The constant demand for cash to settle supplier bills, pay employee salaries, pay utility bills, make loan repayments, pay rent, and even pay taxes such as Value Added Tax (VAT) and Pay as You Earn (PAYE) are realities that business owners cannot avoid in the ordinary course of operations.
Despite these cash outflows occurring regularly, many entrepreneurs find themselves in the unenviable position of limited downside resources, especially at the end of the month when the above obligations become due.
The limited cash resources that characterise many month-end seasons can be the biggest nightmare for business owners, as undercapitalised companies are tough to run.
It may come as a surprise to you, but many businesses do not collapse because of lack of profit. The main culprit is usually lack of cash.
This statement may be confusing, so I’ll explain.
As an illustration, consider the entrepreneur who manufactures cakes that cost her one thousand shillings to produce per piece, but which she sells for one thousand five hundred shillings.
If she chooses to sell the cakes on a cash basis, she will recover both the cost of production (of one thousand shillings) and the profit (of five hundred shillings) immediately she sells a cake.
If, on the other hand, she chooses to sell her cakes on credit, she will book the transactions as sales in her financial records, but she will not have received any money, since the transactions are credit sales whose payments will be received in the future. In other words, from an accounting perspective, she has made sales and recorded the associated profit, even though she has not yet received payment from her clients.
To complicate matters a little, let’s assume that cake sales are also subject to VAT and that the entrepreneur is servicing a monthly loan. You could also add payments such as salaries, electricity, rent, airtime costs, and the purchase of inventory items such as icing sugar, wheat flour, and margarine, and a clear picture of her end-of-month cash balance begins to emerge.
It can be seen that if the entrepreneur has been selling her cakes largely on credit, the end of the month will be a sure source of sleepless nights for her if she hasn’t received any money for the cakes she sold on credit.
Here is why.
For one, the taxman expects the entrepreneur to pay VAT on her credit sales (adjusted for the VAT she paid for her supplies) based on what she invoiced, rather than the actual money she collected. If the entire monthly sales of her cakes have been on credit, where is she going to get the money to pay VAT, which is paid in cash?
Secondly, we could also ask where she will get the money to settle other obligations, such as PAYE, salaries, rent, and loan servicing, if the entire monthly sales have been on a credit basis.
The point should be clear by now.
Even though the entrepreneur could be making good cake sales with healthy profit margins, her business could easily come under intense financial pressure if the majority of her sales are on credit.
The fact that she has booked strong sales with healthy margins in her financial records doesn’t necessarily mean that there is money in the bank.
If, on the other hand, the majority of her cake sales are on a cash basis, it is unlikely she will ever have trouble settling her obligations with suppliers, the taxman, employees, and her landlord, even if her profit margins are small.
One may even argue that, as long as she breaks even on her cake sales, the entrepreneur who sells her cakes on a cash basis is likely to remain in business much longer than if she chooses to sell all her cakes at better profit margins but on credit.
The lesson is clear: credit sales could be the biggest contributor to your present cash flow challenges.
However, many entrepreneurs will still go ahead and sell their products on credit even though they know that such decisions could put pressure on their cash flows or expose them to the risk of bad-debt losses.
The reasons behind this are varied, including the desire to boost sales, prevailing industry customs or traditions, the rush to beat the competition and gain a bigger share of the market, or the inability to negotiate with large buyers such as supermarkets and government agencies.
In fact, suppliers to our local supermarkets and government agencies often endure long wait times before their invoices are settled in full.
To meet the cash shortfall resulting from giving too much credit, business owners usually troop to banks to obtain facilities such as overdrafts, invoice discounting, uncleared effects facilities, and loans.
Bank overdrafts are services that allow customers to draw funds beyond the amounts actually standing in their current accounts, subject to an authorised limit. In practice, this means the bank will allow your current account to swing into negative balances whenever cash is needed.
In the case of invoice discounting, the bank undertakes to pay you a percentage of an accepted invoice in the form of a cash injection to your account when you present it to the bank. To illustrate, suppose you are one of the suppliers to our large local supermarkets, which are notorious for holding payments, in some cases for up to 6 months.
Once you have supplied your goods to the supermarket, you could arrange with your bank to pay you a percentage of the invoice amount (technically known as “discounting“) while you wait for your full payment from the supermarket. As soon as the supermarket pays the invoice amount, the bank will recover the amount it advanced to you, including its service charges, and send the remainder to your account.
The third option, known as “uncleared effects facilities“, allows customers to draw funds from their accounts even though the cheques banked have not yet matured (or “cleared“). Ordinarily, banks return cheques drawn against uncleared funds in your account, but when you sign up for un-cleared effects facilities, the bank will allow you to draw some uncleared funds in cash. In practice, this means you can draw funds from cheques deposited in your account before the mandatory three working days required to clear the cheques have elapsed.
Lastly, there are the good old loans, which, once drawn, are usually paid monthly until the entire facility is cleared. Most banks offer loans on a reducing balance basis, which means your monthly loan repayment includes both interest and principal.
If you have taken the trouble to study your loan statement, you will notice that the interest portion of your monthly loan repayment is higher than the principal portion during the early period of the loan, while the principal portion is greater than the interest portion as the loan period draws to a close.
There are pros and cons to using bank facilities.
Let’s begin with the good side.
If properly utilised, the bank facilities mentioned above can help ease financial pressure, especially during crunch times when many obligations fall due simultaneously. Many entrepreneurs would rather maintain a good reputation by spending on bank interest than lose the goodwill they enjoy with clients, landlords, employees, and suppliers. The opportunity cost of losing the benefits of these valuable business relationships pales in comparison to the inconvenience or cost of paying bank interest and fees.
On the downside, these same bank facilities can mask the inefficiencies in your business when you fail to address the root causes of your current financial difficulties.
Usually, the main culprits are failing to collect the money owed by your debtors, giving too much credit, or both.
If this is true, then the cure for your financial troubles may not be increased access to bank facilities, but the discipline to control your credit sales and prompt collection of whatever is owed to you. In fact, rushing to the bank to obtain facilities to make up for your failures as an entrepreneur could trigger a downward spiral in the financial circumstances of your business that may leave you worse off than if you had chosen to forgo the bank facilities altogether.
Whenever you fail to manage your credit sales to the extent that the resulting strained cash flows force you to rely heavily on the support of banks, you are in effect administering the financial equivalent of steroids to keep your business afloat.
Just as overdependence on real steroids leads, sooner or later, to adverse effects, an excessive reliance on bank facilities to make up for the shortfalls of the shoddy management of credit sales can easily lead to dire financial consequences for your firm.
The allure of readily available (and at the moment, relatively cheap) bank facilities can be hard to resist when the demands for payment from suppliers and the taxman are mounting by the day. Whenever such situations arise, you will be well advised first to examine what is owed to you, and then take the necessary steps to recover the money that is currently lying with your debtors. You may also want to consider the painful option of toning down your credit sales, especially to those star clients who take too long to pay.
Lastly, before you consider doling out credit facilities to boost your product sales, you will do well to keep in mind this adage: Turnover is vanity, profit is sanity, and cash is king.
Mr Kiriinya Kithinji is a Director of Strategy at WYLDE International. You may connect with Kiriinya via email: [email protected]
Also Read: Business strategy 101: a practical guide for entrepreneurs
