Cash Management

Profit and cash measure different things, and in a young business they often disagree. Profit records a sale when it is made and a cost when it is incurred. Cash records money when it arrives and when it leaves. A business that invoices generously and collects slowly, or that buys a quarter's stock in one month, can report a healthy profit in the same month it cannot meet payroll. When that happens, the owner usually fills the gap from their own pocket, with a loan to the business, a personal card or a transfer from savings, and the business gets through the month.

The cost shows up later. A buyer reading the bank statements and the owner's loan account sees every one of those transfers and reads each as a month in which the business did not pay its own way. Cash Management is the driver that turns breakeven from an accounting result into a cash result. It forecasts cash, collects receivables on terms and keeps a reserve, so that the business runs without new capital.

A year without new money

The goal is a full year of operations funded without new capital: no new equity, no owner loans, no new borrowing and no personal card used for operating costs, as shown by the bank statements and the equity and loan accounts.

A buyer pays for a business that carries itself, because after the sale nobody else will carry it. An owner's loan to cover a payroll shows that in that month the business could not. One such month can be explained. A pattern of them tells a buyer that the profit arrives on a schedule the business cannot live with, and that the next owner will need deep pockets or a line of credit to run it. That is a doubt about whether the earnings last, and a buyer prices it.

The first tool is a rolling thirteen-week cash forecast, updated every week with actual receipts and payments, with the lowest projected balance flagged. Thirteen weeks is a quarter: long enough to see the quarterly tax payment, the annual insurance premium and the slow season coming, and short enough to stay accurate. The flag is what the forecast is for. A tight week seen two months ahead is a scheduling problem, solved by moving a payment, chasing a collection or delaying a purchase. The same week seen on the day means a call to the bank or a transfer from the owner.

The second tool is a reserve: several weeks of fixed costs held in a separate business account and refilled first from each month's surplus. It absorbs what the forecast cannot fix, such as the customer who pays a month late or the repair nobody saw coming. It has to be a separate account, because cash in the operating account gets spent when it looks available, while cash in a reserve account has to be moved on purpose, so drawing on it is a decision somebody takes.

How big the reserve should be

The reserve is measured in weeks of fixed costs, because fixed costs are what still has to be paid when revenue stops. Rent, salaries and insurance fall due whether or not customers paid this month. Sized that way, the reserve answers a precise question: for how many weeks could the business keep its doors open if every receipt stopped tomorrow?

How many weeks depends on how long the business would need to recover from the shock it is most exposed to. A business with many small customers can lose one and barely notice. One whose largest customer is a fifth of its revenue needs enough to keep paying its fixed costs while it replaces that customer. One with a pronounced slow season needs enough to get across it. The framework starts from several weeks and leaves the owner to size the reserve against the business's own largest exposure.

That sizing is also how the reserve shows up in value. Two of the risks a buyer prices most carefully at this stage are losing the largest customer and a sudden rise in costs. A reserve makes neither less likely, but it makes each less damaging, because it buys time to respond: to win new customers, renegotiate with a supplier or adjust prices before the cash runs out. A smaller loss in each case means a smaller discount in the price. Most of the work on this bridge reduces risk by improving the evidence about it; the reserve is one of the few pieces that reduces a risk directly.

Revenue that turns into cash

Receivables have to be collected within their terms. Over the latest year, customers should take on average no longer than the stated payment terms plus a short allowance, and no single overdue balance should be large relative to a month's revenue.

Revenue that has been invoiced but not collected is still only a promise to pay. When customers pay on time, revenue turns into cash predictably and a buyer can treat the two as nearly the same thing. A long tail of overdue balances makes the cash value of the revenue uncertain, and a single large overdue account concentrates that uncertainty in one customer's willingness to pay. Either way, the buyer marks the revenue down.

Slow collections also tie up cash the business has already earned. Days sales outstanding, the average number of days customers take to pay, measures how much. Every day above the terms is a day the business is lending its customers money for free. In the illustration, a business with $1.2 million of annual revenue whose customers take 52 days on 30-day terms is carrying about $23,000 more in receivables than it would at terms plus fifteen days. Bringing collections back within that range releases the cash once and for good, and it can go into the reserve the business needs.

Collecting on time starts with terms written into every agreement and every invoice: the due date, the accepted ways to pay, and what happens if payment is late. A payment is hard to chase when nobody told the customer when it was due. Then a collections routine runs every week, with an aged receivables report and a named person who contacts every account past due. It works because it is weekly and because someone owns it. Collections that wait until the owner has time wait until the cash has already run short.

What has to be in place first

All revenue has to be collected into the business account, which is the habit built under Paying Customers. A cash forecast built on money that bypasses the account is wrong from its first line, and no reserve can be built from cash the business never receives.

The forecast and the collections routine also need someone who owns them every week, usually the bookkeeper or an administrator with the hours. In a young business that person is often the owner. That works while the business is small and becomes a constraint as it grows, since a weekly routine is exactly the kind of task that slips when the owner is busy.

Knowing that it works

Days sales outstanding, tracked monthly against the terms plus the allowance, shows whether collections are holding. Weeks of fixed costs in reserve, also monthly, against the target the business has set, shows whether the cushion is there. The plainest measure is capital injections each month, counted and in dollars, with a target of zero. A month with an injection is a month the business did not carry itself, and the count of those months over the year is the number a buyer will look for first.

The test for the owner is to read the thirteen-week forecast, name the tightest week, and say what will be done if receipts that week come in below forecast. An owner who can answer has time to act on a tight week. One who cannot finds out about it when a payment fails.

Why it slips, and what holds it

The decay this driver guards against is the business needing new capital again, and one common route runs through the owner's own pay. In a good month the owner takes a larger draw. The next month a large bill arrives, the reserve is short, and the owner lends the money back. The business has paid the owner from cash it needed for operations and then borrowed from the owner to cover the hole.

What holds it is a rule about order: the reserve account is refilled before any payment to the owner above the set draw. Cash for operations comes before cash for the owner, so the reserve is full when the bill arrives and the loan from the owner never happens. Of everything in this driver, that small rule does the most to separate a business that carries itself from one carried by the person who owns it.