I’m explaining how to discover where your company’s cash weaknesses lie so you can identify opportunities for greater profitability and better cash flow. If your business is growing while you are running out of cash, this article is for you.
In Part 1 of this article, we covered phase one, Calibration, where you create a set of adjusted financial statements that help you more clearly see your cash flow behavior. Now we move on to Phase 2 and 3, where we look at what we have and create solutions.
Phase 2: Forecasting and Planning
At this point you have made adjustments to your past financials. You have many months of income statements and balance sheets lined up. Great! Now you need to dig out the assumptions built in there.
1. Examine how unit gross profit and margin change with scale. Suppose you’re buying parts for the widget you make, and you’ve doubled your volume. You are likely getting better pricing now, if you’re renegotiating those costs. You might get better shipping rates or your cardboard boxes could be 10 cents cheaper. Everything you’re increasing volume on will improve margins. (We’re going to assume your widget price stays the same.)
We want to find out if you have margin improvement with scale. Different businesses react differently.
In the food business, once you have a certain amount of traction, you may feel less pressure to provide discounts to retailers, for instance.
Look at your unit economics. For every product sold, how much money are you making on it, and how is that going to change as the business continues to grow? It can be challenging to figure this out, but it’s important to find out where you’re headed.
2. Look at changes in expense items as you scale. The simple goal here is to identify which items are fixed and which are variable. Certain expenses will grow as the business grows, others won’t. For example, as a business goes from $3 million to $5 million, your marketing team payroll won’t change because it’s the same team. So per revenue dollar, per unit, there’s less marketing expense at $5 million.
If your overall cost of marketing is declining relative to revenue like this, you’re going to have more profit and more cash flow at the end of the day.
You will have a lot more gross margin in the future. That will improve your cash flow situation!
Your advertising, however, will probably grow in lockstep with your revenue. You might spend $100,000 at $3 million and $170,000 at $5 million. It’s going to continue to grow linearly. Once you identify these factors for your business, you can create assumptions around the relationship of advertising relative to revenue, allowing you to more confidently project into the future.
3. Check the balance sheet. Sometimes everything grows with revenue: accounts receivable, inventory, accounts payable. And sometimes companies find efficiencies where they can improve, say, accounts receivable or inventory because of increased velocity (meaning as revenue or sales volume goes up, they may be able to require less inventory and draw less cash to buy it).
At the end of phase two, you should have your actuals for to-date operating cash flow. Once you see the patterns, you can move into Phase 3 and figure out how to shift those patterns.
Phase 3: Growth Rate Analysis
Now you understand your cash flow better and are ready to start changing the slope of that curve. Given your plan to grow the company, look at where the cash flow starts to change. You can look at the actuals and ask, what’s my operating cash flow at $500,000 a month? At $600,000 a month? At $800,000 a month? What happens if we change the relationship of inventory or other factors to each other? Can we do that? How do we do that?
Patterns will begin to emerge. You may discover stepping points where profitability jumps, and that can give you something to aim for.
Phase 3 is about adjusting your assumptions and operating practices to improve your outcome. All these volumes and levels you can examine start to illustrate how they impact the outcome metric of operating cash flow as you scale. This analysis has many benefits:
1. Find a target to shoot for. A number of low-profit businesses I’ve worked with have found the light at the end of the tunnel this way. Their next goal became apparent: “Man, if we can just grow this business by 5% a quarter, then our gross margin will improve. Then some of our fixed expenses around X, Y, and Z improve, and these are all additive.”
2. Improved cash flow compounds on itself. If you find out how to save a buck here and save a buck there, at the bottom line it can have more impact than you might think. For example, a 1% price increase, a 1% COGS decrease, and a 1% reduction in operating expenses, can result in a 20% uptick in profitability. And imagine what small incremental improvements to Accounts Receivable collections and Inventory might do as well. It becomes very powerful! And pretty soon, cash begets cash. And when you can put newly discovered cash towards solid new projects, it will compound on itself.
3. Learn to drive your business. For the company that had the inventory problem (at the beginning of Part 1), that owner essentially discovered the levers of his business. He knew exactly how to make an impact on his bottom line, and it enabled him to do that. When you have this analysis in hand, you can ask, “What if we did this, what if we did that?” and immediately see the impact it would have on overall cash flow.
4. Make smarter decisions and prioritize better. A business owner can answer the question: “Should I focus on reducing product costs or should I focus on getting our customers to pay us faster?” Cash flow analysis shows which choice really wins the day and which one is easier.
You might even decide, “Wow, this one wins the day but it’s super hard. I’d rather tackle this other project first where we get more bang for the buck and my confidence about getting it done quickly is high. Then we can focus on the second one later.” This analysis helps an organization prioritize.
5. Gain management team agreement. This forecast in terms of operational cash flows and planning really helps your management team understand and agree on the assumptions underlying the business. They can all see what is possible and what it will take to get there, for example, to a certain level of profitability or to run things with the existing marketing team. If you do this well, it creates commitment and forges agreement among management to drive execution. That’s a valuable side benefit.
Cash flow analysis creates achievability. It can move you from the fog of not knowing where your cash is disappearing to or how to grow effectively to being able to say, “Okay, I know it’s going to be hard, but if we can get from $3 million to $5 million, then life gets a hell of a lot easier and we can start a new project. And here is how we are going to get there.”