The Cash Flow Conundrum

The current state of our industry balances between a historically low cost of capital on one side, and unimaginable, ever-mounting debt on the other. The latest round of NPA declarations by banks have thrown up some astounding numbers. The ultimate culprit here is poor corporate governance (both from the banks as well as the borrowers). One does not simply amass a debt of many billions of dollars unless one has been very lazy in reviewing one’s financials.

However, it does still beg the question as to why companies continually dig themselves into holes with regards to their cash flow situations, despite having a sound business model to begin with.

I recently embarked on a small entrepreneurial venture requiring a relatively low initial investment. One of the main features of the business model was that the net cash position was always positive. Much like a standard retail model, payments were first received and creditors were paid later. In such a situation (as long as the margins are positive), one is never cash negative. As a result, whenever an invoice is received from a vendor, there is always cash in the system to make timely payments. The peace of mind from having a favourable cash flow cycle contrasts sharply with the standard manufacturing business model.

Cash flows in manufacturing

Consider this sequence of events that most manufacturers invariably experience.

It starts with the client placing an order. Credit terms in manufacturing can vary from 30 to 120 days and in India, the clock is usually turned on only after the client receives the material.

In order to service the order, raw materials are procured. Again, there would be credit terms offered by the vendor. Whether or not these terms are more or less than the terms offered by the client play a big role in overall cash flow management.

Once materials are received, there is a turnaround time, namely the time it takes to turn those materials into finished product. This feeds back into your net credit terms to effectively worsen your net cash position. In many cases, vendor payments can start falling due even before the finished product has been dispatched.

Inventory costs will also add to the pressures. Clients may ask you to hold material so that their supply chain is smooth. Similarly, vendors may insist on minimum order quantities, meaning you hold stocks that won’t be utilised during the current production cycle. The recent shift to GST resulted in many dispatches getting delayed as clients asked us to hold billings until they had updated their systems. The effect of this forced increase in inventory was felt nearly 6 weeks later, as payments that were due two weeks prior had still not arrived (due to the delay in billing), while creditors were already calling, asking for their payments.

Finally, once the product is received by the client, the payment falls due after the agreed credit period. In some cases, the client makes timely payments. In others, they may try and extend for some time beyond, citing their own cash flow problems. Our own experience in India has been the latter. While there certainly are Indian clients who pay on time (export clients, by and large have very rarely delayed payments!), the bulk of them will extend the credit period by anywhere from 10 to 30 days. Infrastructure clients – for the most part – will pay you when they pay you!

In the midst of all this, there is time lost due to logistics. As mentioned above, clients may agree to pay only after receipt of the materials. At the same time, vendors may insist that payment is done against the date on the invoice. In the case of an SME, caught between a large client and a large vendor, you may find yourself in a position where each day the materials are in transit is a day of credit lost.

The pressures of growth

The above sequence is merely an indication of the steady-state in manufacturing. To this we need to add two more elements that serve to put a further burden on the cash flows.

The first is organic growth. As clients scale up requirements and new clients enter the fray, companies need to use today’s receipts to fund tomorrow’s turnover. The corporate world is riddled with case studies outlining the pitfalls of growing too fast too soon. It leads companies into a situation where any payments coming in are immediately used to pay off creditors, leaving nothing in the bank account. Throw an exogenous expense into the mix – such as a breakdown or a client rejection – and the system starts getting shaky.

The other element is capital expansion. In order to fuel growth, expenditures on buildings and new equipment pull cash out of the system while often offering no return on investment for weeks or even months. New staff may sometimes be required to manage the new equipment and between training, trials and getting the whole system production ready, the drain on cash flows can be crippling.

The levers of cash flow

The below diagram shows how each lever pushes to form the net cash position. For all the negative cash flow levers (red), there remain only 2 levers (blue) propping things up.

It should be said that net credit terms do not always need to be negative. You may have a client who prefers to pay in advance and a vendor acceptable to higher credit terms. Even when compounded with logistics, turnaround time and inventory costs, it may very well be the case that you actually get paid before your creditors come calling (much like the retail model described above). But in manufacturing, this is not the status quo. As volumes increase, clients will always ask for credit and even if managed properly, net credit terms will more often than not be a drain on cash flows.

It boils down to profitability to hold up the cash flow position. But given the dynamic nature of manufacturing, how much profitability is needed to adequately balance the equation in the favour of the manufacturer?

The table below offers a rather striking illustration of this.

Taking a month-on-month growth rate of 1.5% (which equates to a respectable, but not stellar annualised rate of ~20%) and a PAT Margin of 15% (which again, suggests a EBIT in the range of 20-25%), shows us that starting from zero, the net cash position would continue to be negative even after a year of operations.

Playing with the numbers suggests that a PAT margin of at least 20% is needed to ensure that total receipts exceed total payments by the end of 12 months.

Keep in mind that this simple model excludes capital expansion (interest costs are blended into the net margin, but this goes towards paying off equipment on existing operations. New equipment usually comes with an advance down payment, followed by a waiting period while the machine is delivered). It also excludes logistics, inventory costs and any of a range of other exogenous expenses such as breakdown maintenance, rejection replacement and R&D. It also excludes – ironically enough – the interest on the working capital borrowed to actually fund the ever-increasing cash flow gap!

It is therefore no surprise that companies fund their operations by constantly borrowing money from banks. If the aim is to grow perpetually via capital expansion and the margins and/or credit terms are not favourable, then your net cash position will always be poor, even if the bottom line itself is consistently positive.

Conclusion

While it is not new wisdom to suggest that high profitability results in high cash flows, it helps to realise that even a very healthy level of profitability can result in a negative cash position depending on how the other levers play out.

Our own understanding is that many SMEs do not operate at levels of high profitability. Supplying to the automotive industry, for example, is a low margin venture combined with high volume growth and often harsh credit terms. The reasoning is that since the client is offering volumes, pricing and credit need to be squeezed and stretched to the maximum possible level respectively. It is easy to see that this is a perfect recipe for a terrible long-term cash flow position.

Most importantly, however, is that the conundrum of a weak cash flow position may often have nothing to do with profitability, but instead requires a long hard look at the other levers to understand where the system can be worked on to improve the flow of funds into and out of the business.