Forecast for Success: A Guide to Cash Management

Intro

Throughout my career, I’ve often found that financial reporting and management performance metrics are skewed toward the profit and loss account with less of a focus on the balance sheet and cash flow statement. In this article, I’ll share my thoughts on:

• The importance of cash management.
• Some key working capital metrics whose trends can be analyzed to help predict potential future cash issues.
• Cash management best practices from my own career.

Through their understanding of the balance sheet, CFOs and finance teams can add tremendous value to a company by bringing better visibility to the cash flow statement and ensuring the correct cash metrics are in place.

Why Is Cash Management Important?

Cash flow is arguably the most crucial financial metric a company should focus on, and positive cash flow is critical to growing and sustaining a business.

Cash (or lack thereof), is indeed often highlighted as one of the most important reasons why startups fail.

Of course, running out of cash is often the symptom of another issue, but it does reinforce the notion that a critical element of the business plan must be a cash forecast.

Well-established companies also lose their way when it comes to managing cash. Even General Electric (GE) has had many issues recently, one of which was cash.

Cash Management Actions and Techniques

Having established the importance of cash management in a business, what are the steps that should be taken? Based on my experience of working in many different industries, from short-cycle consumer products to longer-cycle energy and mining industries, here are my suggested actions that should be relevant to any business—large or small, young or mature.

Ensure your business analyzes cash and produces a forecast on a weekly or monthly basis (“Why Every Business Should Build Weekly Cash Flow Forecasts”). As I highlighted at the beginning of the article, cash reporting and forecasting can vary in its detail, but it’s imperative to understand the differences between a company’s profit number and its cash flow. There are good reasons why profit may be greater than cash—a young, growing company will consume cash and even a more established business needs capital investment through the business cycle—however, over time, profit should equate to cash. If this is not the case, then it calls into question the cash management techniques of the business, or worse, possibly indicates overly aggressive accounting techniques. A good understanding of the cash flow statement of the company should enable root causes to be analyzed and actions to be taken.

I will outline the key strategic considerations below:

1. Introduce the relevant working capital metrics into your business and ensure they are embedded throughout the organization. Too often, I have seen these metrics be part of a financial report without being a key performance metric of the commercial and operations teams. Cash management is not just the responsibility of the finance team. When it comes to overdue receivables, for example, I would argue that the sales manager is the one best placed to have the “difficult” conversation with the customer regarding payment, yet it often falls to an accounts receivables clerk to carry out that task. The best overdue performance results from the commercial and finance teams working in partnership to address the issue. It also helps if an element of the variable compensation of the commercial teams is linked to receivables performance. Likewise, inventory should be a key performance metric for manufacturing and supply chain teams.
2. Avoid using your suppliers as a banking facility. I’ve not yet mentioned Accounts payable, which is the other key element of working capital after receivables and inventory, yet it is the lever often used by companies to manage cash. Many businesses simply stop paying suppliers in the run-up to a key financial reporting milestone such as a quarter-end or year-end. This rarely helps build long-term partnerships with suppliers, and in many countries, legislation is being introduced to ensure suppliers are treated more fairly. If a supplier payment hold is essential, then negotiate a one-off event (and perhaps reciprocate by agreeing to pay a supplier early at a critical milestone for them). Extended supplier payment terms are often a sign of a company in trouble. Carillion, the UK construction company which ran out of cash and collapsed last year, had many issues, but one warning sign was that suppliers had complained that they were being made to wait 120 days to be paid, double the agreed terms.
3. Evaluate working capital financing options. Profitable companies which are expanding quickly may find they need finance to support this growth. Banks and other financial institutions do offer working capital financing packages, but they do tend to be relatively expensive and only considered as short-term. A more specific type of working capital financing, and one which I have used in the past, is receivables factoring. Accounts receivables financing companies typically advance companies 70 to 90 percent of the value of their outstanding invoices. The factoring company collects the debts and pays the original company any remaining amount beyond the financing amount minus a factoring fee. The fee charged will depend on a number of factors such as the credit rating of the customers in the receivables balance, the age of the receivables, and whether the factoring is recourse or non-recourse (where default risk transfers to the factoring company).
4. Unlock hidden cash from the balance sheet. There are accounts not included in the definition of working capital which often include significant amounts of cash tied up. Examples include:
   1. Accrued revenue. This is a sale that has been recognized by the seller, but which has not yet been billed to the customer. It is most common in software companies or longer-cycle project businesses. Revenue can be recognized when certain performance obligations are met, but these triggers may be different from the progress payment milestones that allow the customer to be billed. These timing differences should ebb and flow over a business cycle, but an increasing accrued revenue balance requires closer analysis.
   2. Prepayments. These are payments made to suppliers in advance of the product or service being received or utilized. Often, they are justified (advance payment of rent is a typical example), but they can also be the result of a poorly negotiated supplier contract.

Next, I’ll discuss some of the more useful cash management tools and metrics required for successful cash management.

Working Capital Management

As businesses grow, they typically start to require higher levels of working capital to support operations.

I’ll share some key working capital metrics that I have found very useful during my career and which can provide some early warning signals that cash problems may lie ahead.

Inventory

Inventory turns measure how often a company has sold and replaced inventory during a given period.

= Previous 12 months' sales / Average inventory (as measured by the average of the last 12 months or last 5 quarter points).

It’s essential to look at the trend of this metric over some time. A worsening number (that is a turns number that is reducing) may indicate a weakening of sales or poor demand forecasting. There may also be a perfectly reasonable explanation:

• The opening of a new warehouse to support sales growth in a new market or region;
• A manufacturing plant shutdown that requires an inventory build to maintain service levels;
• A new product introduction that requires an inventory build to support the launch.

A vital element of managing inventory is the compilation of accurate sales forecasts that are fed into the manufacturing and supply chain teams for production planning and material sourcing.

Demand forecast accuracy measures the variation in real demand versus forecasted demand expressed as a percentage. Clearly, it’s challenging to forecast customer demand 100% correctly, but attention on this metric does help control the production of excess inventory (or minimize the risk of customer service shortfalls). If demand forecast accuracy is not addressed, then it potentially leads to slow-moving and obsolete inventory which ultimately leads to write-offs.

Striking a balance between holding enough inventory to maintain exceptional service levels while avoiding the risk of excess inventory building up is a challenge for even the most successful companies. A recent example is an issue faced by Micron Technologies (MU), which relies on DRAM and NAND sales for most of its revenues. As cloud customers worked through a glut of inventory in the face of price increases, Micron was left holding substantially more inventory and anticipated a necessary correction over a few quarters.

Similarly, in 2016, Nike, underwent a mismatch of inventory and demand, noting on its conference call, “As we go into the next quarter we expect clearly to remain in excess inventory through our factory stores and also through select third-party value channels.” This ended up causing a significant degradation in gross margins.

Receivables

Receivables days sales outstanding (DSO) is a measure of the number of days that it takes a company to collect payment after a sale has been made.

= Accounts receivables balance / Previous 12 months' sales * 365

As with inventory turns, it’s important to look at this metric over time. A worsening number (that is a DSO number that is increasing) means that the company is taking longer to translate sales into cash, which could be due to several reasons—the most common being that customers are taking longer to pay their invoices. A high DSO could signal a problem with cash flow due to the long period of time between the sale of a product and the time the company actually receives the cash. Several common reasons for an expanding DSO include:

• The collections department is not functioning properly;
• Credit is being extended to customers that aren’t creditworthy;
• The company has increased credit terms to some or all of its customers—for example, from 30 days credit to 45 days. This may be an attempt to grow sales or respond to a competitor’s credit terms;
• The company is growing into new markets where the credit terms are significantly higher. In Europe, for example, it is not uncommon for credit terms to vary by country. Northern European countries such as Germany tend to have shorter credit terms (30-45 days) whereas Southern European countries such as Italy typically have longer terms (90 days is not unusual). A German company experiencing growth in Italy may, therefore, see DSOs increase purely because of geographic mix.

In the last two examples above, arguably the increase in DSOs is the result of a conscious decision made by the company (to increase credit terms to customers and to grow into a new market with higher credit terms). The second example can be attributed to customer behavior and is why an additional receivables metric to complement DSO is often measured.

Overdue (or past due) receivables, expressed as a percentage.

= Value of receivables outstanding that are past their due date / Total receivables

Any amount of overdue receivable deserves attention, but once again, identifying whether there is a trend developing is vital. An increasing amount of overdue debt, on the one hand, can simply point to a lack of focus in the company, but on the other, can indicate a customer in financial trouble or a whole market starting to experience a credit crunch.

In an interesting piece of research, Sageworks analyzed those industries that wait for the longest to be paid in the US.

This certainly jives with my experience. The longer-cycle businesses I have worked in such as oil and gas in GE and Orica Mining Services tended to have higher levels of overdue receivables. For oil and gas as well as mining, this is due to (1) high customer concentration, (2) high value of invoices, which are often linked to the supply of large pieces of machinery or product, and (3) disputes greatly affecting DSOs, as receivables are less granular. However, these statistics do reinforce the importance of a proactive approach and open lines of communication with the customer.

Companies want to be mindful of extending too generous payment terms to customers, as “eventually, the additional financing costs that suppliers incur because they aren’t being paid promptly work their way back into higher prices for consumers [customers],” according to V.G. Narayanan, Chief of the Accounting Practice Unit at Harvard Business School.

Concluding Remarks

The majority of the analysis of a company’s financial performance focuses on the income statement—revenue growth, gross margins, operating margins, EBITDA, EPS—yet it’s important not to forget two widely used catchphrases: “cash is king” and “revenue is vanity, profit is sanity, cash is reality.”

Successful cash management strategies will help provide funds for investing in growth, pay down debt, and return money to owners and shareholders, and should thus be prioritized and understood by all parts of a business, not just the finance function.