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Can You Afford To Grow?

Article By Brent Charlton | | Accounting & Tax

Nothing dries up business cash flow like growth

It’s common for business owners to want to grow and expand their business. The assumption being the bigger revenues will mean bigger profit and bigger profits mean more cash flow for business owners.

Whilst this can indeed be true, the process of growing can require significant cash resources to fund that growth in revenue. For example, let’s look at a growing legal firm. Let’s assume that other than growth, all other financial metrics and margins remain the same:

  • Revenue has grown from $2 million to $2.5 million.
  • The firm operates at a 20% profit margin, after accounting for owner salaries.
  • Debtor days (average number of days for a client to pay their invoice) is 30 days.
  • Work in Progress days are 45 days (work in progress value / total annual revenue x 365 days)

Now lets run the numbers:

  • Increased Profit of $100,000 ($500,000 increase x 20% Net Profit Margin)
  • Increased Debtors owing of $41,096 ($500,000 x 30 Debtor Days / 365 days)
  • Increased Work in Progress of $61,644 ($500,000 x 45 Debtor Days / 365 days)
  • Negative Cash Flow of $2,740 ($100,000 increased Profit less increased Debtors of $41,096 and increased Work in Progress of $61,644)

As you can see the $500,000 in increased revenue and $100,000 in increased profit doesn’t equate to increased cash flow, not at least straight away. Moral of the story is plan and model out your growth goals to ensure you don’t get unintended consequences. Our example shows only a small deficit, but if you needed to expand and invest in additional assets or purchased another firm to facilitate your target, you further add to the cash flow deficit.

Now this doesn’t mean don’t grow. It means, plan ahead and have funding available to help grow. Here are some options:

The Bank

Getting an overdraft or term loan might be the best way to manage a cash flow issue with your business. For many industries, the Bank can provide funding to support your businesses investment in working capital such as Debtors and Work in Progress.

When choosing either an overdraft or term loan, consideration should be given to how long the shortfall will exist. If the shortfall is expected to be consistent (i.e. the loan balance isn’t likely to fluctuate), a term loan is the best option due to its generally lower interest rate and the ability to pay the loan off over an extended period (usually up to 10 year).

Where the cash flow shortage ebbs and flows, typical in more seasonal businesses, an overdraft might be more appropriate. Whilst the interest rate is likely higher, the business won’t need the funds for the entire year, therefore making it an overall cheaper option.

Invoice Financing

Invoice financing is a type of short-term financing in which businesses borrow money against the amount owed on invoices it has sent to clients.

The benefits of invoice financing are flexibility, instant availability of funds and getting funding without going into long-term debt. The downside is the cost of the financing, either to your business or your clients (depending on how you decide to utilise it).

Business Owner

Finally, personal funding might be needed to keep things going, but this is on the basis you have the ability to do so. This funding may need to effectively come from the Bank via an increased home loan. Alternatively, it’s from savings that could be otherwise invested.

Overall, the best way to managing growth is by planning in advance and identifying where cash flow shortfalls could arise. Having a heads up allows you to have contingency and funding plans in place, and ultimately allows your business to grow without the added cash flow stress.

If you don’t do the planning up front, you take the risk of having tomake difficult and potentially expensive decisions down the track. Need help with planning your growth and business goals? The team at Altitude can help.