One of the most difficult obstacles to managing a small business occurs when it grows but a significant chunk of its net growth for a year gets caught up in accounts receivable.
If your business has receivables, have you ever experienced what I’m talking about?
Perhaps without figuring out why?
For instance, let’s say your business grew from $800,000 in sales to $1 million from one year to the next. But let’s say your accounts receivable also grew for the year, by $23,000 from $92,000 to $115,000.
Let’s also say you were counting on most or all of that $23 grand to buy a new truck. Or pay income taxes. Or pay personal bills.
This situation is almost always unwelcome, and is quite often unexpected! And it can be confusing to figure out if you don’t know what’s going on or where to look.
I’ve heard it said more than once from more than one owner… “Well, our numbers say we’re growing and profiting from it, but where’s all my money?”
To which I typically reply: “Some/most/all of it is stuck in receivables.” And you cannot “see” that on your Profit & Loss statement (though it is reflected on a Statement of Cash Flows statement if you know how to interpret it).
The Problem is Found in Your Hidden Costs
To know how to anticipate this problem, first it’s helpful to consider a quick summary of the hidden costs related to running a business.
There are four key hidden costs of running a business that tend to get overlooked in planning because they don’t typically show up on a Profit & Loss statement. They are:
- Cash and Working Capital Changes (including increases in ARs)
- Debt Principal Payments
- Capital Investments
- Owner Income Taxes
What Goes Unnoticed, Goes Un-Planned
When it comes to financial reports, I’ve found small business owners most closely (and often solely) follow their Profit & Loss statement, and sometimes figure on their so-called “bottom line” being what will go to them for distribution.
But this can cause problems for owners because the bottom line amount is typically not entirely available to the owner for distribution. Rather, the four hidden costs noted above must be covered from this amount, and often wind up getting covered with or without the owner realizing these costs must be subtracted from the bottom line before the owner’s take home or profit draw.
Growth in Accounts Receivable
Several years ago, a Wall Street Journal article reported a figure that has stuck in my memory bank - that the average days of outstanding accounts receivable for small businesses was around 42 days’ of sales/revenue. Expressed another way, small businesses have around 11.5% of a full year’s sales in accounts receivable at any given time.
Therefore, as a baseline rule of thumb (not always accurate), for planning purposes businesses with accounts receivables may anticipate that about 11.5% of their annual growth in sales accumulating in accounts receivable (i.e. not flowing through to you for distribution). But, I’ll show you below how to calculate this figure more customized to your business.
Plan Using this Formula
So, the point of this commentary is this… If your business is growing, has accounts receivable and you want to save yourself an unpleasant cash flow shortfall surprise, you should plan ahead using this calculation:
Step 1. Take your Total Accounts Receivable at end of last year: $__________ (e.g. $92,000)
Step 2. Take your Total Annual Revenue from last year: $__________ (e.g. $800,000)
Step 3. Divide the figure in Step 1 (e.g. $92K) by the figure in Step 2 (e.g. $800K) to arrive at % of sales/revenue your business had in Accounts Receivable: _____% (e.g. 11.5%)
Step 4. Multiply the percentage figure in Step 3 by Your Expected Annual Growth in Sales/Revenue for the Year Ahead to arrive at expected A/R growth for year: $______________ (e.g. $200K x .115 = $23K)
The importance of calculating your growth in receivables is that you need to anticipate how much of your net income will effectively get “stuck” there, unavailable to you for cash distribution!
For instance, if you’re planning on growth of $200,000 and your business generally produces around 15% net income margins, you may (incorrectly) assume you’ll have $30,000 more next year than in the year past available to you for owner distribution. And that may be true from an “accrual” accounting perspective.
But if your business “clears” $30,000 more in the year ahead and $23,000 of that winds up in growth in accounts receivable, then your advancement in distributable cash flow is actually only $7,000… and oftentimes even that amount winds up getting used or consumed to cover other hidden costs like owner income taxes or capital investments.
It is for this reason that rapid growth can sometimes be difficult or damaging to owners of small businesses with accounts receivables. And, yes, this reality is counter-intuitive… which is exactly why I recommend you consider this commentary and the calculations noted above when planning how much you, as owner, may or may not benefit for any given year’s growth in sales.
Growth does pay off over time, so long as your receivables continue to regularly get paid. The challenge to keep in mind though is that you, as owner, may not realize its benefits in the form of distributions in years where your business growth is rapid.
Due to the hidden costs of business including accounts receivable growth, sometimes owners of growing businesses don’t experience increases in their distributions until their business growth slows down, plateaus or even turns negative.
Again, yes, this is an oddity. And, yes, this “gets” too many business owners as their business grows… both of which are exactly why you would do well to digest the key points of this commentary and its calculations when planning growth and how much you’ll be able distribute to yourself from your business’ cash flows as it grows.
If you would like help doing so, we’re here to help and encourage you to contact us here.
Long live small business! Long live small business owners!
Jim Smith, Founder, PERFORMIDABLE, LLC