Cash Flow and Supply Chains – Not Just About Profit

In a previous blog, we touched upon cash flow as one of the four things every business owner must always have in mind when it comes to their supply chain. 

So as a bit of a refresher, let’s start with the Cash Flow Cycle Time and how you can determine it using this relatively simple formula: 

CFCT = DIO (cash tied up in your business in inventory, wip and goods in transit) + DSO (cash coming into your business from customers) – DPO (cash going out of your business paying suppliers). 

Now for some who are relatively new to business, this might sound very similar to calculating profit. However, there is a subtle difference between the two (in fact, we’ll be discussing supply chain profitability at a later blog). 

Profit is a concept, which consists of income-less operating expenses adjusted for the cost of doing business. We measure it annually when we prepare our financial statements.

Cash flow, on the other hand, is the very real, literal flow of money continuously paying for the entire operation. It is the money paying suppliers for raw materials. It pays for the process that adds value to the materials (such as turning them into finished products).

We need to have a handle on it at all times. And if we don’t, we all know what it’s like to run out of cash! It’s painful and horrible and we make promises to ourselves that we will never let it happen again and usually take steps to ensure that it doesn’t. 

But let’s deviate for a moment. This all goes back to the primary reason why we start businesses in the first place: We want a means to generate a great return on investments that surpasses other options, like banks. If we cannot make a better return than a bank, then why would anyone invest in our business? 

For this to happen a business needs to be both profitable and cash flow positive. But as hard as this may be to believe, we can be a very profitable business and not have enough cash to pay for these and all other bills when they fall due. 

A business that cannot pay its bills as and when they fall due is said to be insolvent and there are harsh penalties for directors, owners and founders leading these businesses in most western nations. 

That is not a good outcome for a director, business owner, or founder (and neither is it for banks and investors). 

We mentioned before that cash flow ensures the solvency of your business. And with the economic impact of the pandemic, solvency will be a stronger indicator of how long that business can keep on operating. Many governments have relaxed their penalties for the short term as the result of the virus, but this will not be the case forever. 

So, what do we do now? Let’s start with the following steps:

1. Calculate our cash flow cycle time with each component DIO, DSO and DPO while using the CFCT formula to determine the actual CFCT. 
2. You will, of course, already know if you are trading insolvently. In these circumstances, if you are in Australia, you may need to review safe harbour legislation and determine whether that is appropriate for your business and your current situation. 
3. Check for whatever cash you put aside for rainy days to deal with cash crunches. (Though given the current circumstances, this cash could be all used up already.) Cash crunches is another name for times when the cash flow of a business is slowing down to dangerously unsustainable levels. It is why, no matter how financially clever you may be, it is still always better to have a reserve on hand so that any unforeseeable or unavoidable cash crunch does serious damage to the supply chain. 
4. Lay out your supply chain diagram (which should show clearly how your supply chain works). See how many suppliers you have and where they are located. Check how many factories, manufacturing facilities and warehouses and what happens in each one. Exactly how many customer locations do you know? Are you shipping directly to them or into customer warehouses?

Now, if you’ve already done all this, what comes next? 

#1. Understand your own performance and make comparisons.

Take the results of your calculations and start comparing the result to your performance in the previous year. After that, compare it to the averages of your industry. Have it all double checked with your bookkeeper or accountant. Speak with your accounts receivable clerk, inventory analyst and accounts payable teams and confirm they are in agreement. Finally, if you have a supply chain manager or analyst ask them to validate your thoughts. Show them your diagram and ask them for their input. 

Do your numbers seem intuitively correct? 

How do your figures compare with your own position twelve months previously? Is your CFCT improving or deteriorating? Can you determine why?

How do you compare with similar positioned businesses in your industry? Is your CFCT better than the industry average or worse? Why?

#2. Identify best places to seek improvement in cash measures 

From the previous step, you will have an idea of where to focus. Will it be paying suppliers more slowly, reducing slow moving or inappropriate inventory, that is not selling rapidly enough to customers? Or, perhaps you need to start increasing the rate of collections?

Don’t panic, but focus on areas where the costs are most manageable within your organisation (such as inventory management). Prioritise those supply chain areas that you are most capable of transforming so that their costs will not strain your cash flow compared to areas more resistant to your initiatives. 

You will need to work with your team to ensure that the areas that you are working on can be transformed without damaging other aspects of your business, like your supplier and customer relationships. 

#3. Come out strong for your suppliers. 

Finally, knowledge of your cash flow should lead you to having a stronger position when negotiating with suppliers. A good cash flow means you are less likely to be slow on payments and more likely to be high up on your suppliers list of priority customers. Likewise, if you are having cash flow troubles, let that be a reason to manage your expectations on delivery (or even save that bit for last until you have fixed problems closer to home)!

On a final note, it is important to really understand your cash flow via your CFCT because your CFCT is what is either keeping your business alive or sinking the ship!

(Image by Pexels.)