In the wake of COVID, many business owners are focused almost exclusively on growing sales to survive. However, sales don't guarantee cash in the bank. So if your goal is to generate more cash, it's important to consider the other factors impacting your cash position.
To illustrate this, assume the following set of business circumstances:
- Monthly sales: R1,000,000
- Gross profit margin: 50%
- Operating expense ratio: 40% (i.e. operating expenses consume 40% of revenue)
- Average debtor days: 30 (i.e. your customers take 30 days on average to pay you)
- Average creditor days: 30 (i.e. it takes you 30 days on average to pay your suppliers)
- Average stockholding days: 30 (i.e. it takes you 30 days on average to sell your stock)
In this scenario, your EBIT (earnings before interest and tax) is R100,000. Therefore, you should generate R100,000 worth of cash from operations every month assuming your working capital efficiencies don't change. (For the sake of simplicity, I'm excluding the cash flow impact of interest, depreciation and tax).
Now what would happen if you doubled your revenue by focusing exclusively on sales?
Assuming nothing else changed, your EBIT would grow from R100,000 to R200,000. However, if you expect your bank balance to swell immediately, then you're going to be sorely disappointed, because your working capital accounts will also double:
- Debtors will double from R1,000,000 to R2,000,000
- Creditors will double from R500,000 to R1,000,000
- Stock will double from R500,000 to R1,000,000
These changes will tie up R1,000,000 in working capital. So, assuming everything remains constant going forwards, it will take almost a year before the additional profit from your sales growth will offset the negative cash impact of your working capital.
Now let's compare that to a scenario where, instead of focusing exclusively on sales, you improved all of the factors affecting your operating cash flow by a mere 5%. How would that look?
- Monthly sales would increase from R1,000,000 to R1,050,000
- Gross profit margin would improve from 50% to 52.50%
- Operating expense ratio would drop from 40% to 38%
- Average debtor days would decrease from 30 to 28.5
- Average creditor days would rise from 30 to 31.5
- Average stockholding days would fall from 30 to 28.5
In this scenario, your EBIT would increase from R100,000 to R152,250. However, your working capital efficiencies would improve as well:
- Debtors would drop slightly from R1,000,000 to R997,500
- Creditors would increase from R500,000 to R523,688
- Stock would dip from R500,000 to R473,813
As a result, instead of having an additional R1,000,000 tied up in working capital, you would actually free up R52,375 by managing your working capital more efficiently.
Think carefully before going all in on sales. Sometimes a few small changes can have a bigger impact than a single large one.