Thriving Where Cash is King

“Revenue is vanity, margin is sanity and cash is king.”  The saying is old, but its truth has surely been re-proven during the past 18 months.  Liquidity and cash flow are the financial grease that keeps companies working, and the recent past has provided a crash course in what happens when the grease is in short supply.

For thousands of years, civilizations used the barter system to exchange goods and services (e.g. one pig equaled ten bushels of wheat).  However, the barter system had flaws – particularly one known as “The Coincidence of Wants.”  In this scenario one party was not interested in the goods being offered, so no transaction could take place (“Yes, my pig is worth ten bushels of wheat, but I don’t need the wheat”).

Eventually, every civilization or society created a medium of exchange based on “unit accounts” (e.g. cowrie shells in China or silver coins in the ancient Middle East).  The establishment of a “store of value” makes it possible for someone to sell his goods in exchange for these units that have an agreed-upon value.  He could then easily transport these units to purchase other, needed goods.  Thus, the portability and agreed-upon value of a trading unit – basically, the establishment of money – made all business transactions easier.  For centuries, this was the method of business, and it was not until 1971 that the United States moved away from “commodity money” to “fiat money” (i.e. money not backed by the reserve of a commodity, but its value backed by the government and decreed as legal tender).

When an economy contracts and credit becomes tight, a premium is placed on liquidity and the astute management of cash flow (witness the past 18 months). Executives at the best-run businesses understand that free cash flow drives valuation, not assets or reported earnings, and these businesses are managed accordingly.

A key component of free cash flow is the management of working capital.  This is where some of the best businesses shine.  Companies that can minimize the number of Days of Working Capital (DWC) outstanding are the ones that receive higher valuations relative to their peers.  These businesses require less capital and hence the returns on equity are higher.  DWC is calculated as follows:

DWC   = Days Sales Outstanding (Receivables) + Days Sales Outstanding (Inventory) –  Days Sales Outstanding in Payables
Assume that a business is generating $500,000 in annual sales.  If it is able to reduce its DWC from 90 days to 60 it can reduce its cash needs by $41,100 ($500,000/365 * 30).  Alternatively, if a business became sloppy and let its DWC slip to 180, the business would require another $123,000 in working capital.  In times of tight credit, this could cause a business to default on its obligations.

Managing working capital is often easier for companies with large market positions because they can dictate terms, for example Dell, with DWC of approximately minus 23.

Smaller companies with standard products don’t have that luxury.  Focusing on quality, reliability, and service all help, but small businesses need to go a step further.  They need to make it personal.  In difficult times, when a customer is deciding which supplier to pay first (all other factors being equal) it will usually be that supplier with whom they have the best relationship.  Here is where numbers are not as important as human connections.  For example, knowing the owner of a small business recently became a father for the first time; have you inquired about the health of the baby and mother?  Do you know their names?  When that business owner is deciding which bills to pay first, those human touches make a difference.
Other ways to improve DWC might be culling out “deadbeat customers” to improve accounts receivables, investing in technology to improve inventory management, finding suppliers that have short lead times or negotiating better terms on payables.
Operating a business is a balancing act with pressures from all angles, often intensified for small businesses.  However, by focusing on the key drivers of free cash flow and the priceless intangible of human connectivity, one can always get the best terms to trade for a pig, wheat or maybe even some rum.