Many Managing Partners get exasperated by their firm’s inability to get away from being cash-strapped, despite seeming to make decent profits, whether annually or month-by-month.
There is a constant worry about paying the salaries and other major commitments, such as rent, rates and VAT, or loans to fund the firm’s working capital, or its overheads, such as PII.
How can it be that a firm making profit finds cashflow a problem and what can you do about it?
There are three basic reasons why this problem occurs.
Firstly, it happens when a firm is growing.
As it grows, it needs more staff and it also has step-changes in its cost base, as it needs to buy ever more sophisticated support, larger accommodation etc. Taking on new fee earners might seem to be the simplest way of making more money. The firm will incur NIC and pension payments and incur ancillary costs, such as IT licences etc. The problem is that the firm must incur those costs before they generate any income – and more importantly, the cash. Cash will be paid out for those costs, and in respect of salary, every month – until they start generating more cash than they cost the firm.
Even when that position is reached, the firm will have several months of deficits to claw back, i.e., when the salary, (plus on-costs), exceeded the fee earner’s cash generated, so the firm will be out of pocket for a while. If this is not clear, hopefully the table below will help.
We are going to employ a fee earner who:
- Is paid £40,000 p.a. but costs another 20% of that in on-costs, (NIC, pension etc)
- Has secretarial assistance costing £20,000 p.a.,(also plus 20% on-costs)
- Eventually bills £10,000 p.m. but takes six months to reach that level
- Doesn’t bill the work immediately or collect the cash straight away either: but takes three months to do so, (quite optimistic, in truth).
In this scenario, cash builds up, as shown in the blue line. The first month that this fee earner makes a positive contribution is Month 7, when the income exceeds the cash outflow by £1,000, (in white).
But at that point the firm is already out of pocket by £34,000, (the bottom line under Month 6). It takes us right through to Month 15 before the firm is cash neutral, (Bottom line of Month 15), from employing this fee earner, and – mercifully – in Month 16 they start to make a positive contribution of £4,333.
The firm has to fund that £34,000 and that is why growing firms need more cash and why growing firms can be short of cash.
That is why it is crucial to get fee earners working effectively early on and why we must recruit when there is plenty of work for them to do.
The second major reason profitable firms can struggle to be cash rich, is that their financial structure is wrong.
This is too big an area to explore in detail now: but broadly the firm’s finance, (whether from equity or borrowing), should match the time-frame over which that borrowing will be needed.
A classic situation when this goes wrong is when the firm runs on overdraft all year round and perhaps year after year. That tells us that some of the overdraft ought to be replaced with equity or perhaps some longer-term borrowing. Then the overdraft will only relate to the short-term funding needs. The longer-term funding will be met by that equity or term borrowing.
Why is this a problem? Overdrafts are repayable on demand, so the firm can get caught-out if the bank decides it no longer wants to provide that level of borrowing. In any event, this firm may well be running up to its limit too often and the payment of salaries or partners drawings may well be in jeopardy because there is little margin for error.
Part of financial structure is having the best possible financial management disciplines. This means billing work early and collecting cash as soon as it is billed. The maximum financial exposure in the table above would only be £17,000, and the firm would be cash positive in Month 9, instead of Month 16, as above.
The third main reason is that the firm does not know how it stands financially and makes decisions that jeopardise itself, financially. Typically continuing to live beyond its means.
For example, it may not have good management information, which tells the owners and managers through the year, how well it is doing in terms of profit and in cashflow. It needs good and accurate management accounts and a cashflow projection.
If a firm does not have the right information, it may well, for example, continue to pay owners their profit shares, even though the firm has not been earning enough to justify those amounts. Eventually, that behaviour will lead to a shortfall of cash to pay the routine bills, such as salaries.
If your firm is earning £50,000 p.m. but are paying equity drawings at the rate of £75,000 p.m., the firm is going to have paid out £300,000 more cash than it has earned by the end of the accounting year.
Similarly, it may have a number of loan commitments, both long-term and short-term, which have to be paid away out of profits. If those profits are paid to equity, at some point, there will be insufficient cash to pay the loans.
A cashflow projection will show you if there could be a problem and if you have good management information, you can plan ahead to deal with potential pinch points, such as VAT quarter payments.
Even the smallest firm needs to have these basic disciplines in place. It is a comfort to the bank manager, when the firm has these available and that they can review them to check that their client will remain solvent. Furthermore, they become documents to help identify where changes need to be made within in the business, such as matching staffing levels to long-term work patterns and cutting unnecessary expenditure.
Read more from this series…
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