Navigating Choppy Economic Waters:
Are You the Captain of the Ship?
By: Chris Tedford, Senior Advisor
When the COVID-19 pandemic took the world by surprise, the focus of most businesses quickly turned to understanding the risks to their business, managing potential supply chain disruptions, protecting liquidity and assessing the impact on their workforce. While the full impact of this pandemic on businesses remains unknown, the one constant is this event will inevitably have global economic and financial ramifications that will have a ripple effect among all businesses, small and large.
So, What Can You Do?
Whether you’re a small business owner or the chief financial officer of a large global organization, meticulous short-term cash flow management is paramount to the success of any business. Think of cash for your business as gasoline (or electricity!) for your car. Without it, it’s impossible to keep moving and get where you want to go. At a minimum, the immediate cash needs for any business will typically take the form of procuring goods and services, covering payroll costs (e.g., salaries, wages and benefits), keeping current with rent and utilities, servicing principal and interest payments, compliance with tax obligations, and other vital day-to-day expenditures. Carefully ensuring that a business has adequate cash reserves requires thoughtful planning, and the ability to anticipate not only core cash needs, but the ability to prepare for the unexpected. Steady financial discipline, meticulous execution of a liquidity plan, and at times, the need to pivot quickly to react to unexpected situations will allow all businesses to navigate the roughest of waters and ensure smooth sailing ahead. This process can be rather stressful at times, but stress no more, as we at SierraConstellation Partners have you covered with several proven techniques to successfully manage short-term cash flow needs.
Keep Calm and Focus on the Basics
Positive Cash Flow: Positive cash flow occurs when the cash coming into your business (i.e., cash from sales, accounts receivable, etc.) exceeds the amount of cash leaving your business (i.e., monthly operating expenses, employees’ salaries, etc.).
Negative Cash Flow: Negative cash flow occurs when the outflow of cash in your business is more than the cash you have coming into your business.
Cash Flow vs. Profit: Generating profits do not always equate to positive or “good” cash flow and knowing if a business turned a profit differs considerably from knowing what happened to its cash.
Businesses must look at other financial metrics besides profit and loss to truly understand cash flow (positive or negative) to effectively manage liquidity challenges. Other key financial metrics that allow a business to properly assess cash flow include EBITDA (earnings before interest, taxes and depreciation and amortization), working capital trends (primarily a function of changes in accounts receivable, inventory, and accounts payable), capital expenditure activity, debt service payments, and tax obligations.
Most businesses primarily focus on EBITDA as it is the best indicator of whether a business has positive or negative cash flow. Working capital trends will also play a major role in managing short-term cash flow needs. Timely and effective collection of accounts receivable will improve cash flow, as will the ability to sell-through (or turn) inventory quickly. Together with the timing of when a business pays its accounts payable, these activities will determine the cash conversion cycle. In short, the cash conversion cycle is a metric that measures the length of time (in days) that it takes for a business to convert its investments in goods and services into cash flows from sales. The shorter the cash conversion cycle, the better liquidity will be in the near-term.
So, What’s Next?
Borrowing on the experiences and learnings from the 2008 Great Recession and related credit crunch, we offer the following strategies and techniques to add to your virtual toolbox.
Have a Plan
Cash flow management involves understanding upcoming expenses and comparing them against sales, accounts receivable and future cash receipts. To project net cash flow, businesses should begin by analyzing prior year financial results to establish a base, then adjust for anticipated changes in sales, potential changes in the cost of goods and services, changes in headcount, and other variable expenses. Understanding cash flow forecasting techniques is a critical first step to effective liquidity management. Developing forecasts that project net cash flow on a monthly basis is a good start, however, creating and maintaining a reliable thirteen-week cash flow forecast is the most common approach to managing short-term cash flow challenges. As the year unfolds, cash flow projections should be updated often to accurately incorporate changes in business trends. It is also imperative to continually compare projected cash flows to actual cash deposits and expenditures, which will help refine future projections and improve forecasting precision.
Boost Your “Sails”
If a business needs more cash, likely the initial reaction is to simply attract new customers or sell more goods or services to existing customers. But this may be easier said than done. New customer acquisition is essential to a growing business, but it can take time and money to convert prospects into sales. Selling more to existing customers is more cost effective and you may be able to do this by analyzing what they are buying and why. But be warned, escalating customer credit to hopefully generate higher sales could just increase accounts receivables and not translate to actual cash receipts if additional customer credit is not warranted.
Review Credit Histories of Customers or Clients
Having customers who want to purchase products or services is important, but it is just as important to make sure they are qualified. Be sure to perform rigorous credit checks on new customers or clients that apply for credit and flag any account that has a history of slow payment. If required to deny credit terms to a customer, do so graciously and urge them to complete the transaction in cash, credit card or to reapply later. Also try to flag unprofitable customers who cost a lot to maintain and don’t add to the bottom line.
Think about ways to cut unnecessary costs or expenses your business incurs. Focus on recurring payments to see if it is possible to scale back or defer inventory purchases, payroll, rent, utilities, or any other costs that are not essential to day-to-day operations.
The best way to properly prioritize cash outflows is to decide whether a payment: (i) must be made; (ii) should be made; (iii) or is highly discretionary. In situations where cash flow is tight, typically cash reserves should only be expended for goods and services that are necessary and critical to the immediate viability of a business. During difficult economic times, many companies may look to reduce headcount (e.g., salaries and wages), defer capital projects and default to a “keep the lights on” approach to capital investments, and rationalize other goods and services that are deemed unnecessary in the immediate term.
Delay Payments to Suppliers or Vendors
It is always advisable to have a good relationship with all key vendors and suppliers. Typically, engaging in open dialogue with key vendors to make them aware of end-customer payment and credit terms is an effective approach to stretching payables and improving short-term cash flow. Remember that you are supply chain partners with your vendors and allowing some level of flexibility with regards to payment timing will likely benefit both businesses in the long run.
Sell Unused Assets
Identifying slow-moving inventory or equipment that is no longer in use can generate quick cash. Over time, many businesses have invested in assets, such as equipment or real property. If these investments do not have immediate or anticipated usefulness, why not monetize them to help your business weather the current storm?
Consider Financing Options
There is an adage in business that “cash is king.” If that is true, then “leverage is queen.” Short-term cash flow challenges may often necessitate a business to secure a loan from a financial institution. Some loan types include revolving lines of credit secured by accounts receivable and/or inventory (asset-based loans). Most of the time this type of borrowing arrangement accomplishes its goals by allowing a business to accelerate the cash conversion cycle. Other revolving lines of credit are secured by the future cash flow of a business. Another common financing option includes a long-term loan with a typical maturity of 3 to 5 years and typically require principal and interest payments until the loan is paid off. It is critically important for businesses to consider all available financing options and ultimately align on the debt structure that meets the specific needs of the business.
Full Steam Ahead!
Understanding cash flow management is vital to the success of any business. Implementing effective cash flow forecasting techniques, continually refining cash flow projections, remaining keen to the ebb and flow of sales activities, closely monitoring the cash conversion cycle, and viewing each dollar as truly flexible will ensure your business is well-positioned to successfully navigate through any choppy economic waters encountered. While you should feel much more equipped to manage short-term cash flow challenges and captain the ship, know that you do not have to go it alone. We at SierraConstellation Partners have experienced and skilled professionals that can assist with ensuring smoother sailing is ahead.