Olga Utlyakova
A company can be profitable, but if it doesn't have a handle on its cash flow it may find itself out of business in a hurry. Louis Gagnon, an associate professor who teaches finance at Queen's University in Kingston, explains why cash is king and how it isn't enough to have a paper profit.
The following is an edited/condensed version of the interview with Dr. Gagnon.
What are we talking about when you talk about cash flow?
We are talking about all the money that is generated by the business. These are revenues minus the costs. Inflows minus outflows, it's as easy as that.
You can't look at net income and interpret it as cash, because that number contains non-cash items such as depreciation. While they are significant from an accounting point of view, from a strictly financial point of view they are not cash.
Cash is king, as they say, and there are smaller companies that may be profitable when it comes to net income and it looks good on paper but they can't actually pay the bills. You need cash to sustain the business.
How does a company get in this situation? Profit, but no money?
They need a number of things to happen, but imagine for an instance that the firm's clients don't pay. The receivables don't turn into cash at the pace in which they should.
Say something happens, the economy goes down and the big clients stop paying or extend their terms of payment. That can create a crisis within a firm. This is just like what we've recently experienced with the economy globally as a result of the credit crunch.
If a firm is able to produce things profitably, but there isn't enough cash in the till, it finds itself short of cash and banks may not be willing to support the firm. They go bankrupt. It happens all the time, and especially with small businesses that don't always have easy access to cash.
Are small businesses too forgiving when they need to collect payments?
They don't have the same negotiating power, they don't have the big end of the stick when they deal with larger clients. Imagine a small firm in rural Quebec which has one large client such as Wal-Mart. If they decide to take more time to pay, that can be fatal and there is little you can do. Things happen, and that is why you need to have lots of cash on hand and try to be very liquid.
So how do you keep the cash flow flowing?
You have to watch your working capital. You have to monitor your clients, monitor your credit and collect your bills. It's an almost classic situation when a small firm appears to be doing very well but you look at their receivables and see they don't have the discipline to collect their bills and they have extended credit to the wrong people. That comes home to roost and can lead to big issues.
It all sounds kind of obvious, but people keep falling into the same trap. Why?
Nowadays if you are in a business school you learn a lot about options and derivatives. I teach these courses, so I'm not putting myself down. But we are so interested in derivatives we talk about them at every turn and lose sight of what's important. And you know what? Simple cash management is the single most important thing.
If you don't manage cash properly, you lose employees and suppliers and things go down very quickly. You need to keep a close eye - and I know this sounds mundane, but I argue that mundane is where all the action is.
So who should they be looking to for help?
The bank manger is often a really good source of information for small companies. And of course they often hire accountants, and even though they specialize in the books they can really be an accessible source of business information. Small businesses should leverage these relationships to the best extent possible.
Where else do small business make mistakes?
At the end of the day it is a very tough balancing act. Liquidity is crucial and you can't stay around without it, so it is important that you do not try and do anything too fast. Some put cash into facilities and production and stuff and don't set aside any cash for a rainy day.
They kill themselves that way. It may sound boring or simplistic, but it is so very crucial.