“What do you mean?” I asked.
Turns out, Steve is invoice rich, but cash poor -- he has plenty of business (invoices going out and payments coming in), but he also has a lot of cash going out. He needed to understand the difference between cash flow and profitability.
The definitions are pretty clear, but sometimes the application is a little more complicated. Cash is the amount of money you have in your wallet, in your bank, or under the mattress. Simple as that. Cash flow is the actual movement of that money in or out of the business. Profit is the (theoretical) amount of money you keep after you pay your expenses. It is closely related to cash and cash flow, but it is NOT cash.
Steve’s design agency is doing all right. They generate $1.2 million in revenue and earn a 5 percent net profit on that volume. Steve’s customers pay 30 days after he invoices them. But here’s where the gap occurs: At month 1, Steve incurred $95,000 in expense that he had to pay out in cash (utilities, rent, employees), but didn’t receive a dime in cash on the $100,000 of revenue that he had “earned.”
We needed a way to convert his profit into cash fast enough to sustain his business. Since profit drives cash, increasing his profit margin is an obvious solution. At his current profit level of 5 percent profit, it will take him 2.5 years to climb out of this initial cash hole of $95,000. If he increases his rates to gain a 10 percent profit, he will be able to become cash flow positive in 16 months. It's still not fantastic, but it’s a significant time-savings.
But what else can we do to improve Steve's cash flow quickly? We came up with 3 simple tips that worked for Steve -- and apply to just about any business in a similar situation:
- Keep good records. The only way to get paid faster is to have a system in place so that errors or inconsistencies are minimized. Steve is already ahead of the curve because. He has put together effective accounts and executed receivable processes on a regular basis. The design team is tracking their production. They submit their approved work schedules to the accounting team for invoicing on a weekly basis, and the accounting team knew exactly what to look for or remedy. Lesson learned? We need to rely on ourselves to collect what we've earned; experience shows us that no one will be jumping to pay us if we don't keep good records ourselves.
- Words matter. The next quick win took all of five minutes to implement and the positive effect was surprisingly huge. By reviewing the thousands of invoices that our teams had cut over the years, we've discovered a few interesting observations. In short, words matter, so choose them wisely on your invoices. We've discovered that people took "due upon receipt" as "pay whenever you want," so we eliminated that language. We've learned from statistics that invoices asking to be paid "within 21 days" produced the best results, so we changed our terms. We also know that being polite helps, so we added "please" and "thank you." We were skeptical at first, but we saw an improvement almost immediately.
- Don't forget outflow. Finally, we turned our focus toward the other side of the table: cash outflow. I asked Steve's accountant when they pay all their bills. He answered, "When we do our check run." I asked if it was before or after the invoices are due. The answer? "When we do our check run." So, I got rid of the "check run." Most accountants don't think about how their work affects the company's financial operations -- they simply do what they were taught in school and make sure the pennies match. Our new rule is simple: all invoices will be automatically paid on the day they are due once approved. Management electronically approves invoices once a week.
When we peel through all the bells and whistles, we find that there are two basic levers business owners can pull to manage cash flow: cash inflow and cash outflow. It's a timing issue. We are not talking about cutting the coffee supply in your office, since that primarily affects your expense issue and will aggravate your team.
Instead, we are talking about systematic improvement to your collection and payment processes to improve the flow of cash in and out of your business. Speed up cash inflow and slow down cash outflow, and you will win the game.
If Steve’s story sounds familiar, then your company has either been in his shoes or you know someone just like him. Having an understanding of your current cash flow picture is essential for raising the right questions that should drive your operations on a day-to-day basis.
Michael Hsu, founder & CEO of DeepSky, is passionate about knowledge and entrepreneurship. He believes entrepreneurs should focus on taking over the world instead of building and managing their accounting departments. With that belief, he created DeepSky.
The Young Entrepreneur Council (YEC) is an invite-only organization comprised of the world's most promising young entrepreneurs. In partnership with Citi, YEC recently launched StartupCollective, a free virtual mentorship program that helps millions of entrepreneurs start and grow businesses.