Understanding Cash Flow Dynamics

Bill Warner Friday, January 11, 2008

Whether you are starting a business or expanding a current one, understanding the early cash flow dynamics is essential to both determining how much you need to finance the business and your overall success in achieving positive cash flow in the first several months of your business.

The first several months of life of any business are very tenuous. You are just starting to bring in revenue. You had several extraordinary operating expenses to get the business up and running. You may have had to build inventory and hire a few key people. You don’t yet have the reputation needed to get preferred payment terms from suppliers and contractors. You may not yet have credit worthiness. All of this adds up to spending more than you are bringing into the company. The accumulated loses over the first several months determines the negative cash “bath tub” you have to swim through before you reach a point in time where you are bringing in more money than you are expending.

How Much Do You Need?

In both our work as partners in Paladin and Associates, our business consulting firm, and as executives of the Triangle Accredited Capital Forum, an angel investor network, we see dozens of companies every month that struggle with determining how they are going finance the early cash demands of their businesses. I can’t tell you the number of times we ask “how did you determine how much money you need to finance your business,” and get the following general answers:

  • It is the based on the lowest amount of retained earnings
  • It is based on the amount of the company I am willing to sell to investors
  • It is the amount of borrowing power I have
  • I have seen other businesses start up for about the same amount of money
  • Industry trends indicate that a business of this kind should be able to be financed for this amount
  • It feels right to me, based on my experience
  • I used the lowest ending balance in the cash flow statement of my financial forecast

Certainly, most of these answers are important to know, but are extremely shallow with respect to the depths of understanding you need to have about the cash flow dynamics of your business. The closest answer will be from the cash flow statement, but only if it has accurately reflected the adjustments to profit necessary to reflect the actual sources and uses of cash. None of the rest is based on a specific understanding of how cash is brought into the business and how cash is expended.

What Do You Really Need To Know?

As best as they can determine, we encourage companies to really dig into the details about how cash is generated and how cash is used every month for as long as it takes to start accumulating a positive cash balance at the end of the month.

First of all, the business needs to have a financial forecast. We first look at the profit and loss statement to make sure that revenue, costs and expenses are reasonably estimated. The dilemma is that this analysis does not really reflect when cash will arrive in the company and when cash will be expended. Let’s break this down into its major components:

  • Revenue – Your payment terms and how well your customers adhere to them will essentially determine when you will actually receive the cash for the revenue you are claiming in any given month. For example, if you claim $100K of revenue in October, and your payment terms are 30 days, but most of your customers really don’t pay for 60 days, you will not get the $100K in cash until sometime in December. Whatever costs and expenses you incurred in generating that revenue have to be paid out of your cash balance. In other words, the “bath tub” is $100K and growing because you will also have to pay for the revenue you will be claiming in November and some of December.
  • Costs – If you are a manufacturer, you had to buy parts to build your products. As a new business, you may not have very attractive payment terms from your suppliers, leaving you in a position of having to pay your suppliers before you actually get the cash from the sale of the products. You will also have to pay the people who worked on the manufacturing line. These costs will also have to be paid out of your cash balance, making the “bath tub” even bigger. If you are a services company, the people that performed the services have to be paid immediately, long before you actually receive the cash for the service.
  • Expenses – Your operating expenses may be quite large when you start a business. You have marketing programs to launch. A sales operation has to be put in place. A customer support team may have to be created. Certain capital expenditures may be required for production machinery and operating capital equipment like computers and furniture. You have employees to pay every month. Again, as a new business, your payment terms are not going to be very attractive, requiring you to pay vendors, leasing companies, banks and contractors in 30 days or less. Pushing it much further puts you in danger of default. So, now the “bath tub” is nearly full.

How Do You Empty the “Bath Tub?”

If you cannot explain the details of your cash flow, you need to go back and study some more. Any financing source we know of will ask you endless questions about it. I you don’t know the answers, you won’t get financing.

But, before you ask for financing, do some homework to see how much water you can take out of the “bath tub” before you approach a financing source.

  • Revenue – Get the money quicker
    • Ask customers for a certain amount of cash up front, to at least cover your manufacturing and services costs
    • Get paid upon delivery
    • Offer your first few customers a preferred price or free services if they pay early
    • Offer discount options for paying earlier than your current payment terms
    • Use your accounts receivable and committed purchase orders as collateral for short term borrowing or factoring
  • Costs – Look for cost offsets
    • Offer a premium to your suppliers for extended payment terms
    • Ask the customer to pay for parts or provide parts on consignment
    • Use contract labor so that you only have to pay for the time you actually need for their services and get deferred payment terms
  • Expenses – Conserve cash
    • Using the equipment as collateral, borrow money for or lease capital equipment, reducing the amount of cash outlay
    • Ask for abatements on early payments for capital equipment and building leases
    • Outsource as many services as possible, giving you at least 30 days to pay versus paying direct employees immediately

By improving your cash balance by taking some of these actions as well as many others, your financing “bath tub” will be shallower.

The Real Answer

Once you have emptied the “bath tub” as much as you can, you now have a well thought out basis for an estimate of how much you need to finance your business. The final judgment is to then increase that number by an amount that gives you enough of a cash reserve to bridge you to another financing event, if one is needed. Also, you increase it based on your risk assessment of achieving your revenue objectives. In other words, you are creating a “buffer” of cash to get you through the worst case business scenario. You now have the amount of money you need to finance your business and the reasons why you need it.

If you have done this thorough analysis of your cash flow dynamics, and are taking the actions necessary to manage them, you will be viewed by your financing sources as a more thoughtful and trustworthy company than most they consider. If you haven’t, you will be viewed as someone who probably cannot manage money.

Filed Under: Angel Investment, Financing a Company, Business Operations, Managing Business Financials



Bill Warner is the Managing Partner of Paladin and Associates, a business consulting firm in the Research Triangle Park area of central North Carolina, and is the Chairman of the Triangle Accredited Capital Forum, an angel investor network with over one hundred members throughout the southeast.

Commenting is not available in this weblog entry.