I recently read a wonderful brief written by a marketing professor for his marketing students. The reason for writing the brief was that the professor believed that many small businesspeople focus too much on the marketing and do not appreciate how the financial aspect ties in. As finance and accounting professionals, we obviously agree with that assessment!
The brief written by the marketing prof was exceptionally well done. It laid out in the clearest of terms the distinction between revenues, expenses and profits. From an accounting perspective, it gave the small business entrepreneur everything they needed to know about accounting to operate a business. In my opinion however, it was missing three critical finance elements necessary for an entrepreneur to have a successful business. These three elements were; (1) an understanding of the importance of the timing of the cash flows, (2) and understanding of the importance of the uncertainty of the cash flows, and (3) an understanding of the importance of the working capital cash flows which do not get explicitly accounted for in the formal accounting of a business.
In this blog, I would like to talk about the importance of the timing of the cash flows, and cover the other two issues in subsequent blogs. For a small business, the timing of the cash flows is almost as important as the size of the cash flows. There are two aspects to the timing of the cash flows. The first is the difference in the timing between the cash inflows and the cash outflows. The second is the timing of the cash flows throughout the year, or the cyclicality of the cash flows.
In a typical sales transaction, the cash goes out the door, before the cash comes in. For example, supplies and equipment must be bought and paid for, the product must be made, and workers paid, the rent and structure of the workplace must be paid for, and all of this before there is even a product to sell. Then the product sits there in inventory until a customer decides to buy, and even then, the customer may take some time on credit before they pay.
The timing between the cash going out the door and the cash coming in the door of the business is often called the cash-to-cash gap, or the cash conversion cycle. The cash-to-cash gap does not directly show up on the accounting statements of the firm, but it imposes a real cost on the business. It requires financing to maintain, and it affects the liquidity of the business and its ability to grow. Managing the cash-to-cash gap is part of working capital management.
A second component of the timing of the cash flows is the cyclicality of the cash flows. Most businesses, tend to be cyclical or seasonal in their sales and in their expenses. This is especially true for small businesses who often do not have the scope or scale to diversify their products and services. Management of the cash surpluses is very different from cash management during periods of cash deficits. Mismanagement of either component can lead to trouble, while successful management can lead to greater profits and more opportunities.
Timing of cash flows does not directly show up in the formal accounting of profit or loss. However, mistakes in understanding the timing of cash flows will likely show up on the heap of failed businesses. The takeaway is that there is more to understanding the finances of a successful business that the revenues, expenses and net profit. The timing of the cash flows, and management of that timing is key to success. Look for future blogs that will cover the importance of the uncertainty of the cash flows, and the working capital cycle.
*This is the first blog of a three part series on Cash Flows