CASH: NOW YOU SEE IT, NOW YOU DON’T – PART 2

Last week I introduced the topic of cash flow management, using the graph below. Cash flows generated or use by any business are the net result of the inter-action of three inter-related cycles. They include the expense and revenue cycles, which I discussed last week.

Today I complete the topic with a review of the capital cycle.

The capital cycle:

If you have been in business any length of time, you know that capital is always a scarce and expensive commodity. Therefore, the capital cycle involves allocating or assigning available cash to its highest and best use. The process analyzes competing alternatives, such as opening a new location, expanding your sales force, product research and development, increasing inventories, debt repayment and so on. Unlike cash, the list seems almost inexhaustible.

Therefore, this cycle requires a quantified prioritization that incorporates a variety of factors including expected returns, time horizons, risk assessment and the cost and availability of required capital. Most business people are familiar with some applications of capital allocation. A simple example is whether to buy or lease company vehicles.

Other applications are not as well recognized. For example, assume two identical businesses earned a $100,000 profit. Company A had $1 million invested in the business, while Company B only had $500,000 of capital. Company B’s 20% return is double that of Company A. Unfortunately, it is not as simple as the math implies. While reducing capital increases returns, it also increases the risk of running short of cash and failing due to unexpected events. Every business requires some level of cash to serve as a buffer against this uncertainty.

Another application of the capital cycle is identifying and quantifying the need for outside funding to meet your needs. Obtaining adequate funding under terms and conditions that make economic sense in light of expected benefits is crucial to the process. This includes short-term needs like financing seasonal fluctuations in receivables and inventories, and long-term needs such as procuring equipment and facilities.

The capital cycle also includes securing “start-up” money, probably the greatest challenge and source of frustration most small businesses encounter. New businesses owners frequently make two critical mistakes in their search for start-up capital. The mistakes are:

  • They significantly underestimate the amount of cash needed to carry the business until it turns cash positive. Again, a clear distinction exists between turning an accounting profit and being cash positive. If you sell something for $100 that cost you $85, and the related operating costs are $10, you have made a $5 profit. However, if you need an additional $30 to expand your inventory and prepay next month’s rent, you are $25 short of cash. Lack of cash is a more immediate and serious problem than lack of profit.
  • The second mistake is assuming a business can borrow 100% of its initial capital needs from a bank or similar source. I cannot begin to count the number of times I have encountered entrepreneurs with an attitude of, “I’m supplying the intellectual capital. It’s my great idea. Surely I can find someone willing to put in all the cash!”

Banks are interested in financing established companies who need capital to expand, not start-ups wanting cash to test their ideas.

Conclusion:

Let me end with two simple statements. First, in business, success is a four-letter word. It is spelled C-A-S-H!

Finally, measuring, monitoring and managing all three cycles is vitally important to optimizing your cash flow, and ultimately to your very survival.

© 2011 by Dale R. Schmeltzle

 CFO America: Your Cash Flow Optimization experts

Be Sociable, Share!

Speak Your Mind

*

  • RSS
  • Newsletter
  • Twitter
  • Facebook
  • LinkedIn