Profits, Growth and
Cash Flow…Which is Most Important to Small Business Success?
By Gene Siciliano
growth and profitability. Most entrepreneurs would consider these to
be the Holy Grail of business ownership. So it’s not too surprising
that many participants in the financial workshops I lead are
surprised when I tell them that instant profits and rapid business
growth aren’t always a cause for celebration.
this be?” you might be wondering. The best way to explain it is to
tell the story of the Wonder Widget Company. Haven’t heard of them?
Well, this is a fictitious company I made up to help me explain
business financial concepts in an easy-to-understand way.
A Hot New Launch:
Wonder Widget Co. launched last year with $100,000 in cash
and the hottest new product in its market, the amazing Wonder
Widget. It was so hot that the owners had sales and profits the very
first month of operations. So they quickly leased and outfitted a
factory, production equipment and furnishings (all with minimal
initial cash outlay), bought materials, hired workers, and
manufactured and shipped widgets. Then they mailed invoices totaling
$50,000 to customers in the first month. Amazing!
their bills as they came due and collected from customers in the
normal course of doing business. Meanwhile, sales continued to grow,
increasing by $50,000 every month with no decline in margins and no
serious competition, and profits climbed without a pause.
strange thing happened on the way to the bank: The owners were
shocked to find that they didn’t have enough cash to pay their
bills. Soon, they couldn’t buy any more raw materials to manufacture
Wonder Widgets or make their payroll. Instantly profitable Wonder
Widget Co. was insolvent six months after they opened the doors.
surface, it’s hard to see how something like this could happen to a
profitable and growing business. But when you dig a little deeper,
it becomes clear that there’s a whole lot more to running a
successful business than just profits and growth—namely, cash flow.
The Cash Flow Cycle:
Understanding what happened to Wonder Widget Co. starts by
understanding what’s known as the cash flow cycle. This is the time
lag that exists between when cash is paid out by the business for
things like equipment, raw materials and salaries and when accounts
receivable are collected. In manufacturing, the cycle usually
consists of converting cash into raw materials, finished goods,
receivables, and then back to cash again.
beginning of the cash flow cycle, nearly every business starts out
with—you guessed it—cash. But from that point on, the central
purpose of the business is to convert that cash into other kinds of
assets or to leverage or extend it with liabilities, and ultimately
to turn it back into cash again—but this time, more cash than the
business started with. This process continues indefinitely and
simultaneously throughout the life of a business.
company started up, its first activities revolved around setup—renting
facilities, getting phones and utilities installed, etc. At the same
time, it was purchasing assets so it could start operations.
These included office equipment, computers and the like. Of course,
the company also needed employees to answer phones, run the
office, and produce and sell Wonder Widgets. The owners financed
some of these costs, but obtained credit via bank loans to
cover most of them.
this in place, the company was ready to begin production, or
the manufacture of Wonder Widgets. Unfortunately, the process
consumed even more cash: wages, taxes, sales and marketing, more raw
materials, and so on. In fact, this is the period of greatest cash
consumption for most companies, as they are in full production mode
but no cash is coming in yet.
Wonder Widgets was ready to sell its products and begin the
process of recovering all the cash it has been spending (or
investing) in the business. However, while sales were brisk, they
were made on “net-30” day terms, which means the company won’t
actually receive cash from these sales for another 30 to 45 days, at
To add to
the challenge, growing sales means the company had to buy more raw
materials than they did the first time around. Since they were
selling more each month than the prior month, they needed to not
only replace inventories consumed but also buy additional goods to
satisfy their growing sales demand. Purchases can actually exceed
sales in such a fast-growing environment.
Collections are the final step in the process. While this might seem
like a minor activity in comparison to production or sales, it’s
actually the most critical task in making every other step pay off.
Unfortunately, it’s the step that many businesses, including Wonder
Widgets, neglect—and that leads to their ultimate demise.
Don’t Give It Away:
Are you starting to see how Wonder Widgets failed despite
having strong profits and sales right out of the gate? Nolan
Bushnell, the founder of Atari and Chuck E. Cheese Restaurants, put
it this way: A sale is a gift to the customer until the money is
in the bank. This final step is the one that turns the entire
effort—setup, purchasing assets, hiring employees, obtaining credit,
and producing and selling products—back into cash again.
point, the answers to some important questions will begin to
surface, like: Did the company ultimately make a profit on its
business activities? Did it plan adequately for the working capital
it would need to finance the cash flow cycle in it’s entirety? As
the Wonder Widget story makes clear, answering “yes” to just the
first question isn’t enough to ensure business survival. There are
three key takeaways from this story:
1. Fast growth is a double-edge sword.
Fast-growing companies need more working capital than those growing
more slowly or not at all. When incoming cash flow is delayed while
fixed costs continue and paydays come every week, there’s a limit to
how long a company can operate comfortably, even if it’s profitable.
2. Cash flow needs must be forecasted months in advance.
This is especially critical during the early months of a startup.
And cash flow results must be tracked separately from profits.
3. Business goes with the flow.
The health of a business depends on the health of its cash flow. As
Wonder Widget Co. makes clear, more businesses fail due to a lack of
cash flow than a lack of profits.
Read other articles and learn more about
[Contact the author for permission to republish or reuse this article.]