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It's Called Cash Flow for a Reason - Sep 14, 2008

Posted by: Linda J. Donegan in Articles

Business owners need to think about cash flow in terms of water. We can't survive without water, but too much or too little can have devastating consequences.

A heavy rainstorm starts with dark clouds, followed by a light shower, strong winds, then sheets of rain that fill the streets and overwhelm the storm drains. Creeks and rivers overflow their banks, damaging property and limiting movement, bringing the risk of death unless emergency crews fill enough sandbags to keep the ever-rising water away from homes and businesses.

The effects of drought take longer to become visible, but they're just as deadly as flood damage. First the fields and forests are merely thirsty; then leaves and plants begin to wither. Below the surface, roots die off and the water table recedes. Unless alternative sources of water are found, the land dies, and so do the animals and people who depend on it.

Managing your cash flow is like managing water resources because too great of a demand on cash flow-or too little-at the wrong time can kill your company.

I know of a company that has an outstanding receivable of $1.5M. The Company's cash was tied up in direct and indirect labor and materials to produce products and provide services to one of the Company's main clients. The situation worsened by changes to work orders that resulted in the greater cash consumption. The terms of the agreement were for payment at the completion of the work, but both parties had overlooked the impact of this arrangement on cash flow. The Company experienced a prolonged lack of the life-giving element (cash). Meanwhile, the Company's client was unprepared for the storm. When the invoice arrived, the client felt swamped by the deluge. "We don't have that kind of cash, and our LOC is limited," the client protested. "The payment terms are clear," the Company replied, facing the pain and effects of drought.

The whole awkward situation could have been avoided If both parties had been taken their cash flow needs into account when they were negotiating the contract. The storm of the century could have been just another summer shower if they had built periodic payments into the contract.

Cash management properly using a Cash Flow report is like a weather forecast. It focuses on regular inflows and outflows of cash. Businesses use these forecasts to best advantage by making regular bi-weekly payments and issuing invoices on a regular bi-weekly or weekly cycle. Holding payables back too long is similar to building a dam; the accumulating pressure finds any structural weakness and a hairline crack turns into a disaster. At the provider end, neglecting to invoice in a consistent manner means the well can run dry.

Businesses experience other storms that directly affect cash flow: new product line expansion, hyper-growth, overly aggressive hiring practices, material cost increases, lender rate changes, unplanned tax implications. The list can be long.