April 2009  

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“We listened to what our customers wanted and acted on what they said. Good things happen when you pay attention.”

-John F. Smith

"We will open the book. Its pages are blank. We are going to put words on them ourselves. The book is called Opportunity and its first chapter is New Year's Day."
-Edith Lovejoy   Pierce

"We know what happens to people who stay in the middle of the road. They get run over."
-Aneurin Bevan


Manage Right and Steer Clear
of the Perfect Storm - Part I

Remember the movie The Perfect Storm? The one where all the weather conditions aligned to create the optimum conditions for the biggest storm in 100 years? Picture the monster waves, the howling winds, and the storm-tossed ship. Well, I'm here to tell you that you might have the perfect conditions in your business to create your very own 100 year storm. It's called a cash crisis and it's nastier than any movie N'Wester you've ever experienced.

If you've ever reached the end of the month and seen a decent profit on your P&L only to find you have no money in the bank account you know what I mean. If you've ever neared year's end only to find the same thing, you really know what I'm talking about. Scrambling to make payroll, missing loan payments, and drawing out vendors are a few of the more telling symptoms.

We talk a lot about this issue in our Profit Mastery Workshops because it's such a big challenge for most of the business owners we know. 

Many businesses are especially hard hit because of the three "biggies" that, if not managed correctly, can create the "perfect storm" leading to a cash flow crisis. They are: inventory, receivables, and a seasonal sales cycle.

To see how inventory and receivables can impact cash, take a look at one of our favorite diagrams from our Profit Mastery course - the working capital cycle:

Here's how the cycle works: we start out with cash and purchase some inventory (in some of your cases, lots of inventory). We then turn loose our crack sales force who sell the inventory, and every once in a while we hear those two dreaded words in business - "charge it" or "bill me" - and an account receivable is created. For those of you who don't sell on account, congratulations, you just passed go and collected your sales dollars immediately. For those unfortunate others, don't worry! I'm sure your collection department efficiently collects the payments due and you are back to cash again – cash to purchase new inventory and a little left over to do some other things in the business, like pay rent, make payroll, etc.

The working capital cycle is a key measure of your efficiency as a business owner. Every business owner needs to know what drives the cycle in their business, and what sucks cash out of the cycle. Managing the cycle more efficiently (like making it turn faster) will generate more cash and reduce the level of bank loans (and vendor payables) needed to supplement our working capital. In short, the cycle becomes a nice life preserver to keep us afloat when the squalls hit.

Manage the cycle less efficiently (or not at all) at your own peril, as it becomes a lead weight around the life of your business that will drag it down.

Ok, enough of the storm analogy for now. How do we know we're doing a good job as cash managers? Besides having a nice wad of cash in the bank, we have a few good ways of measuring our effectiveness. They're called benchmark ratios, and in this case they're called, not surprisingly, Cash Flow Ratios. This is an area in which all of our FIT Performance Group members set specific goals and assess their progress on a regular basis.

Specifically, these benchmarks include Inventory Turnover, Accounts Receivable Turnover, and Accounts Payable Turnover.

I'll review Inventory Turnover, as one example using our friend John Thomas as example. Inventory Turns (Cost of Goods Sold divided by Inventory) measures the rate at which inventory is sold. While his industry peers turned their inventory in 211 days, it took John 288 days to turn his inventory. To find out why this 77-day difference is so crucial to his cash situation, let's do an analysis:    


Inventory Turns

Inventory Days

John Thomas Inc.



Industry Peers





77 days

If we know the formula for inventory turnover which is the rate at which inventory is sold on an annual basis, we can use these numbers to find out what the inventory savings would be if John could turn his inventory more efficiently.

Inventory Turnover  =  Cost of Goods Sold/Inventory
=  $795,000 ÷ $636,000
=  1.25 turns per year
=  360 ÷ 1.25
=  288 days

Then we can re-arrange the formula like this:
Inventory =  Cost of Goods Sold ÷ Inventory Turnover

Now we add "Target" to both sides of the equation:
Target Inventory =  Cost of Goods Sold ÷ Target Inventory Turnover
=  $795,000 ÷ 1.70*
=  $467,647

*The target is the rate at which industry peers are turning their inventory



Inventory at 1.25 Turns   $636,000
Inventory at 1.70 Turns   -$467,647
Equals "Inventory Savings"   $168,353


Whoa. That's a whopping chunk of money! If it weren't there in his inventory it would be available to John as much needed cash. Furthermore, when you take the  $168,353 excess inventory and divide it by the 77 days he lets his inventory sit around, you get about $2,200 for every day it sits in his cases. Kind of gives the phrase, "What A Difference A Day Makes" new meaning doesn't it?  This is criminal when you think of the ways you (oops, I mean John) could have used that cash in his business (such as taking discounts from his vendors or paying off his credit line and avoiding extra interest - or maybe even putting money in his own pocket!

You can do the same analysis using Accounts Receivable Turns to see how much you have sitting your customers' pockets that should be in your bank account.

But up to this point, we've just been looking at past history, the "back of the boat" so to speak, to get back to our nautical analogy. How do we steer clear of impending storms created by our seasonal sales cycles? By looking out the bow. In his case, we need to focus on the future and start asking the questions, "Where are we going?" and "What if?"

Stayed tuned for next month: 

Cash Crisis: Manage Right and Steer Clear of the Perfect Storm, Part II. In this article, I'll walk you through why profits don't always equal cash, and how to make plans in advance for required funds using a profit plan and cash budget.


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