June 8, 2011

The Pitfalls of a Successful Business – Managing Cash Flow

By Paul C. Pershes, CPA, ABV, CVA, CFF

The Pitfalls of a Successful Business – Managing Cash Flow
The Pitfalls of a Successful Business - Managing Cash Flow

Why is one business successful and another not? Although there are many reasons and rationales to explain successes and failures – it is really not a mystery. Sometimes a business fails for no other reason than the business model was wrong. In other circumstances, a wrong location is chosen for the right business or it is started or acquired at the wrong time. Frequently, a new business owner just needed help from others but didn’t ask for it.

There are many guidelines written for starting/buying businesses in almost any business book; however, one of the essential rules that will help ensure continued success is to make sure sufficient cash or access to financial resources is available for the business and personal expenses.

The business rule that must be followed for every business, new or existing, and the most overlooked is that cash flow must be managed properly.Without proper cash flow a business will fail. Managing cash flow includes having sufficient cash to invest in the business from the start and then managing operating cash flow wisely throughout the life of the business.

Cash Flow has several components that each business owner must understand.

  1. Initial cash investment is the funds necessary to purchase or start up the business. This includes the purchase price of a franchise or existing business and the costs for starting up a new business.
  2. Cash on hand and working capital includes the funds necessary for the business to pay its short term liabilities and also includes additional funds necessary for the growth of the business.
  3. Cash available for staying power are additional funds required for slow periods, a recession and increased competition. These funds are necessary to “Weather the Storm.”
  4. Cash available for emergencies is required to take care of the totally unexpected. The loss of a major customer or the owner getting sick.
  5. Cash available for personal expenses represents living expenses of the business owner and family. The last thing the new business owner wants is to worry about paying the everyday living expenses for the family.

In addition to the above listed cash flow components, there are several key accounting terms that every successful business owner should have in the front of their mind.

  1. Operating Cash Flow represents the actual cash received during the course of the business year from sales of products and services less the actual cash disbursed for the purchase of products and services and selling, general and administrative expenses incurred during the year.
  2. Owner’s Compensation represents all business and personal expenses that the business pays on behalf of the owner, including salaries and benefits, distributions and personal expenses.
  3. Cash Basis of Accounting accounts for cash transactions only – i.e. sales that are actually received in cash and expenses that are actually paid. Income earned but not received in cash and expenses incurred but not paid are not included.
  4. Accrual Basis of Accounting accounts for all transactions – income earned whether received in cash or not and expenses incurred whether paid or not. The accrual basis of accounting provides a more accurate method of accounting than the cash basis of accounting. It follows a basic accounting theory – MATCH YOUR INCOME AND EXPENSES AS THEY OCCUR. A major Pitfall of a successful business is not paying your bills timely and not understanding the accrual method of accounting.

The Start Up
There are hundreds of thousands of businesses that start up each year. It is essential for a business owner to grasp the “rules of thumb” to owning a business. The following list is not intended to be all-inclusive, but provides several fundamental concepts.

  1. Have cash for at least two years of operations – budget conservatively.
  2. Make sure there are sufficient savings to cover family living costs for eighteen months – make a sound family budget that will work.
  3. Make sure your family and close relatives understand the sacrifices that will be made during the early years of the new business.

The new business can be profitable in the early years but provide little or no cash flow as the business requires all available cash for operations for the first several years.

Buying a Business – Pro’s and Con’s
Buying a business requires investing a significantly greater amount of cash initially than starting a new business. The seller must be paid for their years of effort, the existing assets and customers, and the profits and business goodwill created. These assets being purchased are generally represented in a purchase price of the business calculated as 3-4 times the income before interest, taxes and depreciation and amortization (EBITDA or positive cash flow).Generally, when a business is sold, the seller generally will keep the cash on hand, accounts receivable, real estate and retain the liabilities. Inventories are generally included in the sale price but the seller will try to reduce the level of inventories at the time of sale. The Pitfall here is to recognize the cash needed to operate the business being acquired at the current expected sales level. The new owner will have to add operating cash, fund the business for the lack of existing accounts receivable and the need for increased inventory levels to offset the working capital taken out by the seller. This does not include the additional cash necessary to grow the business. These hidden cash needs often go unnoticed by the new unsophisticated buyer.

Some Stories…Lessons Learned
I have helped many business owners succeed and have had several business owners come to my door too late for rescuing. The following stories will show how cash flow affects business.

Buying a business – Success v. Failures
Two average individuals, Mr. A and Mr. B, each decided to go into business for himself.

Mr. A had $100,000 in cash to invest – his life’s savings. He went to a business broker (not an attorney or financial advisor) who showed Mr. A the businesses he had available for sale that could be bought with $100,000. As rule of thumb, a small business sells for approximately (3-4) times owner’s compensation (which includes salary, benefits, car, insurance and other personal expenses). Therefore, the purchase price of this $100,000 business would presume the owner’s compensation would be $33,000.

Mr. A engaged my CPA services just after purchasing the business. He told me that he found the expected cash flow available for owner’s compensation and running the business was inadequate. The business was failing and he recently purchased the business. He asked me what was wrong.

First, there was no initial cash to invest in the business. Mr. A needed cash to operate and to support the operations until new accounts receivable were earned and then collected – he did not anticipate this additional investment. Second, as a new business owner, vendors wanted to be paid immediately as they did not know Mr. A. He did not have any more cash for working capital and he also needed to take money out of the business to live. The result – within 180 days the business was failing despite years of prior success.

Mr. A should have engaged professional legal and financial advice before purchasing the business.Had he done so, Mr. A would have been advised of these initial working capital cash needs and negotiated a partial payout of the purchase price to provide the necessary initial working capital.

On the other hand, Mr. B who had $400,000 to buy a business sought out both legal and accounting advice. Mr. B asked his CPA to review the financial statements of the business he wanted to buy and make recommendations as to the accuracy of the financial statements and the initial cash and working capital needs. The CPA was also asked to estimate the owner’s compensation that could be withdrawn in the first year based on the prior financial statements and projections being made for the business. Mr. B needed $100,000 in annual owner’s compensation. The purchase price would generally be between $300,000 and $400,000.

The same Pitfalls for cash and working capital needs would result if Mr. B did not have additional cash to invest or alternative financing sources to cover the initial cash and working capital needs described above – only in larger amounts. The CPA advised Mr. B that he estimated $75,000 to $100,000 would be needed to meet the working capital needs in the first year.

Mr. B, together with legal and financial advisors, negotiated a $250,000 down payment and a three year payout for the $150,000 balance for the remaining purchase price, thereby having sufficient cash and working capital to run a successful business and pay expected owner’s compensation.

The Successful Business That Failed – The Example of Company X
Company X, until recently, was very successful – it was worth over $100 million with outstanding positive cash flow, but what went wrong? Initially, Mr. Successful Owner did everything right. He purchased prime real estate at relatively low prices, upgraded the properties as necessary and was able to increase rents. Financing was available and obtained at favorable rates and rents were continually increasing to pay the additional financing costs. As the fair market values of the properties increased, Mr. Successful Owner refinanced the properties and took out more cash. What could be better? NOTHING! What went wrong? EVERYTHING!

Mr. Successful Owner started using the cash proceeds from the refinancing to invest in riskier assets at a time when the market was at its peak. What he did not recognize (for lack of experience) was that the market was topping out and the competition had increased. The market was declining and the ability to obtain financing by buyers was drying up. In addition, the success of prior years provided a very wealthy life style for Mr. Successful Owner as he had spent millions of dollars in owner’s compensation on very expensive personal “Toys” – airplanes, homes, cars, hobbies and art.

Today, there is little equity left in the business. The “Toys” are being sold, and current cash flow is not sufficient to pay outstanding debt. What happened? It was like a Perfect Storm – the liquidity crisis hit, real estate values went down, buyers disappeared and expenses continued to increase. Also, Mr. Successful Owner did not recognize how the market could change so quickly. He did not set-up emergency funds during the good times to protect the investments to get him through the downturn.

Mr. Successful Owner also made mistakes by not retaining qualified legal and financial advisors. Today, he is fighting to survive. A successful business owner prepares for the business cycles, including the unexpected downturns, hard-hitting competition, and mismanagement of cash-flow.

Most importantly, businesses require proper cash flow management for success. When buying a small business, negotiate to include in the purchase price the accounts receivable and a normal to higher amount of inventory on hand. You may have to pay a higher purchase price but can usually get the seller to finance a portion of the higher purchase price; thereby giving you some working capital and time to develop a business track record for future bank financing.

It is also very important to hire competent legal and financial advisors. A good attorney drafting an appropriate purchase contract with all representation and warranties from the seller will save you money in the long run. A good CPA will be invaluable in both assisting in the negotiations of the purchase of the business and as a trusted business advisor for many years thereafter.