Warren Buffett, one of the greatest investors of all time, famously says, “The first rule in investing is ‘don’t lose money’ and the second rule is, ‘don’t forget the first rule.’” Not losing money is certainly a rule to live by in investing. In small business entrepreneurship there’s a similar golden rule: don’t run out of money (“DROOM”).
One of the easiest ways to break the entrepreneur’s golden rule is through poor cash flow management – not having enough cash to pay your debts before you get paid by your customers. Let’s dissect what levers we can pull to avoid any impending DROOM for your business.
When I was CEO at a previous venture reselling tickets, my company had more opportunities to take advantage of than cash to pay for the opportunities. If we could pay for paid search advertising, we could increase transactions, and cash flows would grow. The problem was we needed to pay for the advertising before we could receive the cash from the transactions. I maxed out my credit cards, asked friends and family members to max out their credit cards, and then I paid it all back in 30 days. Rinse and repeat. I didn’t pay any interest on those short-term credit card loans, but if something went wrong in the cash flow cycle, I could’ve been saddled with high-interest credit card debt and those interest costs could’ve been detrimental.
The cash conversion cycle in my previous business was short, less than 30 days, which made our credit needs simple. Most businesses aren’t as simple. At my current firm, ValueStreet, we are private small business investors and see multiple unique business models a day. I can attest first-hand that no two businesses are the same. You’ll need strategies to optimize cash flows specific to your particular business. Here are five ideas to get you started:
- Have a plan for lines of credit – Your working capital needs (the cash you need in the short term to pay what you owe before you are paid what is owed to you) are paramount. Credit cards can be an option depending on the predictability of your business and the size of your working capital needs, but for large working capital needs and less predictable cash flows, you may be playing with high-interest fire. Your banker can extend lines of credit specifically for working capital at much more favorable credit terms. The banker can even help you determine what your working capital needs may be by reviewing your historical financials.
- Negotiate longer-term payables with your suppliers – In the ticket business I would pay our advertising partners and then collect sales from ticket buyers as they came in. As you can imagine, I didn’t have much leverage with the Google behemoth to negotiate when I could pay them for our ads – they wanted cash as it was due, and it was due practically immediately. In other businesses, say you’re buying raw supplies or working with sub-contractors, you can negotiate a payment on 30-, 60-, or even 90-day terms. The longer the better as the longer cash can stay in your hands, the more it’s worth to you. If your cash flow can sustain a shorter payment cycle, you may be able to negotiate discounts with your suppliers (they may be willing to pay you for their own improved cash flow).
- Seek shorter-term receivables with your customers – When you’re selling directly to consumers, you’re likely receiving payment either immediately in cash or they’re paying you by credit card and you’re receiving cash in 2-3 days. Either way, receiving cash in less than three days is about as good at it gets. If you’re selling directly to businesses, those businesses will likely have longer payment terms, but you can offer your customers discounts if they’ll pay you sooner. The cost of the discount may be cheaper for you than the lines of credit you’re utilizing to extend your working capital cycle.
- Recognize your inventory is a form of less liquid cash – If your business includes inventory, that inventory represents a form of less-liquid cash. How much inventory do you need to keep on hand at any time? How quickly can you turn it over? If you can reduce the amount of inventory you need to own at any given time (your par levels) you can put the cash used to store the excess inventory to better use. If you can increase your inventory’s rate of turnover and convert the inventory to cash, you’re in even better shape.
- Know your numbers –Data is useless until it’s transformed into actionable information. Ensure you know the cost of your working capital – what interest rate are you paying? How many days do you have on average to pay your suppliers? How much is each supplier typically owed each payment cycle? How quickly do your customers pay you and how much cash from those payments are earmarked for payables? What is the value of the inventory you need have on hand and how quickly can you get it out the door? Remember, all those answers are related to each other and impact your overall need. Once you’ve identified the full picture you can determine your best course of action.
Every business is different, and it takes time to understand the nuances of working capital. Still, the benefits of understanding how and when cash comes in and out of your business can be huge. Knowing your working capital needs down to the dollar can mean additional cash you can utilize for business growth strategies, or equity you can take out of the business to spend in different parts of your life. I call that a win-win.