Your Business Can Be Profitable and Still Run Out of Cash

When your company hits profitable targets at the end of a quarter, you should feel good about the report your team submitted. That feeling of accomplishment may be short-lived because if it is payroll week and your balance is looking low, so is your margin of profitability.

These things happen to businesses of all kinds. Profits and cash are two separate realities that eventually collide. The disregard for cash flow is usually the culprit.

The Profitability Trap

Every business owner knows the difference between cash and profit, but the reality is most companies can’t ignore the income statement. It outlines profits and expenses regardless of the flow of cash. Cash, on the other hand, is the immediate balance of the company. It’s what is available for a company to cover its debts.

How can something have both stellar profit and be out of cash?

It turns out that scaling revenue has an impact on both profit and timing of cash moving in and out of the business.

The truth is, it’s not uncommon for a business to simultaneously be profitable and run out of cash – if there’s a significant gap in the timing along the cash-conversion cycle.

How a Profitable Business Runs Out of Cash

Let’s say your company has a healthy 20% net margin. Customers pay on 60-day terms, suppliers expect immediate payment, and payroll is biweekly. Finally, taxes are due quarterly.

In this situation, you have closed the gap between collecting cash from customers and paying suppliers. But, you have only paid employees and not yet collected cash from customers, creating a funding gap between expenses and revenues. Since you have productively invested the money, this scenario isn’t dire – assuming it’s less than 30 days and assuming you have a cash reserve or a line of credit to keep you afloat.

Now, assume your business grows, but you don’t grow your cash reserve. Let’s say you also need to increase your inventory to meet rising demand. You’ve invested this increase in product but haven’t sold it yet. One of your customers is a little slow paying their bill, and your quarterly tax bill is higher than projected.

Everything else is okay – but for how long?

The Real Culprit: Cash Conversion

There’s actually a standard way of measuring cash and answering this question, called the cash-conversion cycle. Some of the metrics involved in this measure include – but are not limited to – the following.

Days Sales Outstanding (DSO). This is the average number of days the business holds on to its receivables, agreeing to terms before selling product or service to your customers.

Days Inventory Outstanding (DIO). This is the average number of days that your product sits in inventory in expectation to sell.

Days Payable Outstanding (DPO). This is the average number of days that your suppliers expect to be paid after selling a product or service to your business.

Once you can determine those three numbers, you can calculate the cash-conversion cycle in days. It’s done by taking the sum of DSO and DIO then subtracting DPO.

You can think of the metrics as different clocks tracking the flow of invoices and money around your business: the longer your customers’ clock is running (DSO), the longer they get to enjoy your product without paying; the longer your own product is sitting on a shelf (DIO), the less cash is available to purchase or invest elsewhere; the longer you keep your supplier’s clock running (DPO), the more cash remains in your pocket.

The last number gives you a bit of leverage with your vendors – but credit shouldn’t be stretched for too long. If you are on top of operations, those three numbers could be working in your favor to generate cash.

Five Numbers Every Business Owner Should Watch

To get better visibility of cash flow and avoid a cash crunch, every business owner needs to track five numbers: current cash balance, monthly cash burn, accounts receivable, operating cash flow, and cash runway.

Running your business without this data is like driving a car without knowing the speed limit, and ignoring the signs.

1. Create a list of the inflows to the business each week. Begin with estimated collections based on the cash conversion cycle and the expected payment date for each customer invoice.
2. Create a list of outflows for the business each week. Start with payroll and include other payments to suppliers, collection of taxes, payments against loans, and others.
3. Accounts receivable. You should know the total dollar amount of invoiced sales you have made but not yet collected.
4. Operating cash flow. This is the measure of cash generated by your core business, excluding elements like financing activities and one-time transactions.
5. Cash runway. By understanding both your monthly cash burn and cash balance on hand, this will tell you how many months you could continue to operate your business until you need more cash, assuming expenses remain the same.

It’s smart to review at least these five numbers on a monthly basis.

Tracking, and Frequently Reviewing, Cash Flow

The reason that you want to have good visibility into cash flow has a lot to do with the common ways business owners unfortunately lose control.

For the most part, cash flows leak through your operations when you:

• Delay sending invoices. If you delay invoicing or using collections processes, it could take much longer than expected to collect on the customer’s clock (DSO).
• Let customers dictate credit terms. While it’s tempting to accommodate customers, you still need to maintain healthy cash flow. Giving in to extended credit terms (DSO) to get the sale will have a cascading effect down the cycle.
• Stock up on inventory for no reason. Excessive purchase now means you’ll have to settle for a longer DIO later.
• Hire new people before you have the business to pay them (in both salaries and benefits).
• Lose track of expenses during expansion into a new market or with growing new product lines.

If you want to avoid significant cash-conversion problems, some of these factors should be in check before your annual reviews.

For example, consider a SaaS business that discovered, through detailed review of cash flow records, that the Days Sales Outstanding (DSO) on their product was 90 days. After some digging, they brought in a dedicated collections process and their DSO on invoices went to 40 days pretty quickly.

This improvement had an impact on cash flow for the business that was like getting a funding round, but without anyone having to sell their ownership stake in the company.

The 13-Week Cash Flow Forecast

Let’s say you have constructed a cash-conversion cycle that works for your business, bringing profit and cash together. Now, how do you avoid out-of-cash situations in the future?

For that, you’ll want to use a rolling 13-week cash-flow forecast. This is the best way to master the timing of cash in an ongoing cycle.

Here’s a step-by-step outline of how to complete this type of forecast:

1. Make a list of the funds coming into the business weekly: expected collections (based on the cash conversion cycle and each customer’s expected payment record on outstanding invoices).
2. Compile the list of funds that will be leaving the company each week: payroll and any other items like supplier payments, tax revenue, loan repayments and other expenses.
3. Allocate money to inflow/outflow dates. Move funds in/out of the business into each respective weekly line item.
4. Add the beginning cash balance and estimate of net cash coming in/out for the week. You can then project an ending cash balance fairly ground-up.
5. Repeat. The rolling part means you need to refresh this picture weekly, and it’s easy to get started using cash flow templates.

To Conclude 

With this data constantly updated, you could track down cash-conversion cycle problems down to the week and avoid the unfortunate scenario of being out of cash next month.

It’s important for every business owner to recognize that profit and cash are important but separate metrics – like the scoreboard and the amount of fuel you have in the car.

Moving money in and out of the business on the dates allocated will help you adhere to cash flow requirements. Over time you’ll develop a much greater understanding of how your business performs, and whether you need to make any changes to improve your situation.