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Dec 17, 201512:48 PMOpen Mic

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Are capital constraints negatively impacting year-end planning?

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December is always a challenging month for executives as they finalize their budgeting and planning for the next year, while simultaneously trying to meet their goals for the current year. Despite the importance of this budgeting and planning, we find that many middle-market companies undertake this process in the shadow of capital constraints and thus limit the opportunities they pursue.

Planning in the shadow of capital constraints

Budgets and planning at middle-market companies are usually prepared within the bounds of the unwritten rule that the only money available to support those plans is capital already in the business or that which will be generated from operating cash flow. With those bounds in place the result is predictable — slow to modest growth at best.

What might happen if that constraint is removed and executives are challenged to submit plans that are not limited by the status quo and perceived available cash? What if, for example, the sales executive is asked to consider acquisitions of competitors in different geographic regions of the country as part of her plan, or acquisitions of companies with complimentary products that can be added to the product offering? Similarly, what would happen if executives are told that revenue estimates and new product development should not be limited by the capacity and capabilities of existing manufacturing equipment?

Understand the current cash flow

If capital is going to be removed as a constraint of the company, the executives need to have a solid understanding of their existing cash flow. They should start by reviewing the cash flow statements for the company if they are available, or the balance sheets if they are not. Common items that use cash but do not appear on the income statement include increases in the asset accounts on the balance sheet (e.g., accounts receivable, inventory, prepaid expenses, equipment, other fixed assets), and decreases in liability accounts (e.g., accounts payable, accrued expenses, notes payable).

If any of those balance sheet changes are large on a monthly or annual basis, management needs to dig into them to understand the changes and try to manage and finance them if possible. Maybe sales with a key customer have increased rapidly but their payments are falling behind. Maybe the purchasing manager is buying higher quantities of materials in an effort to receive a discount, but those inventory levels are not supported by sales. Maybe the current debt is being paid down too fast. All of those issues will be revealed on a cash flow statement or by examining changes on a balance sheet.

Rapid growth is an example of an activity that can cause a cash flow issue but is commonly misunderstood by executives because it looks great on an income statement. An example is the easiest way to explain it. Suppose a company receives a $1 million order from Wal-Mart, who wants it to arrive at their distribution center in 120 days so they can have it on the shelves in 150 days. If the company outsources its manufacturing to China they likely have a lead time on the order of 90 days, but to allow for possible delays they place the order 120 days in advance. If the fully loaded manufacturing cost is $600,000, they will need to pay $180,000 (30%) at the time of the order, and $420,000 (70%) 30 days later when it is completed and shipped by the manufacturer. The company will receive and warehouse the product until it is ready to ship to the customer. Wal-Mart will pay for the order 60 days after it reaches their store shelves, but wants it in their distribution center 30 days before it will hit the shelves.

That entire timeframe from when money was first paid for the inventory until payment was received from the customer is 210 days, with the weighted average time of 189 days. That timeframe is commonly known as the cash conversion cycle. The deceiving part of a large order like the one in this example is that the associated revenue and expense will hit the income statement when the product is shipped to Wal-Mart, and it will have a positive impact on profitability, but for 120 days before, and 90 days after booking that revenue the company will have that $600,000 of cash tied up. Therefore, the executives need to understand the cash conversion cycle and that $600,000 will be tied up for every $1 million in growth for a weighted average of 189 days for this customer. That type of slow cash conversion cycle can cripple a business and potentially cause its collapse if it is not understood and planned for.


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