Basic business principles - Profit shows direction, but cashflow can kill.

[Dave A]

Profit tells you where you are going, but businesses fail because they run out of money. It is entirely possible for a business to fail despite never showing a loss.

When you get down to it, businesses are forced to close because they can't pay their bills. Now posting a loss generally isn't going to help your cashflow in the long term, so let's try to keep that bottom line up. But there are other ways to run into trouble too.

To get a better grip on this, let's divide businesses into two broad categories - cashflow positive and cashflow negative. In a cashflow positive business you tend to get paid before you have to pay out the expenses. In a cashflow negative business, you tend to have to pay your expenses before you get paid by your clients.

The easiest way to calculate which side of the line you are on is to relate the size of your debtors and creditors ledgers in relation to your turnover and expenses.

Cashflow negative.
If your monthly turnover is R100 000.00 per month and your debtors ledger is at R200 000.00, you are being paid (on average) at 60 days.

If your monthly expenses are R90 000.00 per month and your creditors ledger is at R90 000.00, you are paying (on average) at 30 days. This would be a cashflow negative business. The business is financing that gap of R110 000.00 out of working capital. Either from owner capital or by overdraft. The profit margin is 10%.

The problem
To clearly illustrate the problem here, imagine for a moment that the business doubles in a year.

Turnover goes to R200 000 per month, debtors to R400 000.00, expenses to R180 000 per month, creditors to R180 000. The business is financing the gap of R220 000 - an increase of R110 000.00 for working capital.

Let's look at what has happened to profit. It's moved from R10 000.00 per month to R20 000.00 per month - on average an increase of R5 000 per month or R60 000.00 for the year.

But that extra R60 000.00 profit has cost you R110 000 in capital. And let's assume that we're talking after tax profit and there have been no other capital demands on your growth.

Where are you going to find that extra R50 000.00?

[Marq]

Phasing of cashflows

Where are you going to find that extra R50 000.00?

I shouldn't have to find anything extra besides the initial outlay of starting this business - which in this case should be R90,000.

The working capital shortfall is a one-off as the business starts - the longer this cycle the more chance of failure - but by month three in the example I would have a monthly positive cashflow of R10,000 a month and by the end of year one, (calculations willing) a positive cashflow of R10,000 for the year. Year two comes along and by the end of year two I should have R140,000 in the bank. Profits for the two years would be R360,000 less the cashflow of R140,000 = shortfall or working capital balance of R220,000. Generally one cannot avoid this - your cash will be tied up in debtors or stocks and is the basic cost of ensuring ongoing business. So there is a negative cashflow in the beginning, (you have a great business if this is not the case) but it should turn around and as one manages the business and becomes trusted and well known, there should be a change to match the variable expense cash outflows with the debtor book inflow inflows and so improve the working capital position.

Expenses should also have a fixed portion in them, so the expenses would not just double - take out the fixed portion and calculate a gross profit and then work with that. This will give you a greater overall profit percentage and a resulting greater cashflow.

If one takes the example further and assumes a gp% of say 55% - then by the end of year two I should have in the region of R1,5 mil in the bank and now I am in business.

[Dave A]

I'm so glad we've got you around, Marq. Actually, I'm trying to get a better handle on this very thing at the moment.

I'm looking particularly at the continuous sustainable growth scenario. What messes things up is that not all the generated profit is available for allocation against working capital.

The key to my mind is to have a profit margin that makes the working capital increases self financing. I've attached a spreadsheet with 3 examples, and you can play with the blue numbers to see the effects.

Hopefully I've got the concept right. Improvements/suggestions welcome.
Maybe we can build a useful tool out of this.

Note: For those not used to zip files - click on the file below, save on your computer, right-click and select Extract all. This should give you an Excel spreadsheet to play with.

[Marq]

gross profit?

Good stuff -I like the model idea to help us understand what we are talking about.

I dont know why the gross profit for the year is the monthly number X 6 - s/b12??

Then I am also not quite sure what your objective is here?

profit margin that makes the working capital increases self financing

If the example has a growth through a predetermined percentage turnover number then the working capital will be a balancing number. If we work from the working capital side using the additional cash generated and you want a percentage of that to generate turnover and grow the business from that angle then we look at it from the balance sheet side. (This is what I assume you are after). I think it could get complicated if we tackle it from both sides.

Hopefully I have not confused the whole issue and put you back to square one.

[Dave A]

Good stuff -I like the model idea to help us understand what we are talking about.

I dont know why the gross profit for the year is the monthly number X 6 - s/b12??

I've split the profit into two parts - what you get from the base income at the beginning of the financial year, and what you get from the growth - and then add the two. I'm assuming straight line growth for the year (it's fiddly enough as it is), which means the profit for the year on the growth portion would be (increase in monthly profit over year)*12/2 - the x6 multiplier for the growth portion is thus a short cut.

If the example has a growth through a predetermined percentage turnover number then the working capital will be a balancing number. If we work from the working capital side using the additional cash generated and you want a percentage of that to generate turnover and grow the business from that angle then we look at it from the balance sheet side. (This is what I assume you are after). I think it could get complicated if we tackle it from both sides.

What I'm suggesting is we set a budget for financing working capital growth, just as we do with everything else, instead of trying to do it out of spare profit we forgot to spend. I think when faced with a healthy profit we start thinking of tangibles - cars, boats, travel and capital equipment - without thinking we need to leave some money in the business to cover next year's growth. As the spreadsheet shows, it's a problem that can kinda sneak up on you, but can mushroom dramatically.

The goal could be to get that last number to 0. Or you could view it as distributable reserves/available for dividends? We could add another column for dividends, then you could plan that 5 years ahead too.

Ultimately, the idea is to be able to punch in your actual numbers from eofy and be able to get a clear idea of a target for affordable growth given the dynamics of your business.

This one isn't done yet, but I think the next tool to develop needs to give insight on identifying and managing affordable capital expenditure targets.

[Dave A]

I'm toying around with the idea of developing a cashflow planner tool with a few options. Most financial programs have a pretty good cashflow forecast tool, but it deals with short term cashflow predictions.

I'm looking more at the kind of issue that has been discussed above.

My thought right now is that it should have an area where you can punch in the critical info from the previous two financial years, and then the tool produces a long range forecast based on the trends that show up from those figures. From there you will be able to tweak some of the numbers to see the effect it will have on your business.

Any ideas/suggestions? What woulld you like to see?

[duncan drennan]

waterall forecast

Not quite the same thing, but maybe a useful tool to use in conjunction is a waterfall forecast which I picked up from Guy Kawasaki's blog on profections which linked through to an article on Redeye VC.

Here is an example

[Dave A]

Hmm. More food for thought. Maybe we need to scrounge around to see what existing tools are out there. I might be re-inventing the wheel. That said, it is certainly working on my understanding of related concepts to build something from the ground up...

I've got the idea of trying to build something that does the business equivalent of a medical check-up, and gives you the power to look at the effects of various business goal decisions.

[duncan drennan]

Reinventing the wheel might not always be productive from a direct output perspective (you just get another wheel), but it can be excellent from an internalisation and development perspective. Sometimes you can't build a better wheel without figuring out how to make a circle yourself.

[Dave A]

Which about sums up my dilemma - time invested vs improved understanding vs other demands. But that be life

[duncan drennan]

Which about sums up my dilemma - time invested vs improved understanding vs other demands. But that be life

The great entrepreneurial conundrum

[Marq]

Unfortunately my - Other Demands at moment > Time available < Need to help get this in place. Might see a gap next next week only.

Will have a go at looking for software (there must be stuff out there already) or build model (if we cannot find) - as soon as my schedule slackens (doubtful given that we are about to go into mad season time.)

[Dave A]

At the moment my theory is that the world has gone just a little mad.

We're either running around like lunatics so that we can get everything finished before the festive season "shutdown", or we're running around like lunatics preparing for the festive season rush.

Keeping my staff's eye on the ball is proving a little tricky right now. I think I've got more disciplinaries lined up this week than I've had for the rest of the year. Yo ho ho

Heck, if we tackle it once the lunacy has subsided a bit - no biggie I reckon. I think it's something that will evolve anyway. Not looking for an overnight solution.

[Candy Bouwer]

Good Luck..Dragon Slayer

[ProValue]

Financial Planning Tool

Hi Dave

Contact me and I will forward you a generic financial business planning tool in Excel that, if acceptable, you are welcome to make available for download to whoever may require it. Nothing fancy, but it should do the job.

Reports covered:
- Income statement
- Balance sheet
- Cash flow
- Capital expenditure
- Detail of accounts (fixed assets, stock, debtors, creditors, bank, etc)

Periods covered:
- Year 1 (12 months)
- Year 2 (4 quarters)
- Year 3 (full year)
- Year 4 (full year)
- Year 5 (full year)

Contact me in case you require formulae to be changed.

Trust it will be useful.

ProValue