BY DOUG AND POLLY WHITE Special Envoys
QUESTION: I have often heard that a business can go bankrupt. If growth means more sales and more profits, isn’t that a good thing? How can a company go bankrupt?
ANSWER: It is true. Depending on the economics of a particular business, a business can literally grow out of business.
Unless your business model is completely broken, an increase in sales will generate more profit.
However, it may also require an increase in things like inventory and accounts receivable that use cash. Growth may actually be negative for short-term cash flow.
Take the case of a distribution company. He has a 25% gross margin and makes 5 cents profit on every additional dollar in sales.
The company must maintain an inventory to enable timely shipments to its customers. Its inventory rotates four times a year. The company offers 30-day net terms.
But the average customer stretches that a bit and pays in 45 days. The distributor must pay its suppliers within 30 days. As sales increase, inventory and accounts receivable must also increase. It consumes money.
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Accounts payable will also increase, offsetting some, but not all, of the growth in accounts receivable.
If the company’s balance sheet ratios remain unchanged, the cash flow implications of one dollar of sales growth in the current year are as follows:
- The profit will increase, providing 5 cents of additional liquidity.
- Accounts payable will increase. Suppliers extend company credit, which will provide 6 cents more in cash.
- The company will have to increase its inventory, which will cost it 19 cents.
- Accounts receivable will increase, costing the business 12 cents.
The net result of this arithmetic is the counterintuitive result that a dollar of sales growth does not increase cash flow in the first year.
Rather, it uses 20 silver cents. The implication is that a successful push to increase revenue that results in a $1 million increase in sales this year would actually result in the company having $200,000 less than if sales had remained flat. This would drive many businesses out of business.
Admittedly, changes in balance sheet accounts – accounts payable, inventory and accounts receivable – are a one-time event.
Therefore, if the dollar of sales growth is sustained, this will result in 5 cents of positive cash flow in each subsequent period.
However, businesses that are currently cash-strapped may not be able to sustain the initial negative cash flow resulting from sales growth. A business can literally go bankrupt.
It’s not hypothetical. Unfortunately, this happens all too often to businesses.
Not all businesses use money as they grow. Some throw money away immediately.
Consider a consulting firm that has excess capacity. An extra dollar of revenue will not change the costs.
Therefore, all the dollar will become profit. There is no inventory and no accounts payable. Accounts receivable will increase.
As in the example above, this will cost the consulting firm 12 cents. However, the dollar of sales growth still translates to 88 cents of positive cash flow.
If your business is in a cash crunch, before launching a major effort to increase revenue, make sure you understand the economics of your business.
Will sales growth immediately result in positive cash flow or will it initially use up cash?
Once you understand the economics of your business, you can forecast how much money you’ll need to support growth.
Doug and Polly White own a significant stake in Gather, a company that designs, builds and operates collaborative workspaces. Polly focuses on human resources, people management and human systems. Doug’s areas of expertise are business strategy, operations and finance.