Growth and profitability. Most entrepreneurs consider these to be the holy grail of business ownership. So it’s not too surprising that many participants in the financial workshops I lead are surprised when I tell them that instant profits and rapid growth aren’t necessarily a cause for celebration.
How can that be, you may wonder. The best way to explain it is to tell the story of Wonder Widget Co. Haven’t heard of it? That’s because I made up the company to help me explain business financial concepts in an easy-to-understand way.
Hot New Launch
Wonder Widget Co. launched last year with $100,000 in cash and the hottest new product in its market, the amazing Wonder Widget. It was so popular that the owners had sales and profits in their very first month of operations. So they quickly leased and outfitted a factory with production equipment and furnishings (all with minimal initial cash outlay), bought materials, hired workers, and manufactured and shipped widgets. Then they mailed invoices totaling $50,000 to customers in the first month. Amazing!
They paid their bills as they came due and collected from customers in the normal course of doing business. Meanwhile, sales continued to grow, increasing by $50,000 every month with no decline in margins and no serious competition. Profits climbed without pause.
But a funny thing happened on the way to the bank: The owners were shocked to find that they didn’t have enough cash to pay their bills. Soon they couldn’t buy any more raw materials to manufacture Wonder Widgets or make payroll. Instantly profitable Wonder Widget Co. was insolvent six months after it opened its doors.
On the surface, it’s hard to see how something like this could happen to a profitable and growing business. But when you dig a little deeper, it becomes clear that there’s a whole lot more to running a successful business than just profits and growth: namely, cash flow.
The Cash Flow Cycle
This is the lag that exists between the time when cash is paid out by the business for things like equipment, raw materials, and salaries and the time when accounts receivable are collected. In manufacturing, the cycle usually consists of converting cash into raw materials, finished goods, receivables, and then back to cash again.
At the beginning of the cash flow cycle, nearly every business starts out with — you guessed it — cash. But from that point on, the central purpose of the business is to convert that cash into other kinds of assets or to leverage or extend it with liabilities and ultimately turn it back into cash again — but, this time, more cash than the business started with. This process continues repeatedly throughout the life of a business.
When Wonder Widget Co. started, its first activities revolved around setup: renting facilities, getting phones and utilities installed, etc. At the same time, it was purchasing assets so it could begin operations. These included office equipment, computers, and the like. Of course, the company also needed employees to answer the phones, run the office, and produce and sell Wonder Widgets. The owners financed some of these costs but obtained credit via bank loans to cover most of them.
With all this in place, the company was ready to begin production: the manufacture of Wonder Widgets. Unfortunately, this process consumed even more cash: wages, taxes, sales and marketing, more raw materials, and so on. In fact, this is the period of greatest cash consumption for most companies, as they are in full production mode but have no cash coming in yet.
Finally, Wonder Widget was ready to sell its products and begin the process of recovering all the cash it had been spending (or investing) in the business. But while sales were brisk, they were made on “net-30” day terms, which means the company didn’t actually receive cash from the sales for another 30 to 45 days at best.
To add to the challenge, growing sales meant the company had to buy more raw materials for subsequent production runs than for its initial run. Since Wonder Widget was selling more each month than in the prior month, it needed to not only replace inventories consumed but to also buy additional goods to satisfy growing sales demand. Purchases can actually exceed sales in such a fast-growing environment.
Collections are the final step in the process. While this might seem like a minor activity in comparison to production or sales, it’s actually the most critical task in making every other step pay off. Unfortunately, it’s the step that many businesses, including Wonder Widget, neglect — and that leads to their demise.
Don’t Give It Away
Are you starting to see how Wonder Widget failed despite having strong profits and sales right out of the gate? Nolan Bushnell, the founder of Atari and Chuck E. Cheese’s, put it this way: A sale is a gift to the customer until the money is in the bank. Collections is the final step that turns the entire effort back into cash again.
There are three key takeaways from this story:
- Rapid growth is a double-edged sword. Fast-growing companies need more working capital than those growing slowly or not at all. When incoming cash flow is delayed while fixed costs continue and paydays come every week, there’s a limit to how long a company can operate, even if it’s profitable.
- Cash flow needs must be forecast months in advance. This is critical during the early months of a startup. And cash flow results must be tracked separately from profits.
- Business goes with the flow. The health of a business depends on the health of its cash flow. As Wonder Widget Co. makes clear, more businesses fail due to a lack of cash flow than a lack of profits.
Gene Siciliano is an author, speaker, and financial consultant who works with chief executive officers and managers to achieve greater financial success in a dramatically changing economy. He is Your CFO for Rent and president of Western Management Associates. His book Finance for Non-Financial Managers is available in bookstores and online.