By Ghazaleh Lyari
Co-head of Investments – Australian Business Growth Fund
A report by Money.com.au found that even before the impact of COVID, more than half of business owners had foregone or delayed paying themselves an income due to cash flow issues.
Despite cash flow issues being one of the most talked about topics within the SME community, it remains one of the most misunderstood. Businesses run into cash flow problems for a wide variety of reasons – and often, it’s not because they’re unprofitable or underperforming.
As was the case in my own experience, cash flow crises often occur during periods of significant growth. It’s how business owners rise to the challenge that determines how far they can potentially grow into the future.
As an investor at Australian Business Growth Fund, I regularly work with high-growth businesses to identify and mitigate cash flow issues. Here is some food for thought on how high-growth business owners can avoid letting cash flow issues control their future.
One of the biggest misconceptions about cash flow is that it’s a static number. When asked about their cash flow, many business owners respond with how much money they have in the bank at that moment, instead of communicating how money moves in and out of their business over a period of time.
Another common misconception is equating cash flow with profit. Many believe if they maintain profitability, they’ll avoid cash flow issues. But the reality is that highly profitable businesses run into cash flow issues too, especially if they’re growing too quickly to keep pace with their working capital requirements.
Mastering your cash flow means having a complete picture of the timing and magnitude of the business’s working capital requirements, whether you have sufficient funds to meet all of your obligations, and how you plan to finance future challenges and opportunities.
Over time, businesses who don’t effectively manage their cash flow end up operating in a reactive manner. Cash crunches limit your ability to step back and take a long-term view of the business. It’s challenging to focus on strategic initiatives and investing in the future when your time and energy is spent on putting out fires and worrying about upcoming payment obligations.
It’s common for small businesses to outsource parts of their finance function – most often payroll and accounting. But where many growing businesses go wrong is failing to strengthen their in-house financial control and planning capabilities early enough in their journey. As a result, they lack strategic oversight of their finances at critical moments.
Having a skilled finance team in-house is important to ensuring good financial management, control, and planning. A capable financial controller or CFO can help you implement better controls over cash flow and put the potential cash flow implications of the business’s longer term and strategic projects into context.
When you are clear on how much money is required to implement your key initiatives and how much you expect to generate from those projects, you can identify and ward off potential issues in advance and prepare for the ups and downs of your cash flow cycle.
I recently came across a highly profitable business that was scrambling for short term funding with an equipment buy-back obligation looming in the horizon. With few options under time pressure, the business owner opted to take an offer to sell a portion of the business at a low valuation in order to remedy its short-term cash flow crunch. This was an unfortunate outcome for a company that was on a high growth trajectory and it could have been avoided with more planning.
While it’s not critical for business owners to understand the fine details of financial management and accounting, it is important to have your finger on the financial pulse of the business. Ensure there is in-house capability for financial control and management and rely on your CFO/Financial controller to provide you with key information and regular reports that enable your understanding of how business performance is tracking against targets.
Poor cash flow could also be indicative of poor capitalisation of a business. This is especially true for fast growth businesses with growing working capital requirements. It’s prudent to plan early and identify various sources of capital (equity, short and long term debt, etc.) that best meet the business needs, and the owners’ preferences.
For business owners looking to get a better grasp on the numbers and the financial health of their business, these three key metrics are a good place to start.
When evaluating the financial health of a business, investors seek to understand its ‘working capital cycle’. This cycle is made up of three parts:
Inventory days How long the company sits on its inventory
Debtors days How long it takes the company to collect cash from its customers
Creditors days How long the company takes to pay for goods and services it receives from suppliers
Once you know these answers, your working capital cycle is a simple equation: (Inventory days + debtors days) – (creditors days)
Working out the difference between the sum of your Inventory and Debtor days and your Creditor Days reveals the gap between cash leaving and coming in. A large gap, or a working capital cycle that is increasing over time, may indicate a cash flow crisis on the horizon.
A key metric in assessing your business’s financial performance is the business’s ability to generate Free Cash Flow (FCF). FCF is the cash that the business generates from its operating activities, after taking into account capital expenditures (CAPEX). This measure identifies your business’s ability to generate positive cash flow from its products and services and helps you understand its true profitability.
FCF is typically expressed as:
FCF = Operating Cash Flow – Capital Expenditures
If money is tied up in outstanding accounts receivable, overstocked inventory, or high CAPEX, you might run into liquidity issues, even if you’re generating large profits.
Another useful metric to consider is your business’s debt service coverage ratio (DSCR). DSCR is a measure of the business’s ability to meet its short-term debt obligations. The ratio shows the company’s earnings as a multiple of its debt obligations due within one year.
Debt Service Coverage Ratio = Net Operating Income / Short-Term Debt Obligations
(also referred to as “Debt Service”)
A DSCR of less than 1 means a business might not be able to cover its debt obligations without additional sources capital injection (equity/debt).
Cash flow issues can stop a profitable, growing business in its tracks and impact its future longevity and prosperity. But with accurate financial information, planning and support, the business owners can take control of the business’s financial future.
At the Australian Business Growth Fund™, we provide long-term growth capital to enable SMEs to scale without giving up control of their business. Start the conversation with us today.