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  • Writer's pictureMike Williams

Is Your Cash All Tied Up?

Updated: Jun 15, 2019

“Why don’t I have more cash in the bank?” – an often-heard lament of many SME business owners. We hear it often when doing business valuations and it causes us to look at three critical issues:

  • What is the short and long term revenue trend?

  • What is the break-even point?

  • What are the working capital requirements?

Sometimes all three issues collide to create a cash flow crisis, and I was reminded of this with a client recently.

The business has great product gross profit margins, in some cases more than 50%, and was experiencing growth in revenue, having recently had the highest monthly revenue for more than two years.

The business owner exclaimed in exasperation and somewhat loudly: “So if my revenue is going up and my gross profit margin is so fantastic – where has the money gone?”

Then we looked closely at overheads – they hadn’t increased at all, although the business was only trading approx. 5% - 10%above their break-even point. Being so close to break-even doesn’t make it easy and it led us to look closer at working capital and monthly cash flow.

We did a monthly forward projection for the next 12 months with modest revenue increases. Sure enough a trend appeared – two months of negative cash flow followed by a month of positive cash flow, then back into negative territory.

In effect their revenue growth in the short term was being chewed up by increasing monthly costs from raw material and packaging costs. We also noted that the first six months of the year followed this pattern before seeing a consistent positive cash flow in the latter part of the year.

This was completely counter-intuitive – their highest sales months were summer time. And that is the point – when already running close to a breakeven point, working capital requirements can chew up an increases in sales and sales improvement doesn’t show up in the cash balance until working capital requirements reduce.

This is why it is critical to keep NON-CASH working capital low – because it chews up spare cash rather than show up in the cash balance.

Non-Cash Work Capital (WC) is Current Assets – Current Liabilities – Cash Balance.

In effect it measures the amount of cash tied up and not yet received. And it is not simply a static variable – it will change from one month to the next. If Accounts Receivable increases, then WC increases whilst all else remains the same. This means you have continued to pay your bills but not yet received money from sales. In effect if accounts receivable increases then this needs to be balanced with increased accounts payable so that WC stays the same.

Non-Cash WC represent how much cash is tied up rather than being in the back. You can be profitable but if it is tied up in purchasing goods and low cash receipts then it is not going to show up in the bank account.

In valuation terms, when we use an income method to assess the value of the enterprise, one of our tests is to see if the working capital requirements increase in the near future. If they do increase, then we reduce the resulting value by the Non-Cash WC.

So in effect, increasing WC can be a real “brake” on the value of your business and be a proverbial “pain in the bank balance”.

How well are you managing WC? How much value are you losing in cash tied up in the business?

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