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If you have ever looked at the financial statements for your business and thought, “Revenues are up and profits are solid, so why is my bank account shrinking?” you are not alone. Many business owners run into this scenario, especially during periods of strong growth. Sometimes, the faster your business grows, the less cash you seem to have. The culprit could be your cash cycle.
What the cash cycle is
In simple terms, the cash cycle is the time between when money leaves your business (for things such as inventory, payroll, rent, and expenses) and when money comes back in from customer payments.
The cash cycle is made up of three key components:
- outflows – paying suppliers, stocking inventory, covering operating costs;
- sales – delivering your product or service to the customer; and
- inflows – collecting payment for what you have sold.
Why growth can make the problem worse
When your business grows quickly, cash outflows often happen before the inflows catch up. If your customers take 30, 60, or even 90 days to pay, the faster you grow, the more cash gets tied up in accounts receivable and inventory. In other words, your growth can actually drain your bank account, even while your income statement shows rising profits.
Why buyers care
A long cash cycle means a buyer must tie up more of their own money just to keep the business running. That is extra risk and extra investment for them. A short cash cycle means the business funds itself more quickly, reducing the need for extra working capital and making the business more attractive. A shorter cash cycle equals less risk, equals higher value. To illustrate this point, consider these two businesses and their cash models.
- The fast-cash model: An e-commerce business sells directly to consumers and is paid by credit card before the product even ships. Cash cycle: Often less than a week.
- The slow-cash model: A custom equipment manufacturer that pays for parts and labor upfront, then waits 90-plus days to be paid after delivery. Cash cycle: Three to four months.
Theoretically, these businesses could have the same revenue and the same profit margins. However, the business with the shorter cycle has more cash available and is worth more to a buyer.
Recurring revenue: The secret cash cycle weapon
One key way that business owners can shorten their cash cycle is to move to a recurring revenue model. This business model is built around generating consistent, predictable revenue streams, often by charging customers on a regular, ongoing basis for a product or service.
Recurring revenue such as subscriptions, memberships, or prepaid service contracts dramatically changes the cash cycle. Instead of paying out for products or services, then waiting weeks or months to collect, you are paid at the start of the cycle, often before the service is even delivered.
This can:
- shrink your cash cycle from months to days;
- create predictable, steady inflows that reduce working capital needs;
- make your business more resilient to seasonal or market fluctuations; and
- increase your company’s valuation because buyers see lower risk and higher cash efficiency.
When you combine recurring revenue with a short timeframe for purchasers to pay for goods and good inventory management, your cash cycle can become so compressed that growth no longer starves your bank account. Revenue and profit stay the same, but your cash position improves and your business becomes significantly more valuable.
If subscriptions or prepaid services don’t fit with your business model, you can still build more predictable revenue through strategies such as bulk discounts, loyalty programs, memberships, rewards for referrals, and other incentives that encourage repeat purchases.
Read more
- Why CPAs should embrace exit planning as a strategic advantage
- Passing the torch: LCGE planning and intergenerational business transfers
- Valuing a small business: Is there an easy way?
How to shorten your cash cycle
Along with a recurring revenue model, there are other ways that business owners can shorten their cash cycle. Practical tactics are to:
- negotiate faster payment terms with customers;
- offer early payment discounts;
- improve inventory turnover by buying in smaller, more frequent batches; and
- add recurring or prepaid offerings where possible.
Overall, the cash cycle is one of the hidden levers that affects both your cash in the bank and the value of your business. Shorten it, and you will see two wins – more money available to you now, and a higher sale price later.
Gerry Lalonde, CPA, CGA, is a growth and value strategist. He helps owner-managed businesses grow, scale, and maximize their enterprise value, so they’re ready for any opportunity or challenge that comes their way. You can contact him via www.xrtp.com.
Originally published on LinkedIn.
