What most small family businesses are doing wrong when it comes to managing cash and working capital
I’ve been having a lot of calls with small businesses over the last two months and thought it would be beneficial to share with you some of the questions I’m receiving and recommendations I’m making. Many of these discussions focus on cash flow and in particular, ensuring cash is forecast accurately for purchasing purposes. When a small business doesn’t know its future cash flow, it can’t purchase effectively and when it can’t purchase effectively, it can’t grow intentionally.
Here are some fundamental questions to ask and answer.
What do you look at when a business’ working capital cycle is too long?
Carl: “When I go into a business and the working capital cycle is too long, what I typically do is I focus on three (3) key metrics. Days sales outstanding days payable outstanding and days inventory outstanding, abbreviated by DSO, DPO, and DIO. Days sales outstanding basically measures the amount of time between executing a sale and the amount of time that it takes to bring cash in from that sale. Days payable outstanding is the amount of time that it takes to bring cash in or to pay cash after you actually purchase raw material from a vendor. Days inventory outstanding is the amount of time that it actually takes to turn inventory in your warehouse. All three of these metrics should be looked at individually to see how you can bring cash in more quickly, delay cash out to your vendors, without disturbing the relationships that you have, and turning inventory in your warehouse a bit more quickly. All three of them independently warrant attention, but together, all three of them directly influence your working capital cycle.”
What are the key challenges and roadblocks I see in small, family-owned businesses?
Carl: “Many of the challenges and roadblocks that I see many businesses are encountering revolve around three key areas in finance.
The first relates to cash flow. Many businesses take a very short term look at cash flow, and don't have a great grasp around what the key activities of the business are, how they impact cash on a weekly, monthly, yearly basis. So many companies are looking at cash just simply a cash balance every week or two, it's much more important for businesses to focus on cash flow, and cash balances over a much longer period of time.
So what I typically recommend to businesses who are concerned about cash, or may not even be concerned about cash, is to understand what the business looks like, at a cash level for the next four weeks, eight weeks, 13 weeks, which is one quarter of the year. Sometimes I recommend even going out to 26 weeks or 52 weeks of the entire year to understand how sales bring cash into the business, how seasonal fluctuations take place, and how they need to be managing their people, their processes and their production in order to make sure that cash is sustainable in the long period.
The second area that many companies need to focus on is actually in sales forecasting. Many businesses have a target sales number that they're aiming for. But they don't really know what goes into that number. It's important for the businesses to understand what products what services, what volume, what prices, how this is going to be changing over the year, over various months, and how to manage relationships with customers and with vendors. It's very important to go into a very significant level of detail and granularity to understand how various metrics influenced the sales over a certain period of time.
The third and final area that many businesses should be focusing on is customer and product and geographic profitability. So while many companies are pursuing robust sales strategies, they don't necessarily have a good grasp as to which are their best products, who are their best customers, and what are their best markets. So it's important for the companies to be able to go out there and understand what are truly their core businesses. What are their true core customers, and products, and services that they should be pursuing?”
Final Thoughts
You don’t need to dive into excruciating detail to understand you cash flows. That’s unnecessary, it’s time consuming, and it distracts you from understanding what’s important. Instead, you need to understand the key drivers of the business, what they mean for billings, collections, costs/expenses, and payments. When you understand those drivers, you can then treat them as levers that can be influenced. Recognize that’s not just a cash flow exercise -- it helps you better understand the assumptions behind your business decisions.