Profitability does not equal cash flow

You could have the most highly profitable business, but if you mismanage cash, you could be punching your one-way ticket to bankruptcy, just like Carl, a small business owner I consulted with, just a little too late.

Carl had a highly successful business in government contracting. Or so it seemed. His business was producing over $1 million in profit each year, on less than $10 million of revenue. Carl was paying himself a healthy salary, signing million-dollar contracts, and growing at more than 25%per year. He was living large. Until he wasn’t.

What a difference 18 months makes

Just 18 months after Carl’s best year ever, and over $1 million in profit, Carl was forced to sell for just a fraction of his prior year’s annual income. Why? Because he had gotten himself into such cash flow trouble that a fire sale was the only way out. He was making one million dollars in annual profit, yet he ran out of cash.

Six months before Carl was forced to sell, he had signed his largest contract. He thought the business was going well, but he looked up one day and realized he was just three weeks away from missing payroll—his very large payroll. Unfortunately, by the time he realized how bad it was, it was too late to do anything to salvage the company. Instead, he entered into a deal with a competitor to avoid bankruptcy and provide continued employment for himself and his staff.

Carl finalized a deal for less than $500,000, while companies with similar results were selling for more than $8 million. But Carl’s business wasn’t worth $8 million because he had so poorly mismanaged his cash.

Had Carl understood his business and the cash flow needs for growth, he could have saved himself a lot of heartache and generated a stable financial future for himself and his family. Instead, he sold for a fraction of market value and is still paying on debts created by the business, even three years later.

Here’s what happened to Carl

Carl didn’t actively forecast and manage his cash flow to understand his true cash burn, cash needs, and how much he needed in reserves to continue his growth.

He outgrew his cash. He was signing contracts that required a significant amount of cash up front, either in cost of equipment or labor force, and his payment terms were not aligned with those cash needs. Those million-dollar contracts he was signing? They were actually pushing his business to bankruptcy.

He was too highly leveraged. Carl financed everything. New equipment, his new truck, future receivables. He was so highly leveraged, his monthly payments took a bigger and bigger bite out of his profits each month until they were crushing the business.

Carl lived large. He saw his profit and loss statement every month and he felt he deserved to take those profits home. He took distributions out of the business without leaving adequate reserves to handle the growth he was experiencing.

Carl’s poor cash flow management was exacerbated by how he used that cash and the way he mismanaged the growth of the business. Simply speaking, Carl was forced to sell at pennies on the dollar because of his overall lack of understanding.

The importance of cash flow forecasting

Carl’s biggest issue was that he didn’t even know he had a problem. He was so used to producing a profit and seeing money flow in, he wasn’t paying attention to how his cash was flowing through the business.

All other decisions that contributed to Carl’s cash flow problems could have been mitigated if he had been forecasting his cash flow and understood how the cash coming in aligned with the cash going out and where the shortfalls were. It’s not enough to review a cash flow statement as a part of a monthly financial package. Carl should have been forecasting his cash flow out into the future. Carl should not have signed a new contract without understanding the cash needs for that contract and how long it would take for payments to come in to cover those cash outflows. He shouldn’t have signed a new financing agreement without first realizing how monthly payments were going to affect his cash flow and his ability to meet his other obligations.

Regardless of the good or bad decisions Carl made that contributed to his cash flow woes, the first critical mistake he made was that he was not keeping tabs on his cash.

Getting the terms right

Carl got so excited about dollar signs and growth that he failed to review how contract terms would affect his cash flow.

He signed a $1 million contract that would produce a 20% profit margin for him—over $16,500 in monthly profit. That’s great, right? But here’s the fine print. The contract had 60-day payment terms.

Each month, Carl had more than $66,000 in expenses on the contract—most of this cost being labor. Employees are paid every 2 weeks. With the payment terms of 60 days, Carl had over $130,000 in cash out the door, before he ever saw his first payment from the customer. What’s worse is that outflow continued throughout the contract and wasn’t until month 10 that the contract was cash flow positive. The contract may have produced over $200,000 in profit, but Carl didn’t see that $200,000 in his cash flow until the last 3 months of the contract.

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This was typical of Carl’s contracts. Large or small, Carl would have an extensive cash outflow before he started to see cash inflows on each contract. If Carl had grown slowly enough, had enough cash reserves, or possibly the right financing in place, Carl may have been able to sustain these terms.

But he really should have worked with his customers to create payment terms that worked for his business.

Small project-based businesses without the cash reserves of larger companies or the financial backing of investors or banks need to work with their customers to create terms that ensure their sustainability. Carl could not sustain such large contracts with these payment terms. He simply wasn’t making enough margin on each contract to account for the lag in cash flow. While some customers are unwilling to adjust their terms to work with a particular vendor, many will.

Here’s what he could have done instead:

• Asked for a quicker payment term for the first six months of the contract so that he could start seeing the profit in his cash flow sooner and give him some breathing room.
• Required an upfront deposit that would cover his first two months of expenses, so that when he started to receive the regular contract payments at net 60 days, he would have already covered his cash outflow for those first two months. His monthly payment would be lower, but he would have the cash up front to ensure the contract is sustainable.
• Worked with a bank or a factoring company to help him get paid on his invoices immediately after issuing them. This alleviates the 60-day wait. However, there is a cost associated, which would need to be built into the contract. Carl could have discussed this option with his customer to see if he could get the contract value increased to cover the cost of capital. Instead, when Carl did have to start using short-term financing options, he hadn’t built the cost into his contracts, and it further exacerbated his cash flow woes.

Getting the terms right would have been a game-changer for Carl. Without it, Carl was digging himself into a deeper mess each time he signed a new contract.

Pitfalls of financing

While financing can be an option when done right and built into the costs of the contract, over use of financing is one of the quickest tickets to cash flow issues. Carl was no exception.

He financed everything. If he needed a piece of equipment for a job, he financed it. If he needed money to pay his taxes at the end of the year, he took out a loan. He started factoring his customer invoices. Factoring is a short-term financing solution where the factoring company pays you for your customer’s invoices immediately after issue, minus a fee. Then your customers pay the factoring company based on their payment terms. This is a very expensive method of financing, and Carl hadn’t built the cost of financing into his contract bids. Soon, his debt payments were eating into his monthly profits so much that he was using short-term financing to cover current monthly expenses so that he could use his current month’s profits to cover the debt payments. It was a vicious cycle that was only getting worse with every new loan he took.

Here's where Carl went wrong: at the end of each year, he’d reach out to his CPA to talk about his potential tax liability. His CPA would tell him that he owed $200,000, but that if he went out and purchased a $200,000 piece of equipment, he could get that knocked down to about $150,000. Of course, Carl wanted to save the tax money. Problem was, Carl didn’t have the cash to go purchase a new $200,000 piece of equipment with cash, so he financed it. He saved $50,000 in taxes for the current year, but added in $60,000 in payments for the next 5 years. Carl did this for a few years in a row, and soon he was paying out almost $200,000 in annual loan payments (which were not deductible because Carl already deducted the purchase). Not only did he have significant debt payments, he also had a higher tax bill, which Carl also financed, because he didn’t have the cash to pay said taxes.

Excessive distributions

Carl’s aggressive spending habits were the final blow. A businessman earning more than $1 million dollars per year might feel entitled to live well—and Carl did. He regularly took significant distributions from the company rather than reserving profits as retained earnings. This left the business without a safety net. When unexpected expenses or delays hit, there was no cushion. He wasn’t prepared for an economic shift or the loss of a major client, and he had no capital set aside to fuel future growth. You need cash to scale, and Carl’s lack of reserves made sustainable growth impossible.

Cash is king

Carl’s poor cash management cost him millions. On the surface he built a good business. His customers liked working with him, his team did good work, and he was turning a nice profit. But, a business with poor cash flow management is just one bad contract or one missed check in the mail from failure. Carl’s story doesn’t have to be yours. Learn from it—and build a business that’s not just profitable, but sustainable.