Business Cash flow – Is your cash spending too much time locked up?

Sufficient cash flow is absolutely vital for business growth. In fact, it’s cash flow and not profit that’s the true measure of the health of your business. Profit is the destination of a business, cash flow is the fuel that drives us there. And sadly, many businesses owners run out of fuel on the way to their destination. An important reason for this is because much of the cash in your business remains inaccessible due to a concept called a “lock up period”. Cash stuck in “lock up” for a long time limits business growth, because there is limited free cash for day-to-day activities, let alone for reinvestment or expansion.

Q: So, what’s a lock-up period exactly?

A:The amount of time capital is tied up in a business before it’s turned into cash.

Let’s see how this concept works in a real business.

Meet Larry

Larry owns a successful architectural firm. The firm turns over $3m per year and has a client base of 75% property developers and 25% mum and dad residential.

Larry is worried, because while his work is busy and constant, he’s struggling to pay week-to-week expenses and there is little cash in the bank. A closer look at his real-time (up-to-date financial data) numbers reveals the following:

Accounts receivable(money owed to the firm) is $520k

Accounts payable (money the firm needs to pay) is$150k

Work in progress is $350k.

These real-time numbers show us there’s $720k currently in lock-up (520 – 150 + 350).

We can also see that cash is locked up for an average of 87 days ($720k / $3m turnover) x 365 days.

This means for Larry, it takes (on average) 87 days fromsigning on a new job to being paid for it. This is too long as we can see by Larry’s day-to-day struggle with cashflow.

How could Larry reduce his lock-up period?

Most accountants and business gurus will make suggestions to reduce lock-up periods like:

• Collect receivables quicker or stretch accounts payables
• Negotiate with your suppliers
• Consider an overdraft
• Build up your cash reserves to cover interim expenses

While these points all have merit, the problem is that they are all external influencesand thus, hard for the business owner toeasily control. As an example, Larry could try collecting receivables faster but if his clients are used to 45-60 days terms he will find this difficult to do.

Instead, Larry could tryaltering his offerings. He could createservices where payment is assuredvia a monthly direct debit system.

Remember Larry’s client base? 75% are property developers and 25% are mum and dad homes. Larry is constantly providing additional services for his property developer clientsafter the original drawing stage. These services include site visits, feasibility studies for potential development sites, council meetings,organisation of other consultants (engineers/surveyors/flood consultants) and more.

Larry’s fees for these continual value-add services are currently charged each time he does a job, meaning his cash must go through the “lock-up” process to be paid, via accounts receivable.

What if Larry were to offer a monthly subscription fee to his developer clients for the ongoingvalue add work?He would then charge one fee for drawing plans (this forms part of the lock-up) and a second, pre-set, monthly fee for the value add work (this is paid via direct debit).

There are many advantages, and by far the most obvious is:

• Cashflow improves

But also:

• Accounts receivables are indirectly reduced. A monthly direct debit fee doesn’t form part of accounts receivable
• Lock up days are reduced
• Larry spends less time working on the external influences of reducing “lock-up” over which he has limited control

The above is just one example of aninternal measure Larry can undertake to improve his cashflow.There are so many others (we’ll save them for another article).

The main point is, when business owners focus on internal (controllable) measures to improve cashflow, the results are far better than when they focus on external (less controllable) measures.

Does this mean we ignore the external influences? Of course not, but shifting focus to internal measures will have the added benefit of reducing the amount of time spent managingthe external factors.

Trending lock-up periods

As we’ve seen with Larry, reducing the lock-up period is agreat way to improve business cashflow. Nonetheless, tracking lock-up periods is equally as important as improving them. Business owners should review their lock-up periods once a month (at a minimum) to gauge how their cashflow is tracking.

Gauging the lock-up period allows business owners to better forecast for future expenses and future investment in business growth.

We understand improving and trending lock-upare not always as simple as we’ve made it in this article,but that’s where we come in.

At Pallium, we’re all about Shaping Successful Businesses. We provide you with real-time numbers and help you use these numbers to measure what matters, make smarter business decisions and accelerate cash flow. The result is a successful, cashed-up business, and most importantly…time for your family. Visit us at https://pallium.com.au/