Cash Like a River Flows

March 28, 2019

This is one of my favorite times of the year - the emergence of spring. The birds are returning from their southern climes, the trees are budding out, and the river flows are starting to fill out a bit. They won’t hit their peak for a few months however - June is the time for big water! 

Here in Colorado, our rivers are comprised chiefly of snowmelt, and our high mountains is where we receive and store most of our snow (that’s why we have skiing!). Though it is warming weekly down here, it’s still cold in them thar’ hills. And as it warms, the snowmelt takes its sweet time flowing down the hill to the stream, down the stream to the river, and down the river canyon to our small city on the banks of the Cache la Poudre River. Some of it we divert into high-mountain reservoirs, others into Horsetooth closer to town.  

Now, to transition to more businessy topics as is my habit, let’s do a metaphor exercise, with visualization. Think of the unmelted snow like it’s your business’s inventory, the snowmelt flowing down the streams and rivers are like accounts receivable, and the reservoirs are like your long-term savings account.  The water that makes it all the way down and goes into the municipal water plant and the irrigation canals is like cash in your checking account. This water is the useful stuff - you can drink it, grow corn with it, kayak in it - coming summer 2019 we can do that right here in town!

The point is, it’s only useful once we can do something with it. Many of you know I come from a farming background, and as with snowmelt, we have one cycle per year to do our thing. We pay the rent, buy the fertilizer and the seeds, pay the fuel bill and the hired labor, and then pray for rain...but not too much. If so blessed, the harvest comes in, the grain is sold, and we have cash for another year’s planting and hopefully something to live on until next season’s harvest and sale.  

In farming, there is a large sum of cash invested on the front end that only comes back to the business once the entire cycle has been completed. Now imagine you’re a manufacturer of high-ticket items - let’s say you build custom robots for manufacturing clients - $500K per unit on average. The machines take three months to complete and you have room in your facility to build two at a time. Up front, you get a 20% deposit ($50K) on each and then go about designing the machine, ordering or machining the appropriate parts, paying the labor, paying the rent on the facility, etc. Your all-in investment is $250K in cash spent on the front end of each unit, $500K if you take two contracts at the same time. You took in $100K in deposits, so have invested $400K of your own cash along the way. The machines are completed and delivered, and your flexible payment terms provide the client with 90 days to pay the balance - so of course they pay on day 89!

In the meantime, you take in orders for two more machines - same $50K deposit per machine, same $400K of your own money invested along the way. So now, before you collect on your first invoice, you’re into the pair of projects for $800K! This is where lines of credit often come in - the first sale was for a total of $1,000,000 - with $100K deposited up front - and so you have accounts receivable of $900K. Banks will typically loan ~75% against current accounts receivable, so you can find most of your cash need in the form of credit, or you need that cash on hand up front.  

In this example, the business is capable of making a total of eight machines per year at full capacity - totaling sales of $4,000,000. And the business will almost always have ~$900,000 in Accounts Receivable - cash that’s coming, but you can’t access it without the proper tool - a line of credit.  With our 50% gross margin, and assuming fixed overhead at $1,000,000 annually, you’ve made a tidy profit of $1,000,000 on the year’s production output.  

Demand for the machines is strong, however, and you determine that your deposits should be larger (50%) and your payment terms shorter (30 days). Also, one of your brightest engineers has encouraged the adoption of some design-build techniques that will let machines be built in two months instead of three.  

Let’s see what happens when we apply these changes to the business. First, the deposit on a two-machine order jumps from $100,000 to $500,000 - which is an immediate source of cash of $400,000. The 30-day payment terms instead of 90-day, and smaller balance owed due to larger deposit will take average accounts receivable down to an average under $300,000 - another source of cash of ~$600,000. You don’t even need the line of credit anymore, since the deposit from the customer covers the all-in build cost.  

Instead of four turns of two machines at a time for a total of eight, you can now do six turns of two at a time for a total of 12 machines. $6,000,000 in sales, $3,000,000 in cost of manufacture, and $1,000,000 in overhead - you can now make $2,000,000 annually, and you rarely have to wait long for payment. What’s more, you’ve identified a huge source of cash that might be used for plant expansion or a big owner’s bonus!  

So, with a river, we’re stuck with one cycle per year. Old Man Winter builds up our inventory, the spring sun melting the snow is like sales, and eventually the accounts receivable trickle in and we have useful water - the cash we can spend. With business, however, there are a number of actions we can take to increase that trickle. We've shown how one can increase cashflow by making adjustments to a business model - taking a larger deposit up front, reducing allowed days for payment terms, or taking actions to turn the cycle faster. These changes can turn a cash trickle into a stream, and the stream into a raging river over time. Cash like a river flows, and just like water for the young plants on a farm it is the lifeblood of your business. 

- Curt Bear
Founder, LoCo Think Tank

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