Cash Flow is King

Profit dominates business-related headlines. This month, Apple announced the biggest quarterly profit ever made by a public company. Apple reported a net profit of $18bn in its fiscal first quarter, exceeding the $15.9bn made by ExxonMobil in the second quarter of 2012. Net profit after interest and tax, or the ‘bottom line’ (the last line on an income statement), is a key figure for a business. Firms naturally emphasise the ‘bottom line’, because this is the sum available for distribution to the owners of the business – the shareholders.

In the simple income statement for BL below, the ‘top line number’ is the $5 million in total sales.  After deductions are made for cost of goods sold, operating expenses, taxes and depreciation, what is left over on the bottom line of the income statement is $650,000 in net profit.

BL Income Statement Year
Total Sales/Total Revenue 5,000,000
Cost of Goods Sold -2,500,000
Gross Profit 3,000,000
Operating Expenses -2,000,000
Net Income Before Taxes & Depreciation 1,000,000
Taxes -250,000
Depreciation -100,000
Net Profit 650,000

Often, the bottom line becomes an important measure for evaluating corporate decisions.  A manager will ask, “How will this affect the bottom line?”  Obviously, if the action decreases the bottom line, it is deemed to be bad.  If it increases the bottom line, it is considered to be good.

However, the primary reason that new businesses fail is not a lack of profit, but rather that they run out of cash. According to Bloomberg, 8 out of 10 entrepreneurs who start businesses fail within the first 18 months and according to a study by Jessie Hagen of the U.S. Bank, 82% of business failures result from poor cash management, rather than a lack of profitability. Although these numbers are disputed by other commentators, cash flow problems certainly kill businesses that might otherwise survive. Indeed, 70% of businesses, which go bankrupt, are profitable when they close their doors.

A common misconception about cash flow problems is that growth will fix it. However, growth often leads to more cash pressures, especially if a firm reduces prices to increase sales turnover. A study of successful businesses conducted by Geneva Business Bank found that the greatest potential threat to cash flow occurs when a firm is experiencing rapid growth. If sales are up, firms hire more employees, expand capacity, develop new products, increase sales force and customer service staff, build inventory (stocks) and experience other drains on their liquidity. However, collections from the increased sales often lag behind as the firm grows and the result is a liquidity crisis. Unfortunately, many small businesses do not engage in effective cash planning.

There are generally two ways to increase the bottom line. Cutting expenses to improve efficiency is the easiest way, although excessive cuts may eventually reduce productivity. The other way to improve the bottom line is to increase the top line revenue numbers by selling more goods or services, but this can raise operating expenses.

Maintaining a healthy bottom line is a balancing act. Kevin Kaiser and S. David Young surveyed many companies in a recent Harvard Business Review article and found that the traditional business focus on the bottom line, actually ties up working capital, setting managers on a death march towards bankruptcy.

If you focus solely on the bottom line you mismanage your working capital, and you could have way too much money tied up in inventories or receivables,” says Kaiser, “A supplier may lower his price to convince you to buy larger quantities than you need, but that means you have cash tied up in inventories. And the cost of financing those inventories will certainly erode your profit margins.”

We call this the ‘death scenario,’” says Young. “You have a payment coming due in 30 days and you pay it off in 10; you give customers more time to pay and buy huge inventories cheaper. If you actually manage to these ratios, you increase the likelihood that you will fail.”

A simple rule of thumb is that every dollar in inventory is a dollar a firm does not have in cash.

For small firms, cash flow problems are likely to be more acute, because they lack the clout to ensure creditors pay on time and to enforce payment from non-payers. In recessionary times, large firms are constantly examining ways of increasing their profits and improving their cash flows. The methods they use to achieve these aims are often questionable and exploitative and some believe are unethical. For example, Mars Inc recently changed its payment terms from 60 to 120 days and AB InBev, the company that brews Budweiser and Stella Artois, has more than doubled the length of time it takes to pay smaller companies, regularly handing over cash four months after it has received their products and services. Suppliers who resist the new credit terms, risk losing the accounts.

AB InBev defended its new payment practice stating:

Like many other global companies, we review our payment terms and conditions regularly in accordance with good commercial practices and applicable law. Elements that influence the payment terms include price, quality, size of the supplier, type of product/service and volume.

The Federation of Small Business (FSB), which said the brewer along with Heinz, which is reported to have similar payment structure, were examples of companies “tarnished by the way they treat their suppliers”. Mike Cherry, FSB national policy chairman, said: “No-one should expect to wait four months to get paid, not least smaller companies that simply cannot absorb the impact these terms have on their cash flow.”

Alternatively, large firms are increasingly making demands on suppliers for payments to retain their position on the shelves, or to fund ‘special promotions’. Premier Foods u-turned on demanding suppliers to make annual cash payments in order to retain their supplier status after it was condemned by the UK Government.

 

IB Style Questions

1. Define the following terms:

  • creditors
  • entrepreneur

2. Explain the reasons for setting up a business.

3. Analyse the advantages and disadvantages of firms acting ethically.

4. Evaluate strategies that small businesses can use to deal with liquidity problems.

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