Plenty of businesses show record profits and are also facing bankruptcy. How could that happen? They ignored the golden rule of business.
A friend of mine recently started his own business. As a first-time entrepreneur, he asked me if I had any advice for him. I told him that he had just three things to worry about if he wanted to be a success.
The first thing I told was not to run out of money.
The second thing was not to run out money.
And third, wait for it, was not to run out of money.
While this might seem like an obvious and repetitive piece of advice, it’s amazing how many entrepreneurs overlook it.
As entrepreneurs, part of our nature is to tend to look at our profit and loss statement, or P&L, first. We want to see how much margin we’re making this month versus last month, last year versus this one. Everyone understands that if you don’t make a profit, you won’t be around long.
But what if I told you that I have seen plenty of businesses that, at the end of the year, showed record profits. And yet, they were also facing bankruptcy. How could that happen?
The answer is that business owners need to pay as much – if not more – attention to their cash flow statement as they do their P&L. Your cash flows tell you how much money is coming into your business as well as how much is flowing out when you pay bills, vendors, or even make payroll.
The problems start when your outflows exceed your inflows in a given period. You might hear some people say that a business is under-capitalized. This is exactly what they mean. You simply don’t have enough cash to cover the cash flow float required to operate. That’s how you go out of business.
Oftentimes, businesses get in trouble when the float or gap between when they pay someone else and when they get their money gets out of whack.
I know of one such business that buys hams here in the U.S. and then sells them into distribution chains like supermarkets in Mexico. The challenge is that when the business buys the hams, the producers demand payment within 3 days. But the business can only expect to be paid, at a minimum, like 60 days after that. That’s a big float to compensate for and the margin on wholesale ham isn’t very high to compensate for it.
This business has basically become a bank for its customers. But if it were to run out of cash because of it, then it could be in for some real trouble – fast.
If the ham company were to try and quickly expand, for example, it would quickly find itself running out of cash as it waited for its customers to pay them. But when the cash finally rolls in, it might be too late.
What’s interesting is that this problem only becomes exacerbated the faster a company is growing. That’s because your cash demands grow fast as well. If you want to keep growing, you need to order more raw materials, hire more employees, and maybe even move into a bigger facility. Growing your inventory, your payroll, and your lease payments requires more cash. All of this happens before your customers pay you. It gets worse if your customers are slow to pay you, and your accounts receivable balance outgrows your bank account balances, you could soon find yourself in a serious crunch. Worst case, you might even have to turn to bankruptcy to try and fend off your creditors – which is a scenario nobody likes to deal with.
Now consider a company that has figured out how to maximize its cash flow: McDonalds. They purchase their products like hamburgers on 30-day terms, meaning they agree to pay their vendors in 30 days. Meanwhile, they have shipped out those burgers to their restaurants, cooked and served them, and collected the cash from selling them for cash or on credit cards charges within just a few days – giving them a healthy balance of cash on hand as their float. In other words, they have flipped the equation and turned their vendors into their bank.
So if you’re running a business, don’t forget to keep a close watch on your cash flows. As the golden rule of business says: don’t run out of money. Or else.