Why is Cash flow so very important?
Many enterprises try to take good care of customers and employees but often fail to take good care of cash flow. In some organizations, the receivables run into more than 90 days. As a rule of the thumb, any receivable above 120 days can be classified as a doubtful debt. This problem is more in the case of SMEs and organizations that compete on low prices. I have often found many sales people shy to ask for the payment after supplying the material or providing the service. I have even found some of them apologetic and afraid to ask for it, which is amazing.
I must add here that if a vendor does not ask for money and keeps giving credit, something is fishy. A good business must keep an eye on sundry creditors list too and how the cash flow is utilized. It is the cry babies that get milk. One of my Kenyan clients, a bottler, was buying bottles regularly from a supplier. With this client the problem was that some raw material was always not available in stock because of erratic cash flow. The worst part was when everything else was available, the required bottles would not be available in stock. At the same time, they carried hundreds of thousands of non fast moving bottles of various sizes in stock which were not required immediately. The production plan was to be altered to suit what is available in stock rather than what was required by sales. It happened too frequently for comfort.
I then carried out an analysis and found that the vendor did not keep up with the schedule and was sending what was available in his stock rather than what was required by the client. They depended on a single vendor and because of large payments due, they were on the defensive all the time and could not reject the consignment, as they were taking delivery at vendor's works. The orders were being placed orally and on telephone by an assistant to the Production Director. The vendor cleverly mixed the required and not required items. I insisted that they identify minimum two vendors for all items and place written orders. Later it was found that the price could be reduced by as much as 20%, if they had paid within 60 days. The vendor was padding more than the extra financing costs into his product. No wonder he was keeping quiet. There were other production problems but all of them because of inadequate cash flow. To cut the long story short, you must collect your receivables and pay your payables in time if you want to be healthy in business.
If a company has positive cash flow, then there is no problem except to identify where to invest the excess cash surplus. You must ensure that the investment can be quickly encashed when necessary. In the case of negative cash flow, the problem is very serious. You can't pay the bills and wages in time. You may not be able to borrow beyond a certain limit. One starts borrowing from Peter to pay Paul at higher interest rates. Soon the whole world comes to know about it.
Ultimately, one goes broke. The major cause for bankruptcy is inadequate cash flow rather than a loss in operations.
However, negative cash flow doesn't necessarily mean disaster or mismanagement. A rapidly expanding company will require large cash flows to finance new projects, R&D and other investments. Some companies have seasonal cash flow. In lean periods such companies may not have adequate cash flow. The main danger is when the short term borrowings or current liabilities become too high to be met by current assets. That is the current ratio will be below 1. Such companies are 'Technically Insolvent', even though they may be making profits on paper. Many good companies do prepare a projected cash flow statement and compare them with actual cash flow but it is largely said than done.
Gross cash flow (GCF) means depreciation plus whatever is left from the net surplus after paying dividends. It represents the internally generated funds to meet future commitments. It must be high and rising all the time. Depreciation is a large chunk of this money and companies must refrain from the temptation of putting it to use for working capital needs. It must be used for improvements and modernization of plant and machinery. Most SMEs use it up in day to day operations and do not have the funds available when they really want to expand or modernize.
Discounted Cash Flow This is a sophisticated method but simply put it shows the value of money invested after some period. It is mostly used in investment analysis of capital projects. You prepare a cash flow statement say for the next 5 years. You assume that the interest rate will be averaging 10%. You must discount the projected cash flow appropriately. That is at the end of the first year, the one dollar you invested is worth 0.9091; in the second year it is worth 0.8264; in the third year it is worth 0.7513 and so on. The values at the end of each year are called PV - Present value. Add up all the PVs and subtract it from the initial investment and you have the NPV at the end of the projected period. DCF is a useful tool but should be used along with other tools like ROCE and payback.
Debt-Equity Ratio The portion of medium and long term debt to shareholder's equity fund represents this ratio. It is one of the very important statistics most investors and bankers look for in a balance sheet. It may sound paradoxical but use of debt properly carried out contributes to the growth of an enterprise.
The only question is how much to borrow and take on as debt. Borrowings are not bad per se, if you can pay back the amount with interest from the earnings. You must not get into such a situation when recession strikes. That's what happened to Dotcoms about a decade ago. When companies borrow to the hilt, they end up getting gobbled up by creditors and go into receivership. The first thing a receiver would do is sell off salable assets and try to bring the debt1equity ratio to reasonable and manageable limits. Some companies, if they can, sell ordinary shares to bring the debts down. You must remember that common stocks, also called as ordinary shares, carry no guarantee of any return and carry risks.
Summary & Conclusion Please do not assume that SMEs only have cash flow problems, but it is no doubt, a major problem for them. However, the giant Lockheed Corporation was bailed out by US Government because it went overboard on its Tristar project and Mr. Lee Iacocca was given a loan by the US Government to save Chrysler more than 2 to 3 decades ago. Both became the biggest turnarounds in business history.
I have a senior banker friend who says ' When a small customer takes a loan from a bank, the customer is in trouble. However, when a big customer takes a loan from a bank, the bank is in trouble'. It is true. When big companies end up bankrupt, a high amount of creditor pressure would be there to revive it because a lot of peoples' jobs are at stake. Collapse of big companies becomes a social and sometimes a law and order problem.
There is nothing esoteric about cash flow. It is very simple. You must have a regular and steady income. You must plan and budget your expenses and spend less than your income so that you will always have some reasonable surplus at the end of the day. Unfortunately, to quote Mr.
Robert Heller ' Like good health, a positive cash flow is something you're most aware of when you haven't got it. That is one of the most profound truths in life.
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