Cash flow vs. profit

As velocity and altitude are typically the two most important gauges for a pilot, for the owner of an SME it is usually profitability and cash flow. Too often, SME owners will neglect cash flow. This may result in the business equivalent of crashing an aircraft. So why is cash flow so important?

Firstly, or perhaps obviously, cash is like the gasoline in an aircraft or automobile. If you run out, you crash. New companies, particularly in the high-tech sector, talk of a “burn rate”: the higher your overheads, the faster you run out of gas, the faster you must either reach cash break-even or get a cash infusion, or else crash.

Second, many businesses are seasonal. Even though they may be highly profitable, they may require huge amounts of cash at certain types of year (e.g., when inventories and receivables need to be accumulated), and throw off huge amounts of cash at other times of the year (e.g., when inventory and receivables might be declining). The cash flow in seasonally positive months may easily give a false sense of security. Like a predator in the jungle that must ensure it has enough energy to make it to the next “kill,” the SME owner must ensure that there is enough cash even in the good months to make it through the entire cycle.

Third, cash is also a buffer that protects a business in the event of a downturn. If the bottom falls out of the economy -- and your company's sales -- your cash buffer will determine how long you can survive or if you can survive at all until your sales pick up again. Deceptively, many businesses with cyclically declining sales are cash flow positive; as receivables diminish, they are turned into cash. Such businesses survive a downturn very well, only to hit a wall when they are recovering at the moment receivables once again begin to accumulate.

Fourth, cash flows may be strained whenever there is a capital investment program. Will your business have enough gasoline to not only make it through the capital investment program, but also the increase in sales required to pay off any bank loans, etc., associated with the investment? One of my clients entered into a 10 million euros investment and expansion program, only to find out that the expected revenues from the expansion did not materialize due to the recent recession. It helps to make an analysis beforehand.

Finally, banks usually monitor cash flow, and will often prescribe cash flow coverage ratios (e.g., cash flow during any given period must be a minimum of X times interest, or Y times principal and interest).

One of the most important exercises that the chief financial officer (CFO) or financial manager should do is making a Profit & Loss/Cash Flow Statement. This is vastly superior to the “back of the envelope” liquidity calculations that most SMEs employ. Generally, an excel spreadsheet will suffice, and it is not difficult to create a spreadsheet that will give you both P&L and cash flow statements. Make the statement as “granular” as you require the information -- weekly, monthly or quarterly, and for as far into the future as you deem necessary: a minimum of one year, but one for multiple years is also possible.

This type of forecast should not be made annually and then forgotten until the following year. Rather, it should be a “living” document, updated periodically to reflect up-to-date information. It may also be used for sensitivity analysis: “what if” decisions. What if the company were to engage in a new investment? What if the company were to open a new office? What if the company were to develop on a new product line? Or open a new store? All of these “what if” decisions may be quantified. And not only will the owners and management of the business be able to ascertain whether such decisions will crash the business or not from a cash flow perspective, if one uses the cash flow forecast to calculate Net Present Value, one may also ascertain whether the decision is accretive to the value of the business, or diminishes its value.

Performing this type of analysis regularly is an important step forward in the corporate governance of a company. The vast majority of investors will require this type of information. You might say that it is the business equivalent of moving from Visual Flight Rules (VFR) to Instrument Flight Rules (IFR), which allows pilots to fly through fog or at night. It may be an important step in leaving behind “crisis management,” to building a real company.

Les Nemethy is CEO of Euro-Phoenix Financial Advisors Ltd. (www.europhoenix.com), a Central European corporate finance company focused on mergers & acquisitions. He is the author of “Business Exit Planning,” published by John Wiley & Sons.