TO most businesses, profits and profit margins are perhaps the key statistics in its financial report card, but there is another area that should not be overlooked - cashflow management.
Emphasising its importance, Albert Ho of CPA Australia told BT that the challenge for small firms is to adapt to changing needs across a range of functions such as the above-mentioned.
'Smaller operations may lack the experience and resources to meet today's rapidly changing business environment and may need to hire or outsource certain functions to experts. Successful business owners and professionals in SMEs tend to be open to accepting and learning new business methods to be well-rounded in their skill sets and knowledge,' said Mr Ho, who is the SME Committee chairman, Singapore Division at CPA Australia.
Indeed, realistic cashflow timing is an important factor in new businesses, but this is one area that is often overlooked, according to Tony Lythgoe of the International Finance Corporation (IFC), a member of the World Bank Group.
During an interview, he shared that SMEs often 'don't factor in some of the risks'. He added: 'And one thing they almost always get wrong is the timing. So the cashflow often lags six to 12 months behind projections.'
Such delays, he said, often result from bureaucracy in emerging markets, and it is critical that SMEs account for this so that the viability of their investments is not jeopardised, he said.
Indeed, Finance 101 teaches us that the amount of cash generated through profits and subsequently ploughed back into the business is an key determinant of long-term business growth.
Specifically, it affects the sustainable growth of a business - the rate at which a firm can continue to growth without running into cashflow problems.
Higher growth
The sustainable growth of a firm is estimated by multiplying the return on equity (ROE) with the profit retention ratio. For example, a firm that has a ROE of 20 per cent, and pays out 10 per cent dividend will enjoy a sustainable growth of 18 per cent - higher than one that pays out 90 per cent of its profits. Therefore, higher growth has to come with higher additional cash generated.
Also, cashflow management plays a critical role in the development of a good business model, said Wan Chew Yoong of Nanyang Business School. For example, an appropriate model also allows the firm to identify the source of its cash flow and where cash is needed.
This is especially so in an inventory build up system, where the cash flow is locked up in inventories, and 'then down the retail chain to the customers, with credit extended to the retailers'. said Prof Wan. A good business model, he added, also matches the company's key strengths with the industry's success factors, and 'covers both the suppliers through to the distributors, the manufacturing process, R&D and supporting functions such as the finance, marketing, staffing and personnel'.
Apart from dividend payout policy, Prof Wan said that another key aspect of cashflow management is tax planning. 'Tax liability is a cash payment within the year, and the tax principles are not the same as the accounting principles,' he said. 'For example, a company that has reported a loss may still have to pay income tax as some of the expenses may not be tax deductible.'
For this reason, firms should conduct proper tax planning in order to minimise the tax liability, and consideration has to be given to payments for technical fees 'or royalties that may be subject to withholding tax, leasing of equipment (and not be caught under a financial lease rather than an operating lease)'.
And if a firm already faces cashflow problems, he suggested a few options to help them tide over the shortfall. One solution is to approach the banks for a short-term overdraft to cover the key payments due, while at the same time, 'we could also talk to principal shareholders for a short-term advance, or alternatively to raise additional capital if we are under-capitalised'.
'If the firm is unable to raise any short-term funds, then it should be honest and negotiate with its suppliers for extended credit terms and work out a schedule to repay them, and to stick to the schedule once agreed upon.
'Does this mean the suppliers will cut us off and not supply us until we make full payments? It is possible. But suppliers will also understand the cash flow issues, and if we truly communicate with them and they know we are profitable and being honest, chances are they will go with us.'
Another area which sometimes bleeds a business of cash is underperforming parts of the business. The difficult decision faced is whether to revive, or sell that business unit. At best, these units may be consuming cash that could be better used elsewhere in the business. At worst, they may actually be destroying the value of the business.
'It is not necessarily hard to spot these problem areas,' said Bob Yap, head of restructuring at KPMG in Singapore. 'Meagre operating margins or disappointing cash generation cycles are typical signs. These warning signals crop up time and again, and often business owners struggle to find a solution.'
Hard decision to take
In the longer term, the tendency to focus on poorly performing units may in itself undermine the value of the entire business. This not only affects cash flow, but a considerable amount of management energy may be squandered trying to solve the problem.
What's more, such attempts by management to turn round a particular aspect of this business risks ending up in failure. Said Mr Yap: 'The difficult truth is that, in some cases, the least value-destructive way to deal with an underperforming division is sale, closure or significant surgery rather than further investment. This can be a hard decision for any business owner to take.'
Likewise, Prof Wan pointed out that the threat of bankruptcy must not be overlooked, especially when cashflow proves insufficient to fund liabilities.
Basically, the threat can be kept in check by ensuring sufficient cash flow to meet liabilities and obligations when due. As a very general rule, there are two main items in the balance sheet that need to be monitored closely - the accounts receivable and inventories.
'Accounts receivable could turn bad while inventories may need to be written off, in which case the charges could wipe off the profits earned and thereby impacting on the cash flow,' said Prof Wan.
In the long run, businesses will also have to shield their liquid assets and margins from the ravages of inflation. The cost increases may come in the form of wages, materials costs and lately, fuel costs.
Here, the common response among businesses seems to be to pass on such increases to their customers by raising their prices. But due to competition, they may not be able to do so and their margins are then squeezed.
'However, firms will want to keep their margins and market share whenever possible. Cost increases are inevitable, and it may create a chain reaction to increases along the value chain,' said Prof Wan.
Therefore, some suggestions are for businesses to deal with the higher cost by relooking at their value proposition and striving to improve their service and value added level, while maintaining a price advantage over their competitors.
This article was first published in The Business Times on Jun 10, 2008
