Dominoes and Cash Flows

Dominoes is a game where you set up a series of pieces so that when one falls, it knocks into the next one, which causes it to fall, and so forth. The effect is stunning as piece after piece falls like a wave rolling over a bunch of grass huts collapsing them.

Cash flows work like dominoes in that when one company gets tight on cash, as they fall over, they hit the next company which may fall over, and on down the line. Perhaps an example would help.

End of year

At the end of the year (fiscal and calendar coincide for my businesses) I try to minimize taxes by spending money on things that are deductible while I can deduct them in that year's taxes. That means I have less cash at that time of year than the rest of the year, but it also means that instead of paying the tax collector half of what's left, I buy some things at effectively half the price I would pay if I waited till the next year (I would have paid the taxes on the money and then had to buy those things anyway). While you could argue that I could deduct them next year, I don't really want to loan the government money a year at a time with no interest. And I run on a cash basis rather than an accrual basis for other reasons.

However, what do you think happens if payments come in late at the start of the new year? Because I spent the available cash in anticipation of the need, I don't have a lot to spare. I try to keep a proper buffer, so that even if payments are a month or so late, I won't run out. But pretty soon, if enough payments don't come in, or if too many contracts get delayed too far, I am screwed!

How businesses fail

Most business failures have a proximate cause of inadequate cash. Now don't take me wrong about this. It is the proximate cause, not the root cause. The root cause is complicated and addressed in many of the other articles I write. But at the end of the day, when you run out of cash, the business has to stop because it cannot pay its bills, debts pile up, and things stop operating. Workers will not usually keep working without pay and in many places it is illegal to not pay them what they earned. Law suits will start to happen, service providers, like Internet and telephone services will shut down, you will not be able to send physical mail or ship packages, and so forth. It gets grim fast.

Of course when someone doesn't pay me, I spend cash, reducing my available cash, and if I start to run out, I cannot pay my bills, and when you don't get paid, you may not be able to pay your bills, and so fall the dominoes. Like a wave over society, the lack of cash flow kills off the weak (those without enough cash reserved for such events), and if things are weak enough, it has major economic effects across the globe. But don't get depressed - yet...

Survival mode

I have ended up in survival mode many times. Every few years, some number of things happen and not enough cash comes in to support the cash I need to spend to keep things going apace. So I reduce spending systematically in advance as I anticipate and predict cash flow problems. I may loan the company money at times (from personal funds which are also finite), buy assets from one company by another (and run them out of the new owning company from then on), spend less (thus reducing my capabilities and the cash flow to other businesses), charge more (at the risk of losing customers), try to get earlier payments scheduled (I use largely prepay contracts at this point, where you pay for services before I perform them), and I try to pay my bills when I get them rather than when they are due (to help others with their cash flow). I sometimes offer discounts or other incentives to close deals sooner and kickstart the cash flow. And sometimes I raise the prices on other accounts to make up for the cash at the risk of losing the clients later on (or in some cases right away).

However, when things get tight, I run in survival mode. My wife is used to survival mode coming up every now and then. We take financial risks to get financial rewards, and as a result, or cash is tied up for a few months every few years. We secured a line of credit when things were doing really well, and as a result, we have a place to go when times get tight, at the risk of losing a lot if they don't get better again - so I try to avoid using that. Many businesses can do the same with their local banker. We cut back on spending in all sorts of ways. We eat out less and eat less expensive (but just as healthy) food (rice is less expensive by the pound than bread). Of course this gets tiresome after a while, so we put different sauces on it. We don't go on vacation trips, but rather do limited staycations. In many business I spend more time selling and less time developing future products and services (which trades future income for current income). I may reduce my pay or stop paying myself for a while. I sometimes reduce hours for consultants working for me. I delay buying things that I am running out of, likely paying more later or ending up spending time getting urgent supplies when I would be doing other things because I didn't act in time. I look at other ways to reduce my costs, make my processes more efficient, and make up for the lost cash flows. And I reduce my trust in those who don't pay me in time, allowing them less "credit" for the future.

Don't wait too long

A really important key to this is knowing how long you have and watching as things tighten. When I taught one of my daughters to drive on the highway, I explained that if you look at the traffic as a mass instead of as a set of individual cars, you can see when the mass of traffic is coming toward you or going away from you. When they are getting closer, you should slow down. When they are getting further away, you might want to speed up. (Safety tip: this assumes we are looking forward... in the rear view mirror it's the other way around.)

It's the same with runway (the amount of time you have before you run out of cash at the current and anticipated burn rate [the rate at which you are consuming cash {the net cash on hand including expenses and income}]). Businesses that want to succeed should keep enough runway so that they can raise additional funds in time to not run out. If you have a 6 month runway under anticipated variations in operations (including plans moving forward), and if it takes 4 months to spin up your funding operations and get additional monies in, then you need not be raising funds and can focus on your business building efforts. But when the time to raise funds approaches the runway, even though you aren't yet running out, it's time to hit the accelerator on funding and start generating more funds.

The big mistakes

The big mistake too many companies make is that they don't try to raise money until it's too late. Then, as the dominoes fall, they get knocked over, and along the way, may take others with them. It's like getting a loan from the bank. You can't get one when you need one, because then you are too big a risk to loan to. You need to get the line of credit before you need to spend the money so it will be there when you need it. Otherwise, it will take too long to get it, you will run out of money, and even in survival mode, you will eventually fall over.

There are tradeoffs involved in making cash flow decisions. I have seen too many executives decide to preserve short-term cash at the expense of longer term cash. Here are two examples where an executive cut off their nose in an attempt to save face. (OK - so my choice of words isn't quite right - but it sounded good to me at the time.) In both cases, they stopped spending money to make money deciding to "save money" and improve cash flow.

In summary

Cash flows are like dominoes. Don't be so easily knocked down. Self-inflicted wounds by the failure to look ahead and understand cash flow can be devastating, not only to a single entity, but to downstream entities, causing a domino effect that may go out of control. It can even come back to damage the originator.

Copyright(c) Fred Cohen, 2017 - All Rights Reserved