Depending on the economics of a particular business, a company can literally grow itself into bankruptcy. An increase in sales will generate more profit. However, it can also require an increase in things such as inventory and accounts receivable that use cash. Growth can actually be cash-flow negative in the short term.
Consider the case of a distribution business. It has a gross margin of 25 percent and makes 5 cents on each incremental dollar of sales. The company has to maintain inventory to enable timely shipments to its customers. Its inventory turns four times per year. The business offers net 30-day terms.
But the average customer stretches this a bit and pays in 45 days. The distributor has to pay its suppliers in 30 days. As sales grow, inventory and accounts receivable have to increase as well. This uses up cash. Accounts payable will also grow, offsetting some, but not all, of the growth in accounts receivable.
If the company’s balance sheet ratios remain unchanged, the cash flow implications of a dollar of sales growth in the current year are as follows:
- Profit will increase, providing 5 cents of additional cash.
- Accounts payable will increase. Suppliers are extending the company credit, which will give it 6 cents more cash.
- The company will have to increase its inventory, which will cost it 19 cents.
- Accounts receivable will increase, which will cost the company 12 cents.
The net of this arithmetic is the counter-intuitive result that a dollar of sales growth does not increase cash flow in the first year. On the contrary, it uses 20 cents of cash. The implication is that a successful push to grow revenue that results in a $1 million-sales increase this year would actually cause the company to have $200,000 less cash than if sales had stayed flat. That would force many companies into bankruptcy.
To be sure, the changes in balance-sheet accounts (accounts payable, inventory and accounts receivable) are a one-time event. Therefore, if the dollar of sales growth is sustained it will result in 5 cents of positive cash flow in each subsequent year. However, businesses that are in a cash crunch right now may not be able to withstand the initial year of negative cash flow resulting from the sales growth. A business can literally grow itself into bankruptcy. Unfortunately, it happens to businesses all too frequently.
Before you launch a major effort to grow revenue, make sure you understand the economics of your business. Once you understand the economics, you can project how much cash you will need to support the growth and avoid growing your business into bankruptcy.