Written by Tim Sernett, Accounting & Finance Advisor for SMBs | Owner-Financial Optics Inc | Entrepreneurship enthusiast | Dad | Sports nut

“Can you afford growth?”

I know that sounds like a strange question, but it’s one that’s come up lately with a few clients. When small business owners are all excited about large new clients and substantial new growth opportunities, seldom do they stop and think about if they can have the cash flow to manage the growth.

Depending on the type of business, a small business can literally grow itself into cash bankruptcy.

This is especially true for a business that sells on terms and is inventory-driven. A top line revenue increase should increase profits, assuming you’re not undercutting your own gross profit requirements just to get the business (a big mistake many small businesses make when they don’t have a good grasp on their gross profit requirements).

However, top line revenue increases often generate a negative cash flow in the short term.

How can that happen? Let’s take a look at a couple of examples:

Example 1 – Product Driven Business
For a product-driven business, hitting new levels of top line sales means an increase in inventory levels to enable timely shipments on the new sales. Most of your vendors are going to require the standard 30-day terms, so you have to pay for the increased inventory levels within 30 days. Well, how fast will that new inventory turnover (sell)?

Let’s say you have an awesome inventory turnover rate of 8 times a year (rare), then your new inventory should sell within 45 days. Don’t forget your own terms with your customers. Assume standard 30-day terms.

So your new inventory purchases have to be paid within 30 days. But the time it takes to sell the new inventory plus the # of days to actually collect on those sales could total 75 days….IF all goes well.

But let’s be honest. What are the chances of selling all of the new inventory within 45 days and everyone paying on time? Not likely.

Do you see a bit of a cash flow crunch here?

Example 2 – Services-Based Business
Cash flow crunches from revenue increases can also happen in services-based businesses. A small business taking on a new, larger client will often accept terms they normally wouldn’t. For example, let’s say your typical payment terms are 30 days. The new big client pays on 60-day terms. You want the growth, so you accept the terms and take the business.

This big new client means more production than your current resources (employees and skill levels) allow for, so now you have to hire. New employees, no matter how talented or what their skill level, require some onboarding and training time. Even if they’re up to speed relatively quickly, how long until you’re actually invoicing for services to the new big customer (which, remember, are on 60-day payment terms)?

Oh, and don’t forget that your new employees’ paychecks aren’t going to be on 60-day terms….more like 14-day terms (bi-weekly payroll).

Do you see a bit of a cash flow crunch here?

Ask the Tough Questions Before You Dive In
I’m not saying don’t jump on new opportunities or take advantage of the chance to grow like crazy if you can. I’m all about entrepreneurial spirit and growth. What I am asking is that you have the courage to slow down a bit and ask some tough questions before you dive in. Are you in a position to afford the growth?

The questions you need to answer (which will also save you some sleepless nights) are:

  1. How much cash am I going to need to finance the growth?
  2. When will I need it?
  3. Where’s it going to come from?

The best way I know how to answer those questions is by preparing some financial projections models. Plan, plan, plan…and plan some more. Compare your actual financial results to your planned financial results. Understand what things aren’t going according to plan and why. And then revise and adapt.

So go for it! Grow like crazy! But before you do, be sure to act like a professional business owner and have some vision into what you expect the growth to do to your business finances. That’s the best thing you can do to prevent yourself from growing into cash bankruptcy.

Thank you for taking the time to read the Financial Optics blog! If you have any questions about this post or any other questions, give us a call at 913.649.1040. We’re happy to help.