To be in control of your business, you have to know how much cash you need for every additional dollar in sales
There's a hard lesson we all have to learn when we go into business. The lesson is that you live or die on cash flow. Sales are nice. Profits are even nicer. But it's cash flow that determines whether or not you survive.
Where most first-time entrepreneurs trip up is in failing to understand that more sales almost always mean less cash flow--and less cash flow means trouble.
Believe me, I speak from experience here. I had no concept of the relationship between sales and cash flow when I started my first company. I thought sales were everything. If someone came and offered me a million dollars' worth of new business, my only question was, "When does it start?" I took all the business I could get, as fast as I could get it, and the company grew like crazy. Our sales went from zero to $12.8 million in five years--fast enough to put us on the 1984 Inc. 500 list. We had cash-flow problems all the way, but I didn't focus on them. I was too busy selling.
The whack on the head finally came in the form of a cash crunch that forced me to go without a salary for four straight weeks. My wife was pretty upset. "What do you mean, you can't pay yourself?" she said. "I thought business was fabulous. I thought sales were going through the roof. How can business be so great, and yet you can't bring home any money for four weeks? Explain that to me. It doesn't make sense."
The truth is, I couldn't explain it to her because I didn't understand it myself--but I realized I had better figure it out. Eventually, I did.
What I learned is that you have to look ahead. You have to figure out how you're going to get the cash required to increase your sales at whatever rate you have in mind. If you don't, you run the risk of selling yourself into a corner. I'm talking about losing control of your situation, about decisions being taken away from you, about being forced to do extreme and unwise things just to stay alive.
Going without pay is the least of it. Many people stop paying their withholding taxes, which is not only illegal but stupid. Between interest and penalties, there is no more expensive money in the world. Meanwhile, your creditors are banging on your head because you can't pay your bills in an orderly fashion. It's a nightmare.
So how do you plan for growth? More precisely, how do you determine the amount of additional cash needed to cover new sales? To begin with, you have to ask the right questions about the new business coming in:
1. How much is it and over what time frame?
2. What's the gross margin?
3. How much overhead will you have to add?
4. How long will you have to wait to get paid?
If you know the answers to those four questions, you can make a rough estimate of how much extra cash you'll need.
I'll give you an example. Let's suppose you're anticipating that sales will increase by $100,000 over the next year. You have a gross margin of 30%, and you don't expect it to change because of the new business, but you know you'll have to add $10,000 in overhead--for commissions, bookkeeping, whatever. You further expect your average turnover of accounts receivable (collection time) to hold steady at, say, 60 days.
Here's what you do:
Start by figuring out your cost of goods sold (COGS) on the new business--the amount of money you'll have to lay out to produce or acquire whatever you're selling. Since your gross margin is 30% of sales, your COGS is 70%, or $70,000. Add to that the extra overhead you're going to need--$10,000--and you get $80,000 in new spending to fill $100,000 in new orders. Divide the total by the number of days in the period covered--in this case, 365--and you find out that the new business is costing you $219.18 a day. If you then multiply that number by the number of days it takes you to collect your receivables, you get an idea of your additional cash needs. For safety's sake, I always increase the collection period by 20%, so in this example, I'd multiply by 72 days instead of 60. The result: 72 days x $219.18 a day = $15,781. (You can try out the formula by visiting the " Paying for Growth" worksheet in Inc. Online's Virtual Consultant.)
Understand, this is a rough, down-and-dirty formula. Some people might say it makes a number of dubious assumptions--for instance, that you pay all your own bills at once. But forecasting is inexact by definition. You need some simple tools to guide you. This one allows you to make a reasonable guess about your future cash needs, and it errs on the side of caution, which is always a good idea.
What do you do with the information? You obviously aren't going to turn away good, high-margin business. So you look for ways to generate the additional cash. Maybe you can reduce the collection days on your current accounts. Maybe you can extend your accounts payable by a week or two. Maybe you can make a deal with the new customers to get paid more quickly than usual.
Or maybe you go to your major vendors and say, "Listen, I have great news for both of us. I just landed a new account that's going to bring in a lot more business, but I'll have to pay you in 60 days rather than 40. Can you handle that?" There are very few vendors who would say no.
Of course, as a last resort, you can always borrow the money, if you don't mind increasing your bank debt and adding to your costs. Then again, you may decide it's better to go without salary for a few weeks.
I myself haven't had to take that route in recent years and would prefer to avoid it in the future. I'm sure my wife feels the same way. She likes it when I get paid every week. So do I, for that matter. It gives us both a sense of being in control.
In business, you can't be in control if you aren't on top of your cash flow. That's a lesson worth learning as early as possible.