Cash Flow Crisis
You need $20,000 by tomorrow or it’s over for you.
No, you don’t have gambling debts with some seedy loan shark from the town over, you are in a cash flow crisis. You don’t have enough money to meet the bills that are due today and you are trying to remain calm as you call past-due customers and request payment. Is this normal? How could this have happened? What should we do? Many questions run through your head, but there are two things you know: you need money and fast. Cash flow is king, but right now you feel like a pauper.
Cash flow and the issues involving it can be an enormous headache that most businessmen face at some point in their career. Most people face this problem because it can happen for several different reasons, some of which have little to do with the condition of your actual business or assets. We will talk about what these crises are, what brings them about, and what we should do about them.
What is going on?
You have a complex business. On the surface, it looks simple. But that’s because you make it look simple. In reality, you have to accomplish critical tasks daily to keep your operation running as smoothly as it does. After a decade of working in the industry, you’ve unlearned more than many people will ever learn about what it means to serve your clients needs. But something is holding you back, you know your business is making a lot of money, but none of it seems to end up in your pocket. Worse, you are in a crunch, a cash flow crisis, where you need to find funds and fast if you’re going to pay your bills and make it to next week. What is happening?
A cash flow shortage happens when more money is flowing out of a business than is flowing into the business in a span of time. That means, during a cash flow shortage, you might not have enough money to cover payroll or other operating expenses. Eventually your accounts receivable will turn into cash and your business will be net profitable, but your bills are due now and not then. But you probably already know that.
What many don’t know is that this can happen for several different short-term and long-term reasons. In other words, it may be a blip due to financing or banking issues or it may be symptomatic of a deeper structural or psychological problem within your business.
Structurally, a business model may erode for various reasons, supply shortages or market adaptation may cause costs to rise while competition may erode profits, which can cause cash flow shortages. The industry has shifted under your feet and your business model becomes less viable by the day. While this situation may seem dire, adaptation and flexibility are essential to the long term survival of any business, so you might as well get started today.
Psychologically, some business managers may not have the financial discipline to reign in costs or think about cash flows and financial reports analytically. The founder may be used to living the life of an employee where he receives a secure chunk of change on a consistent basis and is suddenly thrown into a situation where he has the strong potential to earn large profits but they arrive infrequently, sometimes after several months. These lumpy cash flows can be a poor match to the constant stream of costs and opportunities to spend money. Many are led to search for easy fixes in the form of business management fads that work to correct some of these behavioral biases, but often fail to provide the tools to identify whether or not your business is structurally sound. The sway of the crowd in the form of fad management techniques could be an article on its own.
Banking and financing issues come into play when a business model just does not work without borrowing money. If you sell a job for $50,000 and will be paid in 60 days, but in order to fulfill the order you must begin work immediately with costs of $30,000 due in 30 days, the job is net profitable but if you do not have the funds to withstand the costs you’ll never make it to the reward. Your business must either have a line of credit or its equivalent, a cash stockpile, in order to sustain this business model. Further, it creates an added risk. If troubles arise with the cash stock pile or business line of credit, troubles will arise in your cash flow.
In financial lingo, we call things that we can easily sell, where there is a buyer ready and willing to go pretty much any time we pick up the phone, liquid assets. Liquidity is then a measure of a businesses ability to meet its short-term obligations, such as payroll, bill payments, and loan payments with cash or other liquid assets we can easily exchange for cash. Cash flow management is necessary for businesses of all shapes and sizes and liquidity is one of the key components we look at.
A dramatic example is what may be happening to grain elevators during this massive price run on various commodity grains and the nearly constant attention to cash flow down to the hour that is required in order to manage daily margin requirements. While an increase in the value of grains is helpful to a farmer, an elevator attempts to hedge its price risk so that it makes a consistent spread. While a line of credit should be supported by the value of the collateral you put up, in this case highly liquid grain commodities, you will often have a credit limit beyond which a discussion with your banker is required. If your relationship with your banker is not air tight, you may struggle to obtain favorable terms even though your collateral is of high quality.
Many businesses with less frequent needs have a more persistent problem. That is, while they don’t need to track cash flows down to the hour, they have had to worry about them for years on end.
In the example of grain commodities, what is happening is an acute increase in demand for financial liquidity by the elevators corresponding to a reduction in the supply of cash loans given out by banks. The resulting lack of cash available can cause widespread issues both in individual businesses and the economy. In other words, the banking industry just may not be that interested in expanding your line of credit. It is clear that we are dealing with a complicated economic problem that has a variety of different potential causes. While fundamentally poor or structurally unsound businesses are likely to face cash flow crisis’s and stubborn banks, it is all too evident that sound businesses can also face them.
More persistent cash flow problems are unlikely to be caused purely by the economy. Adaptation to the new economic reality is essential to the long term competitive advantage of any business who seeks to survive.
This complexity can create confusion in the minds of many business owners who are otherwise experts in their line of business. They often turn to easy solutions offered by fad management books that are the equivalent of 5 minute ab workouts. Cash is not the same thing as profit, and you should be wary of the difference. Financial results should not be obtained at the cost of your understanding of assets and liabilities or false confidence in making investment decisions. A cash flow crisis is not necessarily a signal that your business is unsound, but that does not mean there is an easy formula to solving your problems.
How does this happen?
A cash flow or liquidity crisis is rooted in one or more of the following three causes: overall economic troubles, undisciplined management, or an unsound business model. The business may be fundamentally sound if not growing stronger, yet the banking industry is tightening and your inventory costs rising. Management may have implemented credit policies without actual teeth or be unwilling to call past due customers in order to avoid conflict. Or, your costs may be rising and prices becoming uncompetitive because better products and services have entered the market and are competing for your customers.
An unsound business model is exemplified by the paper salesman Michael Scott from the TV show The Office. Scott is the regional manager of Dunder Mifflin Paper Company, a business model that had been scaled too much in the face of rising digital competition. Corporations who need paper like Law and Accounting firms saw cost reductions in the switch to digital so Dunder Mifflin needed to switch up their business model to stay relevant and failure to do so saw many of the cast move on to new careers by the end of the show.
The financially undisciplined are not too much to be blamed, and if anything they are in the best spot because there is actually something they can do about their situation. It will still require discipline, an often painful process of sacrificing what you think you need today in order to acquire something greater tomorrow. You need a sound financial footing to ensure your business can continue to serve clients and provide jobs well into the future.
This is often the case for those in the trades. A long time foreman from a concrete company decides to break out on his own. He understands almost everything about framing and pouring foundations, slabs, sidewalks, and even the intricate steps required in managing dynamic construction projects. But if he fails to recognize the value of his services to his customer and price correctly, along with the proper terms, and furthermore manage his expenses properly throughout the process, he will soon be out of money and waiting on his next installment check. Continuing professional education and trusted advisors can be essential to honing your financial discipline. There are methods and tactics, laid out in the following section, that can help businesses with fundamentally sound cash flows, achieve more stable income.
Economic conditions tend to reach out and touch many businesses, even very small ones. And business owners cannot be expected to understand the intricacies of economic problems while simultaneously being experts at providing their service to customers. However, certain businesses are far more exposed to the financial world than others, particularly those involved in commodities which can be subject to massive volatility or price changes. An oil & gas storage provider may see the value of their inventory rise significantly while tight lending in the banking industry makes it difficult for them to support their position. Closer to home, a construction company running at low margins with contracts out several years may face cash flow difficulties given the recent surge in the price of lumber.
How should I deal with it?
A cash flow crisis should be avoided if at all possible. It can be avoided first of all through close management of supplier and customer payment terms, monitoring late payments, applying finance charges to late customers, and seeking discounts with suppliers. If accounting best practices are implemented you will be in a much better position. If that is not enough, a line of credit or a cash stockpile is needed. However, an unsound business model will continue to erode until it is not even net profitable, at which point you are no longer dealing with just a cash flow problem.
The thread tying all of these together is financial discipline. While the easy answer to financial discipline in the form of the freshest best-selling business book on Amazon may seem tantalizing, gaining a financial education will compound for the rest of your life. So why not do it right? While a fad management tactic may solve your problems if your business is otherwise fundamentally sound, if it is unsound it will at best distract you from your real problems and at worst drive your business to bankruptcy. Financial intelligence is not something innate, it can be learned, and those who learn it well can speak a language that can be arcane to the layman but it will serve you well by enabling you to both spot opportunities and risks and communicate them with your team more effectively.
“Financial Intelligence” by Berman and Knight (2013) is an excellent book that puts accounting numbers in a human light for managers. It is useful for beginners to advanced practitioners and covers everything you need to develop a solid foundation. It’s also not boring.
Accounting numbers should not be a mystery to your managers. You may have a good bookkeeper or accountant, but executives should be informed if they are made responsible for the bottom line. But it’s not all about the numbers, it’s also important to understand how your business is effected by changes in the economy, competition, and technology. If you can speak the language of business, it makes it easier to communicate with the banks, CPA’s, and the other business people you interact with.
Dealing with a crumbling business model can be challenging for a variety of reasons. The entire business model may need to change to adapt to the present environment. This is an Income Problem and not really a Cash Flow Problem, in other words, your revenues do not exceed your costs rather than there merely being a mismatch between your revenues and your costs. The change required may be large or small, however, and may be as simple as moving to new suppliers or adapting your production techniques to new technology like automation. Products or services becoming uncompetitive due to advances in the industry or substitute products can also be a challenge where tight margins reduce your flexibility to expand or invest in new lines of business.
If you are financially disciplined and your business model is sound, you may still need cash. In the example given above about a business with differing terms for suppliers and customers, cash flow will be a persistent problem. The only way to truly deal with this is to enforce new terms on customers and suppliers or to have the cash available to smooth out the operations. This cash can come from a savings account that has been built to a certain size which is periodically refilled with extra cash when payment comes in. This is the rough equivalent to a line of credit in many ways, however this can be just as difficult to save up for.
A line of credit has the advantages of being far more flexible and operating much more like a small business credit card than a loan as there is no lump sum disbursement and you just use it as you go. You can also secure the line of credit with certain assets as collateral. This allows you to continue to earn income on the asset used as collateral in addition to having access to the cash.
Even if you have a solid business model that has proven itself to generate high returns over several decades and were able to avoid many of the major outcomes from the recent economic crisis, without strong financial discipline, a healthy cash position, and a good relationship with the bank, you will still occasionally run into these cash flow predicaments.
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