27 May Watch Out for These 3 Liquidity Traps in Your Business
You might be in a growth phase of your business. Growth always requires cash and cash is generally at a premium. Further, there are some traps to be avoided as you grow. Here’s 3 to watch out for.
1) Excess build up of accounts receivable
It’s normal for your receivables to increase when you grow. However, if you’re not careful, the build up can be excessive if you also experience a slow down in payment from your clients. For every $1 million in revenue, 1 day’s worth of AR is about $2,800. If you’re a $10 million company and you have a slow down of 10 days in your collection period on AR, that’s $280,000 that is sitting in AR that could be sitting in cash. Wouldn’t you rather have all or a substantial amount of that in cash?
To monitor this, calculate your accounts receivable turn. Take annual revenue/AR balance to come up with your receivables turn. To calculate the turn in days, take 360/AR turn). For example, $1 million/$200,000 AR balance is 5x turn. 360/5 =72 days sales in AR.
2) Excess build up of inventory
You can experience the same trap with inventory, or potentially double if you sell the inventory on credit terms and it converts to AR when sold.
To monitor your carrying level of inventory, calculate your inventory by taking your cost of goods sold/inventory balance. To convert it to days take 360/inventory turn.
So, if your cost of goods sold is $8 million and your inventory is $1 million, your inventory turn is 8x. To convert this to days take 360/8 and your have 45 days worth of cost of goods sold inventory.
3) Purchase fixed assets and with cash
You might be a person that likes to pay cash and not borrow money. I get that. But one of the traps that growth company’s experience is not having sufficient cash to meet payroll when that cash has been spent on fixed assets. Generally, you want to match your long term uses of funds (like buying furniture and equipment) with long term sources of funds like loans. You keep your short term sources of funds like cash to handle short term uses like operating expenses, receivables or inventory.
Many business owners have a line of credit for equipment purchases that they fund up throughout the year and then convert it to a term loan. That’s a good way to avoid spending your cash but still making the purchases.
Growing your business is hard enough all by itself. Don’t fall in to these liquidity traps that make it even harder. Stay connected to your balance sheet and monitor your trends in the financials so you don’t get caught short of cash.
If you’d like more information about profitability coaching tips like this, please contact us and we’ll be happy to set up a time to talk in more detail.