|Growing sales and profit can push companies to the brink
In working with clients across a range of growth scenarios, I have found that successfully growing businesses experience unintended consequences of success. It’s a good challenge to face, of course, but it can, and should, be predicted and managed.
Strong and profitable sales growth is obviously desirable, but besides the operational challenges related to fulfillment, managing cash becomes even more important. Accountants will tell you to track two key ratios that can easily be calculated, as follows:
|Ratio||What it says||How to Calculate|
|Quick Ratio||Are there available funds to cover short-term obligations?||Cash + Receivables
(Should be 1:1) or higher
|Operating Cash Flow Ratio||The amount of cash being generated compared to amount of cash being required to lay out||Cash flow from Operations
(Should be more than 1:1)
While these ratios provide a valuable partial picture, they only reflect history and are not adequate to project future cash positions. That is simply because not every business decision about future financial obligations is captured in accounting systems. A growing company can be making abundant profit (on an accrual basis), but quickly run out of money to cover bills. This could occur because a company decides that it needs to increase future expenses by hiring another person or have plans for increasing inventory; neither decision of this type is reflected in these ratios.
What to do? Use a budget! That is, consider how individual actions, which will affect cash but are not yet captured in accounting processes, will affect cash flow forecasts. The process will require updating predictions based on the reality that occurs. While using a realistic budget is not foolproof, it helps reduce the risk of unpleasant surprises related to cash.
Importantly, if forecasts push a company’s cash flow to the edge, either secure cash to meet the predicted needs or, if one cannot get cash under reasonable terms, slow down and even stop trying to grow so aggressively. Growth can create a very tenuous cash-flow situation that can undermine the viability of the entire business. Of course, you should manage A/R and A/P to tip cash in your favor, but after that, especially in rapid growth environments where cash lags behind sales, you may need to slow down so that cash needs do not exceed the ability to generate short-term cash.
I went through this exact situation with a client who insisted on continuing to grow at all costs. And the company did grow – all the way to bankruptcy.