Cash Flow for Solvency (#349)
/The Solvency Conundrum
How can you tell if an operation is sufficiently solvent to pay for its investments and grow the business? There are lots of good issues here. First, can you figure out solvency from the statement of cash flows? Not directly, no. That statement only organizes accounting information about where cash came from and how it was used, so you can see it all on one page. But in terms of judging solvency, not really.
Your best bet for evaluating solvency is to calculate the solvency ratio, which looks at the ability of a business to meet its long-term obligations. The calculation is to divide an adjusted net income figure by the total short-term and long-term obligations of the business. To get to that adjusted net income figure, you’ll have to add all non-cash expenses, such as depreciation, back into the after-tax net income figure. If the resulting percentage is pretty high, then the business can probably pay off its liabilities over an extended period of time.
Budget Model Construction
But did that actually answer the question? No. It doesn’t tell you if an operation is solvent enough to pay for its investments and grow the business. The only way to find that out is to construct a budget that shows your expected cash inflows and outflows, by month, for at least the next year – and preferably longer. Load into that model all expected investments, and the rate of growth that you want.
Now, for this model to be really effective, it has to incorporate the balance sheet, so that you can see how the growth rate you want is impacting the projected working capital of the business – which means that receivables, payables, and inventory will all go up. If you plug in a high growth rate, then the need for working capital is going to go up a lot, which is going to wipe out your cash reserves in no time at all.
Budget Model Accuracy
The problem is getting that model to be as accurate as possible. A good way to keep things realistic is to match it up against your most recent financials and see if all the margin percentages look believable. That means being realistic about the gross margin percentage, and the operating margin, and the net profit margin. As long as you’re essentially copying the company’s historical experience forward into the model, there’s a good chance that what you’re modeling might actually happen.
Budget Model Iterations
At this point, you start doing iterations. On your first pass, your best-case rate of growth, along with all the investment required to make it happen, is probably going to call for a massive financing infusion. This is especially the case if your margins are already pretty low, because the business is not spinning off enough cash to pay for much of anything. For a low-margin business, the piddling amount of cash being generated is always going to put it on the edge of insolvency.
But, if the margins are higher, or if you have a reasonable argument for increasing margins, then more cash can be spun off, which allows you to grow the business a little bit faster without taking on any outside investments or debt. In essence, you use the model to tweak the budgeted growth rate, until you can figure out exactly how much growth you can afford. Try to grow any faster, and you’ll be insolvent. And speaking of which, remember that solvency ratio? Put that in the model too, so you can see – by month – whether the business can pay its bills.
The Investment Requirement
A couple of other thoughts. First and most important is the amount of investment needed to generate more growth. Some business models are pretty asset-light, so you can get by with minimal investment. If so, a moderately low-margin business might still be able to grow fairly quickly. The worst case is when margins are low and you need a lot of incremental investment to increase sales. In which case, sell the business and go look for something else to do.
Sales Variability
Second, lots of businesses don’t have steady sales all year long. There’s probably going to be a slow period, as well as another period in which sales spike. Watch for these periods in your budget, since they’ll impact your ending cash balance. If there’s a sharp drop, that gives you an indication of when you might need to have a line of credit available, and a rough guess as to the amount.
Assumption Modifications
Third, don’t go too crazy on modifying some of your assumptions in the budget model. For example, if customers are used to paying you in thirty days, don’t just assume that you can cut the payment interval to 10 days without getting some customer pushback. And, for that matter, don’t assume that you can massively stretch out payments to suppliers – they don’t like it, either. Instead, it’s pretty likely that you’re stuck with a model that matches how the industry already operates.
Inventory Modifications
Fourth, if there is an area within a business where you might have some room to make changes, it’s inventory. If you tightly manage how much inventory is kept on hand, you might be able to operate with a significantly reduced inventory investment, which frees up cash for more growth. In short, good inventory controls can lead to a bit more rapid growth.
Failure Probabilities
Fifth, assume that something will go wrong. There’s always something beyond your control that reduces your expected cash flow. Maybe a customer goes bankrupt or starts buying from a competitor, or maybe a supplier delivery gets destroyed in an earthquake. Could be anything. So, if you’re relying on that cash to support lots of new hires or store openings, be prepared to be shortchanged. That means you have two choices. Either have a line of credit or some other source of cash in reserve, or scale back your growth plans a bit, so that you have an internally-generated cash reserve to deal with these situations.
A Final Thought
And a final thought on this issue; before you start working on aggressive growth plans, take a really hard look at the company’s historical profit margin percentage and investment requirements. If that margin is pretty low and the investments are high, then you’ll be struggling just to get by, let alone trying to grow the business. So, the real issue with solvency is deciding whether you’re even in the right business. If margins are too low, even your best efforts will probably only raise them a little bit – and that’s not going to allow for much in the way of growth.