Our business is growing yet we are running out of cash. What’s going wrong?

One of the least acknowledged facts about growing a business is that an increase in sales drains the business of short-term cash.

This is common sense, really. If you want to sell a product you usually have to buy it first (although there are a few wonderful exceptions which I’ve included at the bottom of this post) and this generates a time lag between purchasing and selling which you need to be able to fund.

If you are in the service business you are not immune – it’s often human hours you have to pay for upfront, and you can find yourself hiring and paying for an employee many months before you get paid for their services.

I have found that many businesses don’t factor the cash flow element into their growth plans. In fact, the excitement of rapid growth in sales is often not tempered by the lack of cash until the business gets into a pickle and short-term cash runs out.

So how do you know how much cash you are going to need for the new sales?

I don’t think you need to dive into a complicated forecasting model – well, not immediately anyway – but I do think you want to get a sense of the size of the issue, which you can get from a rough and ready calculation.

You need to know:

• your predicted increase in sales revenue
• the gross margin on those sales
• additional overhead you will need to add into the business to support the higher level of sales
• the length of time between paying for your goods and collecting your debtors

Just say you were predicting an increase in sales of $100,000; if those sales have a margin of 20% then the cost of those sales would be $80,000. Let’s say that you have to add an extra $10,000 of overhead in to make those sales; the total cost of the sales then is $90,000. If on average it takes 75 days for your debtors to pay up and you pay for the goods 15 days after you sell them, then you need to fund $90,000 for 60 days.

Now you might well look at this calculation and say, “But we won’t pay for the goods all at once” or “The increase in sales won’t just happen on day one, it will be over a period of months”. To that I would say yes, there are many assumptions in the calculation – but it’s a great leap forward from having no idea how much cash you need for growth.

Once you have a sense of the cash-draining effect of growth you can think about ways to make it smaller, or ways to fund the growth. Either way you will have time to do this rather than having to respond quickly to a cash crisis.

I did say at the top of the page that some businesses don’t buy their product before selling it, and that really is the Holy Grail of a great business model. Dell is famous for its model of getting customers to pay upfront for yet-to-be-made computers, and supermarkets enjoy the fact that we pay cash for our groceries, cash which they then use – sometime later – to pay their suppliers.

Julia Bickerstaff’s expertise is in helping businesses grow profitably. She runs two businesses:Butterfly Coaching, a small advisory firm with a unique approach to assisting SMEs with profitable growth; and The Business Bakery, which helps kitchen table tycoons build their best businesses. Julia is the author of “How to Bake a Business”  and was previously a partner at Deloitte. She is a chartered accountant and has a degree in economics from The London School of Economics (London University).