San Francisco, CA (PRWEB) May 27, 2014
Owning a small business is a little like having your first child. There is no instruction manual on what to do, much of the success comes from one's own instincts and there is no shortage of people who will give advice – some good and some bad.
Business owners frequently ask, “What is the most important single measure of business success that should be measured?” The answer, of course, is that it depends on several factors including the size of the company, the product and/or service, the industry, capital structure and borrowing capacity and the end goal.
However, for most business owners, the measure of the amount of cash that is left at the end of the day is the most critical measure that should be monitored by the CEO. The financial term for the simple concept of “excess” cash, that is cash after all commitments to employees, capital investment and other consumption of cash has been met is Free Cash Flow (FCF). FCF is what is left over to pay investors or and back to the owners.
FCF is generally different from the concept of net income as FCF takes into account the consumption of capital goods and increases required in working capital. It is different from the commonly known measurement of EBITDA (Earnings before Interest, Taxes, Depreciation and Amortization). A capital-intensive company can have a very healthy EBITDA but can be headed for bankruptcy in an industry that is capital investment or inventory intensive.
A company's customers might be affecting the amount of FCF just as significantly as cash tied up in inventory. For example a growing company with a 30 day collection period for receivables, a 20 day payment period for purchases and a weekly payroll, will require more and more working capital to finance operations because of the time "gap" created by receivables collection and the need to have more inventory to meet growing customer demands, even though the total profits are increasing. Many fast growing smaller companies, without outside credit to supplement FCF, literally grow into bankruptcy.
If the goal is to sell or merge the company, FCF is a critical component of value. Using the discounted cash flow valuation model, the value of a company is the present value of all future FCF, plus the cash proceeds from its eventual sale. The presumption is that the cash flow is used to pay dividends to the shareholders and that this return to shareholders is an indication of the ultimate value of the business as compared to alternative investments.
Firms with growing FCF are doing something right and enjoying growth in revenue by efficiently managing assets, paying down debt and reducing costs.
Businesses with declining FCF can expect a decline in earnings growth and worse. Companies in this category may have to take on increasing levels of long term debt, seek additional capital or actually make a conscious decision to slow growth.
But there are other less drastic ways for small businesses to increase cash flow and FCF:
1. Negotiate trade credits with suppliers: A discount from suppliers of only 1% (if you pay bills in 10 days, due in 20 days), will create an annual effective rate of return of 44.32%, far better than from money in the bank.
2. Reduce inventory levels: There are basically two types of inventory – inventory that sells and inventory that does not. Consider stocking fast moving inventory only and off loading custom inventory responsibility to suppliers to drop ship directly to the customer. Unsold and slow moving inventory frequently is the ‘bottomless pit” of a business.
3. Collect on invoices that are past due: There are no “bad” customers. Bad customers go out of business; slow paying customers are effectively using the company to fund their own operations. Only write-off customer billings as a last resort. Dedicate efforts to collecting old billings, negotiate a compromise or payment plan or turn the account over to a collection agency if all else fails.
4. Consider new ways to finance the business: Many companies self-finance growth through FCF however, outside debt for short term needs can be an effective method of financing growth. Many relatively low cost capital sources are available to private companies including Asset Based Lending, SBA loans, receivables financing, sale/leaseback, lines of credit, fixed term debt, and emerging crowdsourcing financing. But long-term financing can negatively affect value and FCF unless it finances profitable growth.
5. Expand revenue through new growth strategies focused on higher margin products:
o Core Strategy – a basic strategy is to expand the core product offering either geographically or to new customers and markets.
o Adjacency Strategy – are there “adjacent” areas around the company’s core products or services that are natural extensions of the core?
o Extension Strategy – extensions involve the concept of the “extended enterprise.” Consider reaching beyond natural adjacencies to product or service extensions that might position the company for growth beyond the core business
o New Market Strategy – consider entering new markets through alliances, partnerships, mergers or acquisitions or even franchising your product.
All small businesses want to grow and “going with your own instincts” is often a useful strategy. However, growth that is not balanced by measures such as FCF has led many small businesses down the wrong path.