Improving Cash Flow

On Monday I defined EBITA and provided the foundation to calculate cash flow from operations. Wednesday, we looked at a real life example of a company that had very substantial EBITA ($200,000 on revenues of $1,000,000) but still had negative cash flow (-$235,000).

Our example company was bidding their work with a good gross margin, they were keeping their costs within budget, but they didn’t have enough money to pay all of their trade vendors, employees, and most importantly, themselves. They believed that by working harder and longer hours, more money would “show up” in their bank account. The small business owner was at his wit’s end and ready to throw in the towel.

Fortunately, this business owner made a few changes that changed his attitude and changed his business.

First, he implemented a 13 week rolling cash flow forecast. This enabled him to get a handle on what his future cash receipts would be and how they would be spent in a given week.

Second, he negotiated trade credit with several of his trade suppliers who he had been paying at the time of material delivery. Some of his vendors already gave him 30 day terms. Our business owner was able to negotiate 30 day terms with most of the rest of his significant trade vendors. Over the year he had been in business, he had established good pay histories with the vendors who had initially given him credit and he was able to prove that positive payment history to others.

Third, he went to a local community bank and asked for a working capital line of credit. Though he had a good relationship with this bank and had personally banked there for many years, the bank indicated to him that they were uncomfortable extending credit because the company is in the construction trade. They believed this was a risky industry with the economy turning worse and homebuilding down.

After going to several other banks and being turned down for a line of credit, he went to a commercial finance company that specializes in financing working capital for the construction industry. After submitting an application, providing tax returns and a personal financial statement, the non-bank lender (known as a factoring company) approved our company for a $500,000 line of credit secured by accounts receivable. As our company needed to borrow money, it would sell its invoices to the lender at a discount. The line of credit was self-liquidating, meaning as his customers paid their outstanding invoices the loan balance would decrease. As our company’s revenues increase, so will the outstanding loan balance. The loan balance will track swings in the amount of outstanding accounts receivable.

By having and working with a cash flow forecast on a weekly basis, our small business owner can now manage working capital and only borrow what is necessary to cover a cash flow shortfall that he can anticipate a week or two in advance. In addition, he now has additional trade credit which further reduces the strain on cash. He pays his vendors on time, and now has adequate cash to pay himself regularly.

Our owner is now managing cash rather than letting it manage him.

Monday I will provide links to a number of sample cash flow forecast models and discuss addtional ways to provide working capital.