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How more sales can cause cash flow problems

01 Sep 2008

The age-old question accountants get asked by business clients is “How come I’ve made more profit but I don’t have anymore cash?”

The answer to this question lies in the issue of the ‘cash flow cycle’.  The ‘cash flow cycle’ is an issue often overlooked by small business owners until business starts to grow and they being to experience ‘cash flow squeeze’.

Let me explain how it works.  In the diagram below you can see a timeline of 365 days. 

The diagram shows:

  •     Before you can sell anything you have to buy something (i.e. stock or labour).
  •     Depending on your sales cycle (i.e. how long the stock sits in store), you may hold on to stock for 60 days.
  •     Depending on the terms you get from suppliers, you may have to pay for that stock after 30 days — which means you have 30 days negative cash flow.
  •     Depending on your accounts receivable management you could wait 60 days to get paid— which adds another 60 days negative cash flow.
  •     This adds up to 90 days negative cash flow.

This means your money has been somewhere other than your bank account for 90 days (i.e. in the bank account of your supplier and your customer).  This is referred to as ‘funding the sale’.  This is also known as ‘working capital’ which means that you need to have a certain amount of money to fund sales all the time. 

Why the above causes a problem when growth occurs is because the issue just gets bigger.  If a business isn’t working to minimise the number of days stock is in store and the number of days customers are taking to pay then the problem just gets worse when sales grow.

Sometimes businesses get very focused on increasing sales and the issues of stock movement and accounts receivable get ignored or are not considered worth investing in.  This is why growth can often kill what appears to be a good business. 

A lot happens to cash on its journey from the sale to your bank account.  If you are planning to grow your business, you must understand this phenomenon or you could be heading for problems.   

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