Creating Your Advanced Warning System to Avoid Cash Flow Catastrophe

Jul 23, 2021 | Cash Management

Maybe the only thing worse than having cash flow issues is being surprised by cash flow issues. A cash flow problem arises when a business begins to have more cash outflows than inflows. We are not speaking about profitability, but money in the bank! As cash flow worsens, the ability of a business to sustain normal operations can be seriously stressed in the short term. Read on to explore how it’s best to create a system to be aware of cash flow problems as soon as possible so you can deal with them effectively.

What are the most common cash flow stressors?

There are typically eight triggers companies experience that lead to cash flow problems. These include:

  1. Accounts Receivable Issues: People are paying you too slowly.
  2. Accounts Payable Issues: Vendors are pressing you for payment.
  3. Inventory Levels not optimized: You have too much inventory, costing money to warehouse, or you don’t have enough inventory, so you can’t sell.
  4. Unexpected expenses that aren’t being met with a reserve fund or access to credit.
  5. Seasonality: You’re not in your “busy season” and cash isn’t stretching as far as it should or could be, and you don’t have credit facilities to help bridge the gap.
  6. Unexpected Growth: Great! Business is booming! Now you’re hiring new people, expanding inventory or physical space, or taking on other overhead that can quickly suck up cash. Or, new clients with complex procurement situations are slowing down payments (see the first bullet!)
  7. Loan interest rate risk
  8. Declining Sales

Developing an Advanced Warning System

Every company will inevitably cope with one or more of these cash flow triggers. Smart companies will be prepared for them, making them easily understood and absorbed into operations. Companies that don’t prepare can find themselves making desperate and unexpected moves like sudden layoffs, broken vendor relationships, risky loans, assets sales or other drastic measures. Here are 10 components of a simple Advanced Warning System that can help you avoid cash flow catastrophe:

Forecast cash flow for 13 weeks

Base this forecast on what’s happening in real time – which means having weekly reporting at the ready. Conduct this forecast on a rolling basis; in other words don’t forecast 13 weeks from now and revisit again in 13 weeks. Simply have a weekly review of what the next 13 weeks look like. This gives you ample time to identify trends. (More on trends in a bit.)

Look at your Accounts Payable Turnover Ratio

Your AP Turnover Ratio is calculated by dividing your purchases by your average accounts payable. This gives you some insight as to how fast you’re paying your bills to suppliers. Are any vendors insisting on Cash on Delivery (COD)? Is any short-term liquidity at risk?

Review your Accounts Receivable Turnover Ratio

The AR Turnover Ratio is your Net Credit Sales divided by Average Accounts Receivable and basically measures how fast or efficiently you’re collecting from customers. Look at these client-by-client if you can. A worsening ratio may indicate a negative trend that could become a problem. If you can identify what clients or customers are driving this, you can prioritize dealing with them before the situation gets out of hand.

Examine Inventory Turnover

Inventory Turnover measures your cost of goods sold (CoGS) divided by your average inventory, or how many times your inventory turns (has been sold and replaced). Look for trends that indicate inventory is out of balance as compared to what’s being sold.

Review Interest Coverage Ratio

Interest Coverage Ratio (ICR) is calculated as EBIT (Earnings before Interest and Taxes) divided by interest expense, and helps you figure out how easily you can pay interest on outstanding debt.

Assess Best, Worst, and Middle-of-the-Road Case Scenarios

Imagine different realistic scenarios and systematize how you’d manage each. Nobody expected a pandemic in 2020, but some companies were better prepared to weather the situation than others. You can bet those companies had done some situation and scenario planning and forecasting.

Create and Study Sales Forecasts

An unplanned change to sales – increasing or decreasing – can cause cash flow issues. When you’re ready for the unexpected…they’re no longer unexpected.

Avoid Unplanned Extraordinary of Capital Expenditures

If you can approach the year, quarter, or season ahead strategically you can be prepared for major expenses. Real estate, acquisitions, significant new hires – taking on overhead means cash flow will take a hit. When you’re prepared for these things so you have cash or credit on hand you’re capable of managing that hit.

Don’t Default on Loan Covenants

Loan payment defaults present obviously serious issues. Covenants, which are basically “the terms of the deal” that lenders can monitor after closing, also impact the lending relationship – sometimes with severe repercussions. Breaking a loan covenants can include not notifying the lender if you do certain things, if you merge or sell your business without their involvement, if you start or leave a line of business. A broken loan covenant can allow the lender to change the terms of the deal – and it won’t be in your favor.

Watch Your Deferred Maintenance

Postponing repairs on a building or peace of machinery until cash flow stabilizes often feels like a sensible short-term solution. Be careful how long you defer, however, or you can end up with a backlog that gets increasingly difficult to manage. Some studies show delaying maintenance can increase future costs by as much as 600%. The analogy of a car is appropriate – if you put off an oil change (a $50 maintenance item) until your check engine light turns on (now a $250 diagnostic issue), but then ignore that light and keep driving until your engine fails…well you can conceivably wreck an engine that will cost thousands or even tens of thousands of dollars to repair or replace. All because you skipped an easy $50 upkeep item. In some ways your business runs the same.

Conduct audits on and built reports around your deferred maintenance so you avoid surprises or an insurmountable backlog that, ultimately, can devalue assets.

Identify Cash Flow Trends

With all components of your Early Warning System, watch for trends. A sudden spike in your rolling 13 week review could be an aberration, or account for one-time expenses or income that impact cash flow. Take note of the general trend line. When it’s moving in a concerning or remarkable way, dive deeper into the characteristics driving the trend. When you can isolate a problematic vendor relationship, maybe renegotiation of terms is in order. If you’re having trouble accommodating seasonal shifts, a new line of credit or alternative funding could be a solution.

Trust Your Capable CFO

A capable CFO will do more than have a look at basic financial reports, give you a thumbs up and see you again in the next meeting. A good CFO is an investigator, and they’ll need to dig into systems issues your company may be having around chronic cash flow issues. Your CFO should be ready with practical recommendations to improve cash flow. They should complement the visionary CEO or executive with the right tactical approach, relationships, and solutions to protect the assets of the company.

Addressing Cash Flow issues can take a variety of strategies, but with your Advanced Warning System functioning with high efficiency, you’ll avoid being caught off guard and in the middle of unmanageable catastrophe.

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