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Cash Flow, Not Profit, Is Real Secret of Business Success

November 04, 1998|JUAN HOVEY

When you start a business, you play a game against big odds. Most businesses fail--and soon.

But the difference between success and failure has only partly to do with whether people buy what you sell. Similarly, it has only partly to do with your balance sheet or your profit-and-loss statement.

It has a great deal to do with cash flow. If you understand your cash flow, you position yourself to make the most of your battle against the odds. If you don't, you march with those whose dreams crash when their businesses do.

It is particularly important to understand cash flow just now, as the turmoil in the world's financial markets makes investment capital and even ordinary bank credit harder to come by. The turmoil has destroyed great piles of wealth, squeezing the supply of capital and forcing the business owner to make the most of cash, not to spur growth but just to stay alive.

In plain English, the turmoil makes it imperative to manage your cash flow so that your business may weather the storm in the financial markets--and prosper when better times come.

"Cash is the lifeblood of the firm, not profit," says Alan Lewis, assistant dean of the A. Gary Anderson Graduate School of Business at UC Riverside. Himself an entrepreneur and former corporate executive, Lewis led a seminar on the importance of cash flow at the recent Los Angeles Times Small Business Strategies Conference.

"Cash is the source of the energy of the business, and the business owner needs to know how to maintain it."

Predicting the Cycle of Payments and Sales

Over time, cash flows in and out of any business, Lewis says, but it comes and goes at different times. If you can understand the ebb and flow of cash--if you can predict when you may expect cash to flow into your coffers and when it must flow out--you can manage the process to your advantage.

The object, Lewis adds, is to speed the inflow and slow the outgo.

Where do you start?

Your first task is to draw a timeline projecting sales over the coming year, Lewis says. You want to know when to expect people to buy your goods or services in the future--and you make this prediction by studying your customers' habits in the past.

If, for example, you sell ice cream, your sales peak in the summer and dip in winter. If you rent ski equipment, the pattern goes the other way. Either way, your timeline shows when you may expect to ring up sales over the coming year.

Next you draw another timeline showing actual cash receipts, as distinct from sales, over the same year, Lewis says. If you sell ice cream in a retail outlet, cash flows into your coffers on the same day that your goods go out the door. If you sell ice cream wholesale, you wait 30, maybe 60 days for payment. If skiers rent your equipment with credit cards, you wait a week, at most, for your cash.

You analyze outgo in the same way, drawing a third timeline showing when you must pay for materials, labor, overhead and other items.

In the examples above, the retailer of ice cream might pay for materials--that is, for bulk orders of ice cream--on 30-day terms. Thus he or she cuts a check Nov. 1 for deliveries made during September. On the same date, the retailer makes payroll and pays the rent and the utility and phone companies.

Making Plans to Save or Borrow

The wholesaler of ice cream, on the other hand, pays for the materials used to make September's deliveries of ice cream on Oct. 1--that is, 30 days before payment comes from the retailer for the same goods. Similarly, the renter of ski equipment pays for boots, skis and poles long before he or she can expect income from skiers.

Why is this important?

"This knowledge of the past allows you to anticipate the future," Lewis says. "If you know ahead of time when you will need cash--and when you can expect to receive it--you can lay the groundwork to go out and get it."

If you see, for example, that you pay a series of big invoices in the first month of every quarter, you have two choices: Save up during the preceding quarter, or tap your banker for a line of credit.

In either case, knowing what you need allows you to plan ahead, Lewis says.

"The worst time to begin your search for cash is when you need it the most," he says. "The longer you wait to get the funding you need, the more expensive it becomes--and the more difficult actually to get it."

But your analysis of cash flow doesn't just protect you against disaster--that is, against running out of cash just when you need it most. It also allows you to plan for growth, Lewis says.

"If your timelines show you accumulating cash, you can anticipate how to make it productive by putting it to work, maybe by expanding your plant or buying new equipment or adding people," he says.

"A lot of companies get into trouble when they try to grow without the cash they need to support it. Sales grow, but they don't have cash to buy raw materials to support the growth."

In the best of all possible worlds, you would get cash upfront, before you made or shipped your product. But in the real world, you pay for your raw materials long before you ship your goods--and even longer before you collect from your customer.

It is that time lag that makes understanding your cash flow crucial, Lewis says.

"The more you shorten the time between outgo and income, the healthier your business," he says. "If you don't know when and how cash moves through your business, you're flying blind."


Columnist Juan Hovey may be reached at (805) 492-7909 or via e-mail at

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