How does revenue or sales growth effect cash flow?
Revenue or sales growth is the biggest cash flow driver for any business since a major part of its revenue comes from its customers.
Most businesses believe that the customer is the reason for their existence based on the logic that the larger the customer base, the more the cash flow. The important thing here is that some customers are better than others, in the sense that they are the ones that help generate cash through their genuine need for the company’s products, resulting in the expected return on investment. Therefore, steps must be taken to retain the loyalty of these good customers. The first thing is to identify these customers, then retain them, and next, develop new ‘good’ customers, reduce inventory to become more cost effective while striving to achieve quality both in operations and products.
Better Control Over Margins And Sales
In the light of the above, the business must continuously work towards improving its margins, bringing down operational costs. There must also be tight control over receivables, payables and inventory in order to make a difference to cash flow levels. Added to this, there must be strong capital budgeting to maintain consistent cash flow and profits. The beginning point for all these is sales.
While it is quite acceptable to place no limits over maximum sales, it is certainly necessary to control margins, expenses, receivables, payables and capital budgeting within the framework of the business’s operation.
Of course, any business will always aim to expand its area of operation and this will directly influence future cash flow. By discounting future cash flow back to the present day, the current value of the business can be assessed. That said, sales growth is the prime factor that builds the business’s total value.
The Growth Effect And Management Effect
Sales growth influences cash flow in two ways, namely, via the growth effect and its effect on the management decision to handle it. Sales growth has an impact that is relative to all other revenue generating activities that figure on the balance sheet or income statement within the organization. How the management optimizes and facilitates rising sales figures – perhaps through better credit terms or other changes within the marketing and promotion function will further have a great influence on cash flow. As a result, management has the challenge of tackling any operational issues that may arise in the process of rapid growth.
It is well known that any change in the balance sheet is a result of sales income. In the income statement, changes filter down from revenue as a first step. The cash flow statement reflects the amalgamation of the balance sheet and income statement. It therefore makes sense to get to know how costs are structured within the company, in relation to the industry to which the business belongs. This helps to make the necessary changes that are required to make things better. For instance, someone from the marketing function would benefit from an awareness of the importance of cash flow and cash drivers that determine the company’s success. By broadening one’s focus, a better understanding can be achieved of the bigger picture, which is the organization as a whole, rather than the department within which one operates.
As a matter of fact, sales growth does not occur magically. Revenue growth is a planned process that takes place as a result of analysis and decision making by the management. These decisions are thereafter implemented to result in sales growth. The decisions could do with the introduction of new products, expanding to new markets, new staff and training programs, additional promotional campaigns, better customer service, better pricing, logistics etc. All of these, which combine to form the marketing mix involve a lot of planning at the top level in the company in addition to a lot of expense. This expense is because of the extra resources required in the form of assets and other direct expenses. Apart from the initial investment, the business will also need to keep investing cash for more inventory and accounts receivable since there will be sales growth.
Planned Growth – The Key
Obviously, to enjoy growth, cash is mandatory. Therefore, a company must plan its growth because unplanned growth can result in major cash deficits and risks. Often, the top management team in the company assumes that for sales growth, since the company needs cash, sales must be increased and customers will pay, after which the cash problem will disappear. This line of thinking might work in temporary situations where you might sell more from your inventory without immediately replenishing it, offer your best customers better payment terms, get better deals from suppliers etc. for specific projects. But none of these things is a permanent solution since they would result in harming the business’s cash flow.
Ideally, with planned sales growth, existing operations must proceed smoothly so that the expansion is seamless. Naturally this could mean more pressure on the staff and structure, and of course, cash flow. Things could also go awry due to the increased pressure. In fact, financial problems are not surprising when sales growth exceeds the ability of the business to sustain itself, unless the business has extra assets in the form of excess inventory, since this would be used up without the necessity to create extra inventory. If the business owns an asset that it does not need right away, it can always convert it to cash by selling it and using the finance towards growth, over and above its cash profits and related expenses.
To manage properly, the management must be able to work out the kind of sales growth that the business can sustain within its existing cash profit and debt liabilities. In the absence of such foresight, the right sales targets cannot be set. Either the forecast is too low or too high, affecting the business negatively.
Linking Sales Growth And Cash
We can link sales growth to its ability to generate cash through breakeven analysis so that this in turn can be reworked to align with the impact of cash on growth. Breakeven is basically the point where expenses equal revenue, and where there is no profit, no loss. This means the gross margin is perfectly offset by the operating costs and financing expenses. Since there is no profit, the business does not incur income tax either.
In breakeven analysis, fixed costs and variable costs are taken into account. Fixed costs do not change, no matter how much sales takes place. Fixed costs could be rent, utilities, wages, depreciation and cost of long term finance. Variable costs, on the other hand, change with sales volume. This means direct product cost, commissions on sales and delivery expenses. Another thing is contribution margin, where we look at the percentage of the sales dollar that goes towards fixed costs and profit. In breakeven analysis, you can also forecast the sales volume required to take care of associated costs.
Maintaining Sales Growth
If sales growth is very rapid, it puts undue pressure on the business’s financial structure, sending leverage ratios to risky levels. Thus, sales growth must be planned since it affects cash in a big way. Sustaining sales growth takes a lot of planning as it means looking at the business’s ability to generate cash without increasing its debt, since this means even more risk. Because of this, the business might incur more interest charges since suppliers and lenders might manage their receivables based on the increased risk. This could place constraints on the inventory, getting in the way of production and merchandizing. The business may also have to sacrifice some margins.
By ensuring that financing is managed properly, risks can be minimized. By maintaining steady and consistent sales growth, you can achieve a balance. This is based on the assumption that the business’s ability to use assets efficiently is constant, along with its efficiency in operations, financing, taxation and net profits. Along with this, the dividend must also be consistent. Thus, steady growth means ensuring that there is no shortage or excess of cash. The business’s cash balance is in proportion to the sales, assets and expenses incurred.
Rapid growth that is outside the sustainable rate will naturally need more cash than when in a steady state. Obviously this extra cash must be generated and this could be sourced from reducing dividends, borrowing more than before, raising net margins by lowering unit costs, raising prices, improving asset efficiency – as all of these are cash generators. Top management in the company must look at fresh options that can increase sales growth in a balanced way. The actual growth rate can be sustained by making sure that everyone in the company extracts the maximum from assets and expense, increasing value simultaneously. This can be attained by understanding cash flow dynamics.