Fundera.com quotes a US bank study published in 2019 which showed that 82% of business failures in the US were caused by a lack of cash flow.
What might business owners say?
Ask business owners which of profit or cash flow they think most important and you’d get a mixed response. In times of crisis, such as during the Covid-19 pandemic, most would say that cash flow is critical because that’s what pays the bills, pays the employees, settles creditors and services debt.
The reason they say that is precisely because they have a drastically reduced incoming cash flow in times of crisis. So its importance to them is magnified.
In more normal times when there’s no crisis to deal with, many owners would say that profit is key. That’s because profit enables them to grow the business over time from its own internally-generated funds.
Also, profit attracts investors, enables the declaring of dividends and (probably) helps in securing bank funding because owners believe that bankers are focused on lending only to profitable businesses.
And while that’s all true, the reality is that businesses that have a profit focus in all likelihood have good cash flow too. So, the owners are not being forced by circumstances to pay too much attention to that aspect of their business’ operations. Essentially, the cash flows on its own without too much management intervention.
What should be the focus for lenders?
For lenders then, what should be our focus? Obviously, we like a business to be profitable. That indicates to us it has an established market and that it has its costs under control.
But, according to Debtsource, in South Africa 3 out of every 5 businesses that fail are actually profitable at the time they close the doors.
So, the answer to my initial question is that, in their own way, both profit and cash flow are important.
But it’s cash flow that is absolutely essential in making a business sustainable. In the short-term especially, we want to make sure that a business can generate sufficient cash flow to repay our debt and cover the interest cost. Otherwise we’re locking in a potential loss further down the line.
Read the cash flow statement
Look at the cash flow statement if one is available. Check the figure, Cash Flows From Operating Activities, to see how strong its cash flow was at that point. This is the cash flow generated from revenue plus collections from accounts receivable less operating expenses and payments to creditors.
This is the most critical component of cash flow. If the business can’t generate positive cash flow at that level, it’s going to have some difficulty improving its overall cash position. It’s main options would be to sell assets or raise new debt. Neither of which are ideal for a lender.
Understand what the cash drivers are in the business
Combined with that information, you really need to understand what drives the cash flow in every business you lend to. So if have a cash flow statement to work with, engage with the managers of the business to explore what might happen to the cash flow in the future in the light of possible changes in those cash drivers.
Get a cash flow forecast
You could ask for a cash flow forecast from the managers of the business to justify the amount they’ve asked to borrow. That’s a reasonable request but remember that it will almost certainly not be anywhere near accurate.
The only value in having a forecast is this; After you’ve made the initial decision to lend, keep it close and refer back to it from time to time to see how well the customer is doing in hitting the forecast numbers. Obviously, if they’re not, it means that your debt is not going to get repaid as planned. Then you need to engage again to find out what the issue is.
Remember the old saying;
Revenue is vanity, profit is sanity but cash flow is reality.
So, is it profit or cash flow?
As a credit manager then, the most important requirement is sufficient cash flow to get the debt repaid ultimately. So that’s what you’ve got to focus on.
If you’re a relationship manager, the best piece of advice you could give to a business customer is – manage your cash flow and watch it like a hawk!
Subscribe now to receive a relevant, useful weekly business banking insight by email delivered right into your inbox. Plus, you’ll receive a free e-book “A Beginner’s Guide to Reading Financial Statements”.