I was having a conversation with the CEO of a successful business the other day.  The business turns over around $25 Million and has a solid profit margin.  He asked me “But where’s the cash?  It doesn’t seem to be in our bank account!!”

Sound like a familiar problem?  It certainly is and I see it a lot.

So I took a look at the company balance sheet and it didnt take long to find out the problem and answer his question.

I calculated that the Working Capital % (WC%) was about 7%.  Working Capital represents what the company has available to run the business in terms of liquid assets like cash.  From that creditors and employees get paid – all the stuff to run the business.  So on $25 Million the working capital is about $1.75 Million.  Simplistically that means the business needs $1.75 million in the bank account (without other funding sources) to keep the business comfortably running on a month to month basis.

So then I looked at the two main items – Accounts Receivable (AR) and Accounts Payable (AP).  The AR was about $3 Million and the AP about $0.5 Million, a difference of $2.5 Million.  I won’t bore you with the details, but in this business this $2.5 Million is pretty much the working capital.  So that’s a healthy margin right?  We need $1.75 Million and we have $2.5 Million. Yes it is, but the thing about AR is that it represents invoices sent to the customer but NOT PAID.  It is money yet to be received.  AP represents invoices received from suppliers and NOT PAID yet.  It is money yet to be paid.

So what does this mean?  The business is profitable and healthy, but the cash isn’t in the company’s bank account, it is in their client’s bank account!  So how do we fix that?  Well it will be the subject of another post but suffice to say I’ve told that CEO what he needs to do and it basically involves getting his clients to pay faster and not being quite so keen to pay the people he owes quite so quickly (that’s delicate so be careful!).

This problem is pretty common.  There is a saying that goes something like “Revenue is vanity, Profit is sanity, Cash is reality”.  The power of the Balance Sheet is that it can quickly and easily tell you which one of vanity, sanity or reality your business is exhibiting.  Think of it as a mirror reflecting your business performance.

See you again next time.