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Predict and Control Cash Flow

Particularly in the wholesale sector of the petroleum industry, predicting and controlling cash flow is paramount to business success. Yet often, very little time is spent performing these vital functions. If you want to get off the cash flow roller coaster at your company, take these steps.

1) Forecast your future accounts receivable amounts.  The widest swings in wholesaler cash flow normally occur due to fluctuations in the amounts of accounts receivable. First check your typical Days Sales Outstanding (DSO) each month for the last year. The calculation for DSO is the total accounts receivable balance on any day divided by one day’s average sales. There are five possibilities for your DSO trends:

  • Steady
  • Declining days (good!)
  • Increasing days (bad!)
  • Cyclical or seasonal trends
  • No pattern

If your DSO are steady (within one or two days each month throughout the year), this makes forecasting easy. With steady DSO, your receivables are a direct reflection of your sales revenue. When sales are up, receivables will be up. This will be the time your cash flow will be stressed.

For example, if you find a steady DSO of 20 days, and your revenue is going to increase from $1,200,000 per month ($40,000 per day) to $1,500,000 per month ($50,000 per day), your receivables will increase by the daily increase ($50,000 – $40,000 = $10,000) times the average days to collect (20 days) or $200,000. Essentially, you have just predicted you will have a $200,000 cash need which means if you don’t have the cash, then you’ll need to find it.

If you have declining DSO, let’s use this same example of a sales increase, but assume that your DSO will continue to improve and be only 19 days. At $40,000 sales per day and 20 days collection time, you were carrying $800,000 of receivables. At $50,000 per day and 19 only days collection time, your receivables will be $950,000. Therefore, your cash need will be $950,000 minus $800,000 or only $150,000.

Conversely, if DSO are increasing and based upon your trends you predict DSO at 22 days, your new receivables will be $1,100,000. The slower collection time coupled with the new revenue will mean a cash need of $300,000! Notice the enormous difference in cash need based upon how you handle your receivables.

If you can trim one day off your current collection time, you only need $150,000 cash for the new revenues. If you let your receivables slip by two days, suddenly your cash need doubles to $300,000! (Now you know why we emphasize receivables so much at Meridian.)

If your DSO pattern is cyclical or seasonal, you will need to forecast your receivables month by month to predict cash flow. Ironically, cash will flow (come in) during your slow periods and will be tight during your large revenue cycles.

If there is absolutely no rhyme or reason to your DSO, you probably need to take a hard look. If revenue is steady, but receivables are erratic, it’s probable there is not a stable collection system in place. If so, your best first move to predicting cash flow is to get a reliable, consistent collection procedure in place so you can predict your DSO.

Step Two – Forecast Inventory.   Find your historical Days Supply on Hand (DSH) by dividing inventory by one day’s cost of goods sold. Again, one of the five previously mentioned patterns will emerge.

To predict the dollar amount of cash you will have invested in inventory, multiply your average DSH by your average cost of goods sold for one day.

Now let’s see how growing revenue effects inventory and therefore cash flow.    Using our example of sales forecasted to increase from $40,000 per day to $50,000 per day, and assuming your costs of goods sold average 85% of sales, your daily costs of goods sold would move from $34,000 per day to $42,500 per day. If you normally keep 20 days inventory supply on hand, your inventory would increase from $680,000 to $850,000 or a $170,000 increase.   So now, not only do you need the cash to support your extra receivables, but now you need the extra cash for your inventory!

What happens if your sales increase but you can reduce your inventory down to 18 DSH? Your new inventory would be only $765,000 so your extra cash requirement would be only $85,000.

Conversely, if during your growth you let your inventory slip up to 25 days, your new inventory would be a whopping $1,062,500 producing a cash requirement of $382,500! Ouch!

Step Three – Forecast trade supplier payables. Trade suppliers are the third critical component to forecasting cash flow. Trade suppliers are essentially free sources of cash, however, many suppliers are tightening terms adding to your cash squeeze. Find out your payment trends by calculating your Average Days to Pay (ADP). To determine your ADP, divide your Trade Accounts Payable by one day’s average cost of goods sold.

Now you can calculate what impact trade suppliers will have on your cash as your company grows. Using the same growth as before, let’s assume you pay trade suppliers on average in 18 days. With cost of goods sold of $34,000 per day, you owed trade suppliers $612,000. At $42,500 per day, you’ll owe $765,000. The net increase is $153,000.

Increased accounts payable is a good thing for cash flow! It means that your suppliers are helping by $153,000 to offset the cash drain caused by the increased receivables and inventory! If suppliers tighten terms, however, you could again be cash short.

In summary, by calculating and predicting just these three critical factors, you’ll get a jump on understanding and controlling your cash flow.

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