“When I was boxing I made five million and wound up broke, owing the government a million.”
Joe Louis
Over 60% of the businesses we work with consume precious cash when they grow. Sadly, most of them did not know this fact. They happily celebrated their increasing revenues and rising profits until one day they ran out of cash. Game over. Done.
We term this malady “Growing Broke”.
Have you and your business been infected by this sly and debilitating illness? It quietly eats you up. As you struggle to make sales you breathe a sigh of relief blissfully, but dangerously not realizing that the cash rash has spread all over your body and you are really like one of the zombies in the series “The Walking Dead”.
We don’t want this to happen to you so we are giving you an easy way to tell if you are healthy and wealthy or you have the cash rash—if you are infected we will give you an early diagnosis and course of treatment.
Let’s take the example of Sam the electronics man.
Sam sells electronic components that are used in the security and technology markets. Sam knows that growing his business is vital and he and his team have been good at doing that. After three years of perfecting their products and building their customer base they are experiencing a surge of rapid growth.
Sam should be in the perfect position to celebrate the fruits of their hard labor. Instead Sam has been spending the last 3 months in numerous and painful bank meetings. Sam was astonished and very angry when the bank has requested that Sam either find an alternative source of finance or close his business!
Sam was completely mystified. This year his business grew 40% with significant profit improvement. Like many before him he caught the cash rash malady and has fallen into the growing broke trap without even knowing it was happening.
The communication problem lies in the different business languages that we speak. Most business people speak Spanish but bankers speak Portuguese. The languages sounds similar yet are very different.
Spanish is all about the income statement and Portuguese the language of the bankers, is all about the balance sheet.
Business people focus on the income statement; it’s what they understand- the ability to make money! Sam sees he is making a lot of money.
The banker is looking at the balances sheet and sees Sam’s business is consuming cash faster than he is able to pay it back to the bank, so the bank wants out. Because Sam did not think about both the income statement and the balance sheet it is almost too late to rescue him.
The reality is that in business we have to be fluent in both Spanish and Portuguese. We have to make money and cash at the same time.
Let’s take a slightly deeper dive into what happened to Sam’s business.
When Sam makes a sale he creates revenue not cash. The reason is that his customers take between 30 and 60 days to settle their purchases in cash. When Sam purchases his components from his suppliers for resale Sam has to pay his suppliers in 15 days.
Let’s say Sam makes a sale and sells a component to his customer for $100. He feels pretty happy. But note he does not have any cash in his hand yet.
On day one his cash position has not changed. However on day 15 Sam has to pay his supplier $50 for that component. The question is with what? He won’t get paid by his customer until at least day 30. So Sam, who feels flush having made a great sales, digs into his existing cash reserves. Little does he know that that flush feeling is actually a symptom of the cash rash!
The cash rash gets worse when Sam buys a bunch of these components from his supplier (because he is focused on his income statement—for every one he buys for $50 he sells for $100 so of course he wants to sell as many as he can!) Now in days 16-30 Sam is out of pocket for multiple times the $50. He runs out of cash reserve. He hastily uses his credit cards. Still not enough. By the time he goes to the bank to extend his loan the bank manager sees a huge cash hole and refuses to lend more.
This is where a basic understanding of the balance sheet is necessary. You need to learn a bit of Portuguese.
At the Science of Business Wealth we will provide you with a way that you will always know if you are growing broke or not.
It involves two things you can easily calculate:
1. How much money are you making in your Income Statement.
2. How much cash is your Balance Sheet consuming. Is it a lean mean balance sheet machine or a voracious and hungry beast swallowing cash and creating the rash?
The difference between 1 and 2 is the Cash Consumption Ratio (CCR)
Here’s how to calculate your CCR— please do this, it could literally save your company at best and at worst will help you predict your cash needs for the future.
Step 1 – Calculate your Gross Profit contribution (Your Income Statement tells you this)
Gross Profit is your Sales revenues less your direct VARIABLE cost to sell your product or service (Listed as Cost of Goods Sold or Cost of Service Sold).
Gross Profit Contribution is the proportion of gross profit to your sales revenues
GPR = Gross Profit/Revenues
Step 2 – Calculate your Hunger Measure
This is a little more complicated but you can do it on the back of your napkin. It tells you how hungry your balance sheet is for cash.
A) Calculate working capital.
Add together your Receivables (what your customers owe you)
Plus your inventory value
Then subtract your Payables (what you owe your suppliers)
B) Divide Working Capital by your Annual Sales Revenues.
The Hunger Measure tells you for every dollar of sales revenues you sell, how much of that dollar is consumed in working capital
.
Step 3 – Calculate your Cash Consumption Ratio
What we have done is to create two measures that are related directly to each dollar of sales revenue.
Your Gross Profit Contribution is how much gross profit you make per revenue dollar.
The Hunger Measure is how much working capital you consumer per revenue dollar.
Now for your diagnosis:
If your Gross Profit Contribution is GREATER than your Hunger Measure YOU ARE CREATING CASH WHEN YOU GROW. You are in great shape!
If your Gross Profit Contribution is LESS than your Hunger Measure YOU ARE GROWING BROKE. You have the cash rash! Get help!
Early diagnosis of cash rash is vital. Treatment takes two forms:
Self medication—improve your Gross Profit Contribution—for example, raise prices or stop selling low margin products and services. Reduce your Hunger Measure-- get your customers to pay you sooner and try and lower inventories.
See the Doctor—If you go and talk to your bank manager early enough and demonstrate you know a little Portuguese she may be able to provide some borrowing while you go through this growth spurt. Or call Mick and Andre and we can help you with treatment.
Well done for getting to the end of this post. Very few business people understand how the income statement and the balance sheet work together to create a healthy and wealthy business.
If you are having any difficulty with your critical CCR please email us at
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