CMA British Columbia welcomes Shantaram Sapre, CMA as a guest blogger to www.cmabcblog.com.
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Sustaining Cash Flows: A Challenge for a Growing Company
By Shantaram Sapre, CMA
It is often seen that a growing company faces cash-flow Challenges as it grows every year. The cash-flow Challenges may be either due to fixed capital requirements or due to working capital requirements. This article deals with the problems of working capital requirements and its management.
Let us assume that ABC Co. Inc is a manufacturing company and it is operating well below its manufacturing capacity. The raw materials cost of the products is 40% of revenue. The company keeps a raw materials inventory of 15 days and a finished goods inventory of 15 days during the year 2008. The raw materials inventory is valued at materials cost and the finished goods inventory is valued at materials cost + other manufacturing expenses.
Table 1
The company has provided 30 days payment terms to its Accounts receivable in the year 2008 and it has got the same payment terms from its Accounts payable. The manufacturing cycle of the company is said to be of one week. The amortization provided every year on fixed assets is $47,500 based on estimated life of the plant. The company has availed a long term debt for financing its fixed assets and its yearly repayment is $43,333 per year. The yearly instalment of debt is paid towards the end of the year. The company has an average income-tax rate of 35%.
Based on this information, the net income statement of the company for the year ending December 2008 is shown in Table 1 that shows that the company has earned revenue of $3,000,000 which resulted in a net income of $325,000 giving a ratio of 7% net income on revenue. The whole of this net income is transferred to Retained earning. The Balance sheet of the company as at December 31, 2008 is shown in Table 2.
Table 2
Since the company is operating well below its manufacturing capacity, let us assume that the company plans for the ambitious revenue growth of 25% during the year 2009 and achieves it. Further, assume that the company had to give liberal credit terms of 60 days payment to its customers to enter new market as well as to its existing customers to meet the ambitious sales growth…. However, its own payment terms to its vendors remain constant at 30 days. The company also had to increase the raw materials inventory from 15 days to three weeks and also the finished goods inventory to three weeks to ensure regular supply to its customers.
The net income statement of the company for the year ended December 2009 is shown in Table 1 which shows the impressive 25% revenue growth of the company and also shows the fact that the net income of the company has risen by nearly 65%. But the real question is-has the company generated enough cash to sustain its impressive growth. Let us see that from Table 3 of Cash flow.
Table 3 shows that, during the year 2009, the company has generated a cash of $395,250 comprising of net income and amortization. The company has utilized this cash in additional working capital requirements and payment of long term debt. The additional working capital requirements consist of two parts here, the first is increase in current assets and the second is increase in current liabilities. The point to be noted here is that the increase in current liabilities includes one item, which is short term credit line (overdraft) amount of $79,958 which is a new item in year 2009. Therefore it can be concluded definitely that the company was not able to generate sufficient cash to sustain its impressive growth and therefore it had to resort to short term credit line facility from the bank. This entire increased working capital block has resulted in paying 60% higher interest expenses during the year 2009.
Now let us examine why the company was not able to generate sufficient cash consequent upon impressive growth. Firstly the average age of Accounts receivable rose from 30 days to 60 days. Secondly, the Raw material inventory and the finished goods inventory went up from 15 days to three weeks. Thirdly no effort was made to extend the payment terms of vendors as evident from the fact that the average age of Accounts payable remains constant at 30 days.
Now let us assume that the company has determined to implement the steps during the year 2010 to correct its working capital requirements and the first step it takes is to reduce the Accounts receivable age from 60 days to 45 days by reducing their credit terms and aggressive follow-up for receiving payment from them. This will have the impact on the company’s revenue growth. It may not rise by the same percentage as happened in year 2009. But it will certainly be worthwhile for the company to install the proper procedures in place consequent upon revenue growth, starting with monitoring Accounts receivable age.
Table 3
Now let us look at the net income statement for the year 2010 shown in Table 1 and cash-flow shown in Table 3. The net income growth is slow which 15% of the last year 2009 is, but nevertheless it is certainly an encouraging growth. The net income has also risen by around 25%.over the prior year. The cash generation during the year 2010 is $481,375 consisting of net income and amortization. The utilization of cash is for the increased working capital requirements, repayment of long term debt and purchase of short term investment. It can be seen in Table 2 that the working capital requirements have been increased only by 2.5% over the prior year as compared to a huge 150% increase in 2009. If the working capital components are examined it will be noted that the short term credit line facility has been paid off during the year and is no more outstanding at the yearend 2010. And the company has invested $423,292 in short term investments in the Short term securities that can act as leverage in case the company wants to mobilize the cash immediately. Thus it can be concluded that the company has generated sufficient cash to sustain its increased working capital requirements consequent to its revenue growth. It has managed its working capital well.
It can be argued that it will be difficult to implement the entire reduction of Accounts receivable age in practice within a short period. In that case the company can assess the possibilities of reducing the other working capital components, for example, reduction of finished goods inventory from three weeks to 15 days since the manufacturing cycle is given as one week (and therefore it does not make sense to have the inventory of three weeks). Similarly the inventory of raw materials can be reduced from three weeks to 15 days if the raw materials sources of the company are close by and those can be procured very quickly. One more alternative of reducing working capital requirements is to increase the Accounts payable age of some of the payables from one month to five weeks. Further, a try may be made for reduction of prices of main raw materials on the basis of more procurement since there is an increase in their quantity purchased consequent upon the revenue growth.
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Shantaram Sapre, CMA currently works as an Accountant at The Kryton Group of Companies.
This article clearly explains issues with cash flow management. The conecpts are explained in simple terms for anyone to understand.
Thank you Kishore, for your time to go through the article!!
A neat detailed article explaining various issues of a manufacturing organization cashflow. Examples make it very crisp.
Thank you Sanjay, for your feedback!!
The article on sustaining cash flow in the case of a typical manufacturing company brings into focus the lifeline of any business, i.e., cashflow. My takeaway from the article is to strike a delicate balance between business growth and its underlying cash flow requirement. Looking at the fact that the borrowing cost is tax deductible, one may argue that we need to sustain the revenue growth over the cash flow in the short term, given the availability of short to long term debt fund from the banks.
Debasish, Thank you for your comments!! I appreciate your feedback drawing the attention to the benefits of tax deductibility of borrowing expenses in short term.
Thank you Shantaram, for making sense of something that typically never made any sense. Your insight gives me insights into how to manage and think before acting within my own business. Fabulous info and delivery.
Always the best to you and yours,
Wonderful article. Indicate your depth of knowledge, experience & inteligence. You would be an asset for manufacturing company
This is a well written article that gives a very clear explanation of how companies in a growth phase can actually fail if they don’t manage their working capital requirements well. By using Inv Days+ AR Days – AP Days = Funding Gap, it becomes easy to see how many days short term financing would be required for. This can be further refined by taking the number of days the funding gap is, and multiplying it by Cost of Goods sold and dividing the amount by 365 days in order to arrive at the actual amount of short term financing required. Then, a company can calculate an interest rate to see how affordable the strain on working capital really is. Shantaram gives good practical examples of how to minimize the funding gap.