance curve and be managing it.
The fundamental issue behind cash management is that while accrual accounting is the most sensible way to manage a company, cash rarely follows accrual accounting. Accordingly, an organization must have the talent to manage the issue instead of the risky prospect of drastic decision-making as a result of bad information.
Executives that get frustrated by the cash vs accrual differential often make the mistake of trying to change accounting to mimic cash so that it can be better understood – exacerbated worse by the growth finance situation as previously fixed assumptions now are changing. That works fine to understand the cash issue. It also destroys budgeting – both as a forecast tool and as a departmental purchasing and management framework and opens up an enormous Pandora’s box of negative consequences. Also, since cash has so many cross-currents, often modified cash accounting takes certain known cross currents into account – and when more cross currents become evident, then accounting methods need to be changed (See #1 above regarding chasing one’s tail. Also see Cash Management series articles which delve into the subject in greater detail).
The bottom line is that situations requiring growth finance are serious and should not be taken lightly. Growing revenue is always welcome and the challenges that situation brings cannot be underestimated. Proper management in place is essential to making a wise and cost-effective decision on capital facilities.
