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So, why is cash king?

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Thursday October 13, 2011 at 9:30am

Cash is king. How many times have you heard that? Too many perhaps, without a full explanation of what it really means.

When business advisors and accountants talk about ‘cash’ being king they are really warning against the dangers of overtrading – in other words celebrating the success you’re having in selling without paying adequate attention to the overall financial health of your business.

You’d think that sales growth was a good thing – but if you expand too quickly you can soon run out of cash. Just think about it – you often have to pay for goods and services well before your customers will pay you, so even though you might make a healthy profit on each sale on a month by month basis you could find yourself short of cash.

Take the example of a business that sells a product for £100 per unit. They buy in the components at £50 per unit, they have assembly costs (in terms of staff) and marketing costs of a further £20 per unit.

They are making a healthy 30% profit on each unit sale. Great you think, until you realise that they have to pay for components up-front, on delivery and their staff and marketing costs are fixed and have to be paid monthly. They allow their customers 30 days to pay – but aren’t great at credit control so often don’t receive payment for 40 or 60 days. A sale of 1,000 units costs them £70,000 in month 1 but they don’t receive payment (of £100,000) until month 2 or sometimes month 3.

If they take an additional order in month 2 they potentially have no cash to buy the components – and consequently can’t fulfil the order.

At this point they are overtrading – selling more than they can deliver – and the business has no cash. Most probably they will lose the new order to a competitor as well as face problems with their bank.

There are ways to address this problem: a bank overdraft or credit terms with the supplier, for example. But better to plan ahead and spot the potential signs of over trading before facing problems of liquidity and running out of cash.

Rather than wait to hit the over trading barrier it’s worthwhile looking out for these signs:

  1. You need to borrow money to get through each month. A sure sign cash is tight. 
  2. Your profit margins are so low your work are desperate for each sale. Could be really dangerous if orders pour in but customer payments are slow to follow. 
  3. Customers are making late payments. This is often the final straw for businesses with a very tight cash position.  

  4. A key supplier is pressing you on payment terms. They may have spotted problems even before you have and worried about getting paid start to enforce their terms.  

  5. Your accountant is worried. A good accountant will spot the signs of overtrading and through regular Board meetings and a review of your KPIs spot it before it happens. Listen to their advice and you could prevent the worst from happening. 

Andy Parker
Chartered Accountant Birmingham

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