Managing Your Cash Flow

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Working capital: Are you overtrading?

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The two examples below show just how easy it is for growing companies to get into serious trouble if they don’t adopt some relatively straightforward financial controls and planning. 

The phrase “forewarned is forearmed” applies perfectly.

Scenario 1: Manufacturing meltdown

A manufacturing company which produces bespoke cases for smartphones and similar products has been growing steadily the past 12 months and is managing its finances well. 

Its sales manager has just pulled off a fantastic new deal supplying into a new geography with the top distributor. All is rosy and everyone can lean back and wait for their bonuses because the annual target is all wrapped up, right?

Wrong, what has actually happened is that the company has fallen into the trap of overtrading. It has to place orders for materials and even though it can just about scrape together enough cash to get its suppliers moving on the larger orders, it then finds that it has another order for month two, which requires another payment to suppliers. 

It doesn’t have the cash because the deal with the client is on 30-day payment terms from the point of delivery. The manufacturing firm doesn’t want its competitor to get the order, so it accepts it even though it knows it can’t deliver it yet. 

The company then realises that it can’t pay its rent or electricity and the payroll at the end of the month, let alone payments to other suppliers to support other deals with pre-existing customers. 

Suppliers become unhappy, customers don’t get products when they want them, staff leave because they’re paid late and the bank calls in the overdraft. A classic case of overtrading!

This business actually has quite a long cash cycle: though the order may be placed and legitimate, the firm has to incur the full cost of production perhaps two or three months ahead of receiving any cash from the clients. Financial planning should have taken this working capital cycle into account and resulted in either negotiating better terms on this big new deal (with both the client and suppliers) or not accepted the order in the first place. 

Scenario 2: Too much app-etite for deals

A software consulting business designs innovative e-commerce solutions for small businesses and has been profitable for some time. It has just closed a major new deal to develop five major apps for a client in a new sector that would open up many new opportunities for the company. 

The terms are 50 per cent payment on delivery of the third app and 50 per cent on delivery of the fifth. The company accepts the order and needs to bring in five more contractors for a six-month period to complete the work. 

One month in, and another deal lands which requires another two contractors – but the client won’t pay until full delivery of the order, which will be three months away. 

It’s a regular client so the software firm accepts the order, but its cash is starting to be stretched thin. 

In month two, it’s paying for all the additional contractors but without any new cash coming in yet.

Month three should be great as it can invoice the first 50 per cent of the large new deal, but there’s some debate about acceptance criteria and the client demands that there is more development on features and wants more time for user acceptance. 

Another month goes by with no cash coming in. The company then loses three of the unpaid contractors who were working on the large deal – and that 50 per cent billing milestone slips even further away. 

Work on other deals slows down as the business is distracted onto fixing the big deal, and then staff can’t get paid, the other contractors leave and the clients still haven’t paid you anything. 

Clients start to terminate contracts (you can’t remedy your underperformance) and then the inevitable call from the bank comes. Overtrading once again!

Chris Chapman is managing director of www.mybusinessFD.comwhich offers high-calibre finance directors to ambitious smaller and growing companies on a part time, flexible and affordable basis. Tel: 0207 717 5254 or enquiries@MyBusinessFD.com. 

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