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Dear Stride: Why am I Generating Profit but Consistently Out of Cash?



Note:  The Dear Stride Series is Stride’s way of helping our clients navigate around their financial statements and understand the language of accounting a little bit better.  We get a bunch of questions so we decided to take a Dear Abby approach here to make it a bit more fun!  Enjoy.

Dear Stride:

I have had a long and complicated relationship with my financial statements.  They seem to send me mixed messages.  On one hand, I think we’re doing pretty great as we’re growing revenue and profit but on the other hand, I don’t have any cash and draw on my credit line to pay bills.  Why is this relationship so complicated?  Can you help me understand what’s going on?


Dear Confused (is that your real name?),

Oh wow, yes, that must be confusing.  No one likes getting mixed messages in any relationship.  I think we can help but you need to be ready to change.  Let’s be clear, I am not going to try and turn you into some financial analyst.  However, I need you to grasp a couple of very important elements of your financial performance.  There are two very important metrics that have a major impact on your cash flow and if you understand these and take action on them, you will see improved cash.  The first is how long it is taking you to get paid by your customers and the second is how long it takes you to sell your inventory.   Let’s break this down.

  • Getting paid by your customers.  This fancy accounting term is called days sales outstanding and it works likes this.  For example, you generate $100 in a month by selling your product to a customer and bill them for your service.  Your income statement shows that you generated $100 in revenue (woot!) but you didn’t get that cash.  In fact, you may not get that cash for 60 days.  During that time, there is an account on your balance sheet called accounts receivable and that’s your holding zone for the cash you want to collect.   The longer it takes to collect, the less cash you will have on hand.
  • Selling your inventory.  This fancy term is derived from a concept called inventory turnover.  The faster that you are able to “turn” your inventory into revenue, the less time your dollars are tied up in a warehouse, sitting on shelves.   For example, that $100 you generated last month had products costs associated with it of $40.   If it takes 60 days to sell the inventory that is on hand, that means you have $80 of inventory sitting on shelves at any given time that is not cash available for other things.    The longer it takes to sell inventory, the less cash you will have available to spend elsewhere.

So in a perfect and slightly simplistic world, the idea is that you want to get paid by your customers faster and if you have inventory, you want to have as little as necessary in order to generate your revenue goals.  When that happens, you are turning sales into free cash very quickly and can use that money to grow.

Here is an example.  David’s Boutique generates $400 for the year in revenue and $60 in operating income.  Not too shabby margins I would say!

However, it happens to take David’s Boutique 45 days to get paid by its customers and he also happens to hold 45 days of inventory in his warehouse at any given time.  Okay, that’s a problem.  Look at what this means on David’s Balance Sheet.  Notice that he has $50 of accounts receivable and $20 of inventory on his balance sheet.  So while David’s generated $60 of operating income (which shows up in the equity section of the balance sheet, $70 is being held in accounts receivable and inventory, which means David is short cash $10.  That’s not good.

The amount of time it takes to get paid and the amount of inventory you are holding for sale to customers can have a dramatic impact on your financial performance.  Just look at this table below.  What you are looking at is an analysis of various days it takes to collect from customers and the days of inventory that you have on hand.  You see the -$10 smack in the middle?  But if it takes David’s 60 days to collect his invoices and nothing else changes, his cash need will go up to $26.  But better, if David’s can collect invoices in 20 days and reduce his days of inventory to 30 days, he has positive $24 of cash.

What’s crazy is that the income statement doesn’t change at all, but the cash flow can vary in a significant way.

Dear confused, I hope this is a bit clearer and at least helps you start digging into ask some more critical questions and put some systems in place to improve that cash flow.  We totally understand that confusion, and frankly, it is why Stride exists.  We’re happy to be here for you to help improve your cash position in your pursuit of financial freedom.

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