How to grow your business and have cash available to pay dividends

So, you have passed the embryotic phase of your business, you have entered the stage of growing the business and you want to control the company’s cash flows, to ensure its further growth and the capacity to pay dividends. In this article you will find a short but thorough guide on how to use different parameters and alternative scenarios into deciding the business plan and its implications on the company’s cash position.

Where do we start our game plan?

To move forward you must have a clear picture of the past. You must gather and study data regarding all aspects of the business. These should include items such as

·????????Sales

·????????Inventory and gross margin

·????????Payroll

·????????Operating expenses

·????????Interest

·????????Depreciation

·????????Receivables

·????????Payables

·????????Long term debt

·????????Required investments in fixed assets

Ideally you should be able to study the historic data for the previous two years. If you have data for the year prior to COVID-19, then it would be most helpful.

Budgeting sales

It all starts with sales. If you do not have sales, you do not have business. Looking back at past sales data you will find the products and services that sell more. You will have to go deep into analyzing what item is selling at what price and to whom.

Now you must work on the budget figures. What is the target level of sales for the coming year? How much growth can you target? Having set the sales growth target level, now is the time to work on a per item, per client and per month basis.

Having set the main sales targets, you can work backwards and try to work on the inventory. How much inventory is required to meet the sales? How much is required to be able to deliver within the required timeframe? If you cannot deliver on time, then you might end losing sales.

Coming to prices now, what is the expected purchase price for raw materials and merchandises? What are the expected transportation and storage costs? These are extremely critical as they determine the expected gross margin. Gross margin is the first level of profitability and is key for the company’s overall profitability, both as a percentage of sales as well as an absolute number.

Budgeting for profitability

The next item to analyze is payroll cost. You must have an analysis per employee per month and you must include all relevant costs. These would include gross salaries, social contributions, employee benefits (at full cost) and provisions for all type of salaries, such as Christmas bonus as well as sales commissions or bonuses.

Having determined the profitability per month, you have a guidance for the maximum level of operating expenses that your company can sustain. So, you must study the operating expenses of previous years and understand the key drivers. There are inelastic expenses, such as rent expense that do not deviate, promptly paid, and occur even if there are no sales. On the other hand, there are elastic expenses that deviate along with sales, such as transport of sales expenses.

We have reached the second level of the company’s profitability which is earnings before interest, depreciation and tax, or EBITDA. Many analysts review EBITDA, usually as a percentage of sales, to value the operating performance of the management. The higher EBITDA (as % of sales), the higher the management’s effectiveness.

A company with a high EBITDA (% sales) would imply that the management has a well-controlled pricing policy, also considering the associated production costs, thus maintaining the gross margin above a minimum level. Moreover, the management is controlling the operating expenses at a level that suffice to keep the company growing, without hurting its profitability.

?Next comes the projections related to the capital structure and the financing of the company. The higher the company’s debt, the higher the interest expense. Also, the higher the investments in fixed assets, such as machinery, tools, and other equipment, the higher the depreciation expenses. Deducting interest expense and depreciation expenses from EBITDA we end up to earnings before taxes.

The next expense item is income tax, which we calculate with the following formula applicable tax rate times the difference of taxable sales minus taxable expenses. Not all expenses meet the criteria set by income tax legislation to deduct the revenues and reduce the tax base. So, to calculate this amount you would need to make the necessary tax adjustments in calculating the taxable income (tax base). Deducting the tax expense, we end up to after tax earnings. Net earnings lead to the amount that the management will either reinvest in the company, in the form of retained earnings, or pay dividends to the shareholders.

Let us examine the case of industrial equipment company (B2B space), with 60 K E equity and zero debt financing, trying to move from startup phase into growth phase.

?

For budget 2023 (B2023) the main parameters are:

B2023

Sales 358.000

Margin 125.300

?Total Payroll 52.500

Total OPEX 40.820

EBITDA 31.980

Fixed assets 18.000

Depreciation 3.067

Interest 0

Taxes -6.361

Net Earnings 22.552

?So, under such a scenario the company is profitable. However, due to thin net margin, the management must be overly cautious in managing the expenses. Another interesting observation is the amount of net earnings, which amounts to 22.552 E or 38% return on equity.

Including the time parameter

Time is the next vital parameter that we must consider. How much time do you have to pay company’s liabilities? How much credit the suppliers offer? How often do you pay income tax or social security? How often do you pay debt installments?

On the other hand, what are the credit terms offered to the customers? It is critical to understand that the more time the company offers to its clients, the less cash is available and the higher the risk of not collecting.

Regarding the time parameters, let us suppose that the main assumptions for 2023 are the following:

Item Days

Receivables (sales terms) 60

? Liabilities

? Long term debt

? Public entities 30

Suppliers 90

Debtors 60

Income tax liabilites 30

Furthermore, let us suppose that due to a substantial risk in supply chain, the management decides that it needs to keep as minimum inventory twice the months’ sale to minimize the inventory risk.

Given the above parameters, this is how the cash flow depicts:

In month 3 the company collects the sales of the first month, so cash increases. However, on month 4 the company must pay the suppliers for the purchases of the first month decreasing drastically the cash flow. Due to extremely thin profitability margins, the cash flow is not increasing. There are four main challenges that management must deal with.

The first one is the low margin of error. If the management underestimates costs of goods sold, or if unexpected operating expenses occur, then this would hurt significantly both the profitability as well as the cash flow of the company.

The second one is the financing of the growth of the company. To produce more sales the company needs more inventory, hence more purchases. More purchases lead to higher liabilities to supplies, thus higher payments and more cash requirements. Moreover, in most cases, higher operating expenses might occur, as for instance more inventory required additional storage space, thus higher rent expense. With a low cash flow, the company has not enough cash available to self finance the growth.

Another challenge is the investment in research and development in new products and innovative technologies. This would require a significant amount of cash, both in fixed assets as well as in intangible assets. The operations of the company, as currently organized, do not produce sufficient cash reserves to finance the function of research and development.

Finally, is the challenge of paying dividends. According to the profitability of the company, the net earnings are more than 22 K E. In theory, this amount is available for shareholders if they decide to distribute dividends. However, if we look closer at the available cash, which is less than 10 K E, then it is evident that this cannot happen.

Overcoming the challenge with a new mindset

How can we overcome this challenge? Let us take as an example the same company with a couple of variations.

Firstly, lets focus on the effectiveness of the management. Having set alternatives sources and alternative transportation routes, the company does not need to tight capital in inventory for twice the monthly sales, but only 1,5 times instead. This reduces both the inventory, as well as the purchases from suppliers. Less inventory means more cash available, less purchases lead to less liabilities to pay soon, thus more cash flow.

The second parameter is to focus on operating expenses. Given the circumstances, the management goes through again the operating expenses, examining every line. So, it manages to decrease all operating expenses, at least the elastic ones, down to the level that each month the company at least breaks even. So, every month creates a positive net income outcome, even slightly. It is extremely important is that the company does not create losses, having all months profitable.

Next the management focuses on its relationships with its customers. It takes two critical decisions. The first one is to decrease the credit terms from 60 days to 30 days. The clients will not be happy about this; thus, the company will have to strive even more to nurture the relationships and manage to grow them. This will put more pressure to the sales team, but this is healthy process.

The last parameter that management changes is the monthly sales target. the company rearranges the sales so that evert month sales suffice to cover expenses. So better planning, more effort in growing the company.

Putting the numbers together

Running again the numbers throughout the profit and loss statement we see that the profitability is increasing from 6% to 7% of sales. So, the impact of these changes to profit is not significant.

B2023

Sales 363.000

Gross Margin 127.050

? Total Payroll 52.500

Total OPEX 38.960

EBITDA 35.590

Fixed assets 18.000

Depciation 3.067

Interest 0

Taxes -7.155

Net Earnings 25.368

Now let us see the outcome of these changes on cash flow.

Now, the company has about 40 K E in cash reserves. It is in position to pay dividends, thus rewarding the shareholders for their trust in the management’s abilities. Furthermore, there is space in purchasing more inventory, hence creating the necessary structure for growth.

This is an excellent example highlighting that there is a way to drastically affect cash flow without analogous changes in profitability and without changing the financing of the company, without requiring more equity or adding more debt. The main change is the shift in mindset onto focusing on operational excellence and nurturing the customer relations.

Concluding remarks

We need to transform a profitable but cash struggling business into a cash machine, meeting its liabilities on time, and rewarding its shareholders for their investment. We followed two main avenues in achieving this.

The first one is to increase the efficiency of operations. Gradually applying just in time principle in inventory management leads to decreasing cash outlays while increasing cash balance. On the same time, as the management examines the operating expenses, decreasing or eliminating elastic expenses for the months with low or negative net earnings.

The second one is to work closely with client relationships. The first step is to decrease sales credit terms from 60 days to 30 days. This increases cash balances while decreasing receivables along with credit risk. Furthermore, management sets higher sales targets for the months that the company does not break even or has low net earnings.

The overall impact on cash flow is tremendous. Without adding equity or debt financing, the company produces necessary cash flow for growth and to pay out dividends.

Is your company’s level of cash flow sufficient to pay dividends and finance growth?