Profitability Doesn't Equal Cash Flow -Case Study (Re-Post)

Nearly every business owner measures the success of their company by the company’s net income, their profit. That often equates to the amount of money that they could take home. Of course, that’s an important number. But it’s not the only measure of success, and often, using that as the “only” measure of how the company is doing is not the best way of measuring the company’s progress against those all-important strategic goals.

Your financial statements may tell a promising story about the company’s success. But you can’t take it to the grocery store or the gas station. You need cash. And to pay your company’s bills, you need cash flow. The bank knows it, and that’s why they keep a close eye not just on your financial statements, but on your credit line usage as well. The statement “cash is king” is old and people are tired of hearing it. But the reality hasn’t changed. Profits make you feel good. Cash allows you to do things. 

Bringing Value Through CFO Insights

Management looks at different measures before they make decisions. Some of their KPIs might include Backorders, Shipments Made, Inventory Level, Inventory Turns, AR Aging, DSO (days sales outstanding), Credit Line Utilization. But there are several times a month when the only thing that matters is how much cash is available. When you run payroll, or pay your vendor invoices, there is nothing as important. And if that number isn’t sufficient, no amount of profit on the income statement matters. 

• Business – Sales, installation, and service of industrial compressed air systems
• Location – Indianapolis, Indiana
• Sales − $15,000,000
• Ownership – Husband and wife, with a son getting ready to take over the business

Initial Contact –

The husband and wife team had been operating the company themselves since they started the business thirty years ago. They always achieved profitability, and used that as a means of determining the extent of their growth plans for the following year. Last year, in spite of the pandemic, they made a profit of over $500,000. As the new year progressed, their growing utilization of their bank credit line caused them concern. What happened to the half million dollar profit from last year?  Did they use it up so quickly, or were their prior financials inaccurate? 

Significant Findings and Recommendations

Cash Flow Management

The owners had always made their decisions based on their years of experience running their company. They had a handle on inventory control, and the business’ needs as their business grew. But as they started to look at retirement, their son was more aggressive in growing into new areas with which they were not as familiar. Those moves ate up a considerable amount of cash. Suddenly, rather than having their bank line of credit available for a rainy day, they were regularly drawing on it to maintain their business. Since they weren’t tracking cash flow at all, the increase in their use of their operating line wasn't surprising. 

There were two activities that drew down their cash availability significantly. They decided to expand their business into a new location in another state. The purchase was worthwhile, but there had been no plan for where the cash was coming from and how long the new location would take to be cash flow positive. Additionally, they decided to develop a private label line of compressors that they could sell with a larger profit. Their company name was well known for quality, so this was a good decision. But there was no planning on how large that initial purchase of compressors would be, and how fast they would be able to turn that inventory. 

Recommendations

• Analyze the impact of each of the two most recent expansions on the use of their available cash from the prior year’s profits. Both the facility purchase and the inventory expansion needed significant start-up capital. Determining the precise impact that each of those changes had on cash availability would provide some comfort to the owners as to the whether there were other places where they needlessly used cash.   
• Develop a cash flow forecast to measure and plan the use of cash in the coming months. The forecast should specifically identify revenues and cash needs from each of the two new expansions. As these new operations develop, it would be important to know how soon each operation would be cash flow positive.   
• Create a new budget for the coming year, specifically identifying the individual contributions of the four significant parts of the company: the new location, the expanded product line, sales from the home base, and customer support through service and parts supplies.
• Write a new strategic plan for the business. This will identify how the new expansion efforts will contribute to the future strength of the company and provide a foundation for addition potential expansion over the next 5 to 10 years. 
• Work with the bank to expand the company’s credit line considering the additional cash needs created by the expansion of product line and the new location. The strategic plan and a long-term cash flow forecast will give the bank confidence in the success of the forward-thinking plan. 

Companies that concentrate on profitability without regard for the ongoing need for cash can find themselves short of the money that they need to support those operations. Significant growth of a business can eat up available cash while waiting for customer collections. The profits of a prior year can easily be used for inventory expansion, or the purchase of additional infrastructure to support that growth. It’s important that cash flow forecasts are created and maintained alongside budgets, since they serve two different but equally important purposes for a company. 

Business operations need to have planned profitability, but that only provides an understanding of the costs and expected margins from the sales of products and services. Planning for the cash that will be needed to fund those expansions, in addition to the ongoing operations of the company, is as important a part of the decision-making process as strategically deciding the direction in which the company should go. 

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