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Cash is King

Cash is the lifeline of any business.  If you run out of cash it can cripple the business and prevent any growth and in the extreme case, result in the liquidation of the company.  While we would love the cash cow business, the reality is where does the cash go?

Cashflow shortfalls can be positive and they can be negative.  When cash is being used to fund growth, this can cause short term cash pain.  Growth is when a business needs to invest in infrastructure, stock, or capacity through increased wages.  The capital outlay needed has a short-term impact on the business, and when growth stabilises the cashflow then returns to normal.  Other factors that impact cashflow while growing are the debtors.  Often debtors will push out their payments beyond the normal trading cycle (normally 20th of the month following) and it is important to make sure that a business does not act as a bank to debtors.  A robust collection policy will ensure that debtors are paid in a timely fashion. 

Stock on Hand is the other area where cash can be invested in, and while it is an asset, if it is not being turned into cash very quickly then that creates some big concerns.  Rising stock levels are a risk to any business as it is cash invested into an asset that may or may not be realised.  If stock levels are being maintained then the cash needs diminish over time as the margin generated then helps purchase additional stock.  If stock becomes impaired and is written off that is effectively cash down the drain.

Using cash to invest in plant & equipment that will generate additional revenue though increasing capacity or efficiencies is always a good plan, but if too much cash is invested this can have an impact on the short-term cash needs.  To alleviate this, for any significant plant and equipment purchases, the business should use external finance as the cost of borrowing over the life of the asset can be easier on the cash needs of the business than the short-term cash needs of the company.  And if the business cannot afford the repayments then the question is, is the asset needed in the business?

If there is a significant project that needs to be funded in the short term, then tax pooling is an option to consider.  For example, a project requires $25K invested in it and will return a $20K profit (gross $45K cash) then tax pooling $25K of income tax at 4-8% is a better use of money to invest in the project (giving an 80% return) and use the cash to pay the tax at the completion of the project.  For more details on tax pooling, check out our earlier article on our website around the benefits and risks of tax pooling.

Cashflow shortfalls in a negative aspect is when the costs of the business are greater than the revenues generated.  This can be due to 2 main reasons.  The first is that the expenses or the debt of the business are too high relative to the revenues generated.  This requires a critical review of the expenditure of the business to work out where savings can be achieved.  Savings can be in operational overheads, or it can be in increasing margin through savings in purchasing decisions.

If expenditure cannot be reduced, or has been reduced as low as it can, then the balance sheet needs to be looked at.  The relationship between the P&L and the Balance Sheet is that when profit is generated it is transferred (after tax) to the balance sheet to increase assets, reduce liabilities, or to cover drawings.  Therefore, understanding where the cash goes becomes important.

If the business is increasing its assets and that is costing the company (growth) then relook at some other measures as above.  If the business is decreasing the liabilities and has a cashflow issue, then re-examine the terms of the debt and see of these can be extended to reduce down the cash requirements for repayment.  We all like to repay debt but at the cost of short term cash it becomes a balancing act.  The final component of the balance sheet is the drawings – how much is the business owner taking to live off.  If this is more than the cash the business generates then the business owner’s lifestyle needs to adjust – as the old saying goes cut your coat to suit your cloth.

If the business has taken all these steps and cannot save additional cash, then an increase in sales or close the business is the only option – but that is the topic of the next article.

Written by David Waine


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