Cash Flow - Overlook it at your Risk.
Most everyone knows that revenue and profits play a big role in how much to value a business. After all, it’s not a coincidence that metrics such as Price Earnings (P/E) and Earnings per Share (EPS) are so frequently utilised (to the point of boredom..but I digress).
And yet.. it’s a serious issue with cash flow that can break your business in the blink of an eye.
Cash vs Profits
Cash flow is different than profits in that it measures the cash coming in and out of your business rather than an accounting interpretation of your profit and loss. For example, if you charge AED 30,000 upfront for a service that takes you three months to deliver, you recognize AED 10,000 of revenue per month on your profit and loss statement for each of the three months it takes you to deliver the work.
But since you charged upfront, you get all AED 30,000 of cash on the day your customer actually pays. Not only does this drive up your cash balance – but also helps drive up your valuation.
One of the reasons has to do with your net working capital. The more cash you have the less stress your business is under with timing of payments. For example, when I worked in financial institutional sales, a couple of our clients – who are major banks you know –outsourced their bill payment function to poorly qualified contractors. It took usually 60 days or longer to get payment (whereas before the outsourcing it was half the time).
The problem was that in those 60 days we had to pay the brokers servicing that client twice (every 30 days). These payments were not just base salary but also an Advance on commission which they earned from the sales with a client.
AS you can imagine this often led to the company having to resort to fund raising or tapping a line of credit to make payroll while waiting for the outsourced departments at the client banks to pay what they owed.
Dry up that line of credit and the company would be in big trouble (Pretty much what happened everywhere when the financial crisis of 2008 hit. It was the timing around cash flow that threw the economy into disarray, not business losses).
Therefore, the more cash you can bring in faster than what you have to pay out, the more valuable your business becomes.
Besides relieving the pressure to make payroll, a positive cash flow cycle improves your company’s valuation because when it comes time to sell your business, the buyer will avoid or have to fund very little of your working capital needs.
Think of it this way. When a Buyer comes to acquire your business, they often have to write two checks: one to you, the owner, and a second to your company to fund its working capital – the cash your company needs to fund its immediate obligations like payroll, rent, etc.
The trick is that both checks are drawn from the same bank account. Therefore, the less the acquirer has to inject into your business to fund its working capital, the more money it has to pay you for your company.
The inverse is also true.
If your company is burning cash on a net basis, an acquirer is going to calculate that she needs to inject a lot of working capital into your business on closing day, which will deplete her resources and lessen the check she writes to you.
How to Improve your Cash Flow
There are many ways to improve your cash flow – and therefore, the value of your business. The standard strategy is to effectively collect revenues from clients faster and delay payments to suppliers longer. Obviously in both cases, this has to be done with tact and discretion.
Another overlooked tactic is to spend less on fixed costs and the machines your company needs to operate. For example, many startups make the mistake of investing a lot of their start up funds in a swanky office and other expensive assets that do not generate significant income. Would a new business be better with a new office and pretty potted plans that set them back AED 350,000 a year or rent a smaller one for 125,000 ad use AED225,000 on sales and marketing?
The restaurant business offers an often repeated truism that it takes three bankruptcies at a single location before any restaurant can make money. The first owner of the restaurant walks in and – with all of the typical optimism of a new entrepreneur – pays cash for a brand new commercial kitchen complete with fancy stove, commercial grade walk-in coolers, etc., as well as all new dishware, pots and pans, thus depleting his cash reserves before opening night. Within a year, the restaurant owner runs out of cash and declares bankruptcy.
Then along comes a second entrepreneur who decides to set up her restaurant at the same location and buys all of the shiny new equipment from owner number one’s creditors for 70 cents on the dollar, figuring she has made a wonderful deal. But the outlay of cash is still too great and she too is out of business within a year.
It’s not until the third owner comes along that the location actually survives. He saves his cash by buying all of the equipment off the second owner for 10 cents on the dollar.
The moral of the story is: find a way to increase the speed of the cash you collect and extend the timing on the cash you spend. Can you buy your gear used? Can you share a very expensive piece of machinery with another non-competitive business? Can you lease instead of buy?
Profits are an important factor in your company’s value but so too is the timing and the cash your company generates. We call this phenomenon The Valuation See Saw and it is one of the eight key drivers of business value. Curious to see how you’re performing on the See Saw and the other eight drivers? Get your Value Builder Score at Sophiall.